[Title 26 CFR ]
[Code of Federal Regulations (annual edition) - April 1, 2019 Edition]
[From the U.S. Government Publishing Office]



[[Page i]]

          
          
          Title 26

Internal Revenue


________________________

Part 1 (Sec. Sec.  1.851 to 1.907)

                         Revised as of April 1, 2019

          Containing a codification of documents of general 
          applicability and future effect

          As of April 1, 2019
                    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
  Finding Aids:
      Table of CFR Titles and Chapters........................     925
      Alphabetical List of Agencies Appearing in the CFR......     945
      Table of OMB Control Numbers............................     955
      List of CFR Sections Affected...........................     973

[[Page iv]]





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

                     Cite this Code: CFR
                     To cite the regulations in 
                       this volume use title, 
                       part and section number. 
                       Thus, 26 CFR 1.851-1 
                       refers to title 26, part 
                       1, section 851-1.

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

[[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 
together to determine the latest version of any given rule.
    To determine whether a Code volume has been amended since its 
revision date (in this case, April 1, 2019), consult the ``List of CFR 
Sections Affected (LSA),'' which is issued monthly, and the ``Cumulative 
List of Parts Affected,'' which appears in the Reader Aids section of 
the daily Federal Register. These two lists will identify the Federal 
Register page number of the latest amendment of any given rule.

EFFECTIVE AND EXPIRATION DATES

    Each volume of the Code contains amendments published in the Federal 
Register since the last revision of that volume of the Code. Source 
citations for the regulations are referred to by volume number and page 
number of the Federal Register and date of publication. Publication 
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Code a note has been inserted to reflect the future effective date. In 
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inserted following the text.

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 
amendments to existing regulations in the CFR. These OMB numbers are 
placed as close as possible to the applicable recordkeeping or reporting 
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PAST PROVISIONS OF THE CODE

    Provisions of the Code that are no longer in force and effect as of 
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Code users may find the text of provisions in effect on any given date 
in the past by using the appropriate List of CFR Sections Affected 
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Affected'' is published at the end of each CFR volume. For changes to 
the Code prior to the LSA listings at the end of the volume, consult 
previous annual editions of the LSA. For changes to the Code prior to 
2001, consult the List of CFR Sections Affected compilations, published 
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 
``[Reserved]'' location at any time. Occasionally ``[Reserved]'' is used 
editorially to indicate that a portion of the CFR was left vacant and 
not accidentally dropped due to a printing or computer error.

INCORPORATION BY REFERENCE

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This material, like any other properly issued regulation, has the force 
of law.
    What is a proper incorporation by reference? The Director of the 
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 
approval is based are:
    (a) The incorporation will substantially reduce the volume of 
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    (b) The matter incorporated is in fact available to the extent 
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CFR INDEXES AND TABULAR GUIDES

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separate volume, revised annually as of January 1, entitled CFR Index 
and Finding Aids. This volume contains the Parallel Table of Authorities 
and Rules. A list of CFR titles, chapters, subchapters, and parts and an 
alphabetical list of agencies publishing in the CFR are also included in 
this volume.

[[Page vii]]

    An index to the text of ``Title 3--The President'' is carried within 
that volume.
    The Federal Register Index is issued monthly in cumulative form. 
This index is based on a consolidation of the ``Contents'' entries in 
the daily Federal Register.
    A List of CFR Sections Affected (LSA) is published monthly, keyed to 
the revision dates of the 50 CFR titles.

REPUBLICATION OF MATERIAL

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in the Code of Federal Regulations.

INQUIRIES

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the top of odd-numbered pages.
    For inquiries concerning CFR reference assistance, call 202-741-6000 
or write to the Director, Office of the Federal Register, National 
Archives and Records Administration, 8601 Adelphi Road, College Park, MD 
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register.
    The e-CFR is a regularly updated, unofficial editorial compilation 
of CFR material and Federal Register amendments, produced by the Office 
of the Federal Register and the Government Publishing Office. It is 
available at www.ecfr.gov.

    Oliver A. Potts,
    Director,
    Office of the Federal Register
    April 1, 2019.







[[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, 
2019. 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, Gabrielle E. Burns 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.  1.851 to 1.907)

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

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

[[Page 3]]



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




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

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

Supplementary Publication: 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)

    Regulated Investment Companies and Real Estate Investment Trusts

Sec.
1.851-1 Definition of regulated investment company.
1.851-2 Limitations.
1.851-3 Rules applicable to section 851(b)(3).
1.851-4 Determination of status.
1.851-5 Examples.
1.851-6 Investment companies furnishing capital to development 
          corporations.
1.851-7 Certain unit investment trusts.
1.852-1 Taxation of regulated investment companies.
1.852-2 Method of taxation of regulated investment companies.
1.852-3 Investment company taxable income.
1.852-4 Method of taxation of shareholders of regulated investment 
          companies.
1.852-5 Earnings and profits of a regulated investment company.
1.852-6 Records to be kept for purpose of determining whether a 
          corporation claiming to be a regulated investment company is a 
          personal holding company.
1.852-7 Additional information required in returns of shareholders.
1.852-8 Information returns.
1.852-9 Special procedural requirements applicable to designation under 
          section 852(b)(3)(D).
1.852-10 Distributions in redemption of interests in unit investment 
          trusts.
1.852-11 Treatment of certain losses attributable to periods after 
          October 31 of a taxable year.
1.852-12 Non-RIC earnings and profits.
1.853-1 Foreign tax credit allowed to shareholders.
1.853-2 Effect of election.
1.853-3 Notice to shareholders.
1.853-4 Manner of making election.
1.854-1 Limitations applicable to dividends received from regulated 
          investment company.
1.854-2 Notice to shareholders.
1.854-3 Definitions.
1.855-1 Dividends paid by regulated investment company after close of 
          taxable year.

                      Real Estate Investment Trusts

1.856-0 Revenue Act of 1978 amendments not included.
1.856-1 Definition of real estate investment trust.
1.856-2 Limitations.
1.856-3 Definitions.
1.856-4 Rents from real property.
1.856-5 Interest.
1.856-6 Foreclosure property.
1.856-7 Certain corporations, etc., that are considered to meet the 
          gross income requirements.
1.856-8 Revocation or termination of election.
1.856-9 Treatment of certain qualified REIT subsidiaries.
1.857-1 Taxation of real estate investment trusts.
1.857-2 Real estate investment trust taxable income and net capital 
          gain.
1.857-3 Net income from foreclosure property.
1.857-4 Tax imposed by reason of the failure to meet certain source-of-
          income requirements.
1.857-5 Net income and loss from prohibited transactions.
1.857-6 Method of taxation of shareholders of real estate investment 
          trusts.
1.857-7 Earnings and profits of a real estate investment trust.
1.857-8 Records to be kept by a real estate investment trust.
1.857-9 Information required in returns of shareholders.
1.857-10 Information returns.
1.857-11 Non-REIT earnings and profits.
1.858-1 Dividends paid by a real estate investment trust after close of 
          taxable year.
1.860-1 Deficiency dividends.
1.860-2 Requirements for deficiency dividends.
1.860-3 Interest and additions to tax.
1.860-4 Claim for credit or refund.
1.860-5 Effective date.
1.860A-0 Outline of REMIC provisions.
1.860A-1 Effective dates and transition rules.
1.860C-1 Taxation of holders of residual interests.
1.860C-2 Determination of REMIC taxable income or net loss.
1.860D-1 Definition of a REMIC.
1.860E-1 Treatment of taxable income of a residual interest holder in 
          excess of daily accruals.
1.860E-2 Tax on transfers of residual interests to certain 
          organizations.
1.860F-1 Qualified liquidations.
1.860F-2 Transfers to a REMIC.
1.860F-4 REMIC reporting requirements and other administrative rules.
1.860G-1 Definition of regular and residual interests.
1.860G-2 Other rules.
1.860G-3 Treatment of foreign persons.

[[Page 6]]

  TAX BASED ON INCOME FROM SOURCES WITHIN OR WITHOUT THE UNITED STATES

                   Determination of Sources of Income

1.861-1 Income from sources within the United States.
1.861-2 Interest.
1.861-3 Dividends.
1.861-4 Compensation for labor or personal services.
1.861-5 Rentals and royalties.
1.861-6 Sale of real property.
1.861-7 Sale of personal property.
1.861-8 Computation of taxable income from sources within the United 
          States and from other sources and activities.
1.861-8T Computation of taxable income from sources within the United 
          States and from other sources and activities (temporary).
1.861-9 Allocation and apportionment of interest expense.
1.861-9T Allocation and apportionment of interest expense (temporary).
1.861-10 Special allocations of interest expense.
1.861-10T Special allocations of interest expense (temporary).
1.861-11 Special rules for allocating and apportioning interest expense 
          of an affiliated group of corporations.
1.861-11T Special rules for allocating and apportioning interest expense 
          of an affiliated group of corporations (temporary).
1.861-12 Characterization rules and adjustments for certain assets.
1.861-12T Characterization rules and adjustments for certain assets 
          (temporary).
1.861-13T Transition rules for interest expenses (temporary 
          regulations).
1.861-14 Special rules for allocating and apportioning certain expenses 
          (other than interest expense) of an affiliated group of 
          corporations.
1.861-14T Special rules for allocating and apportioning certain expenses 
          (other than interest expense) of an affiliated group of 
          corporations (temporary regulations).
1.861-15 Income from certain aircraft or vessels first leased on or 
          before December 28, 1980.
1.861-16 Income from certain craft first leased after December 28, 1980.
1.861-17 Allocation and apportionment of research and experimental 
          expenditures.
1.861-18 Classification of transactions involving computer programs.
1.862-1 Income specifically from sources without the United States.
1.863-0 Table of contents.
1.863-1 Allocation of gross income under section 863(a).
1.863-2 Allocation and apportionment of taxable income.
1.863-3 Allocation and apportionment of income from certain sales of 
          inventory.

   Regulations Applicable to Taxable Years Prior to December 30, 1996

1.863-3A Income from the sale of personal property derived partly from 
          within and partly from without the United States.
1.863-3AT Income from the sale of personal property derived partly from 
          within and partly from without the United States (temporary 
          regulations).
1.863-4 Certain transportation services.
1.863-6 Income from sources within a foreign country.
1.863-7 Allocation of income attributable to certain notional principal 
          contracts under section 863(a).
1.863-8 Source of income derived from space and ocean activity under 
          section 863(d).
1.863-9 Source of income derived from communications activity under 
          section 863(a), (d), and (e).
1.863-10 Source of income from a qualified fails charge.
1.864-1 Meaning of sale, etc.
1.864-2 Trade or business within the United States.
1.864-3 Rules for determining income effectively connected with U.S. 
          business of nonresident aliens or foreign corporations.
1.864-4 U.S. source income effectively connected with U.S. business.
1.864-5 Foreign source income effectively connected with U.S. business.
1.864-6 Income, gain, or loss attributable to an office or other fixed 
          place of business in the United States.
1.864-7 Definition of office or other fixed place of business.
1.864-8T Treatment of related person factoring income (temporary).
1.865-1 Loss with respect to personal property other than stock.
1.865-2 Loss with respect to stock.

               Nonresident Aliens and Foreign Corporations

                      nonresident alien individuals

1.871-1 Classification and manner of taxing alien individuals.
1.871-2 Determining residence of alien individuals.
1.871-3 Residence of alien seamen.
1.871-4 Proof of residence of aliens.
1.871-5 Loss of residence by an alien.
1.871-6 Duty of withholding agent to determine status of alien payees.
1.871-7 Taxation of nonresident alien individuals not engaged in U.S. 
          business.
1.871-8 Taxation of nonresident alien individuals engaged in U.S. 
          business or treated as having effectively connected income.

[[Page 7]]

1.871-9 Nonresident alien students or trainees deemed to be engaged in 
          U.S. business.
1.871-10 Election to treat real property income as effectively connected 
          with U.S. business.
1.871-11 Gains from sale or exchange of patents, copyrights, or similar 
          property.
1.871-12 Determination of tax on treaty income.
1.871-13 Taxation of individuals for taxable year of change of U.S. 
          citizenship or residence.
1.871-14 Rules relating to repeal of tax on interest of nonresident 
          alien individuals and foreign corporations received from 
          certain portfolio debt investments.
1.871-15 Treatment of dividend equivalents.
1.871-15T Treatment of dividend equivalents (temporary).
1.872-1 Gross income of nonresident alien individuals.
1.872-2 Exclusions from gross income of nonresident alien individuals.
1.873-1 Deductions allowed nonresident alien individuals.
1.874-1 Allowance of deductions and credits to nonresident alien 
          individuals.
1.874-1T Allowance of deductions and credits to nonresident alien 
          individuals (temporary).
1.875-1 Partnerships.
1.875-2 Beneficiaries of estates or trusts.
1.876-1 Alien residents of Puerto Rico, Guam, American Samoa, or the 
          Northern Mariana Islands.
1.879-1 Treatment of community income.

                          foreign corporations

1.881-0 Table of contents.
1.881-1 Manner of taxing foreign corporations.
1.881-2 Taxation of foreign corporations not engaged in U.S. business.
1.881-3 Conduit financing arrangements.
1.881-4 Recordkeeping requirements concerning conduit financing 
          arrangements.
1.881-5 Exception for certain possessions corporations.
1.882-0 Table of contents.
1.882-1 Taxation of foreign corporations engaged in U.S. business or of 
          foreign corporations treated as having effectively connected 
          income.
1.882-2 Income of foreign corporations treated as effectively connected 
          with U.S. business.
1.882-3 Gross income of a foreign corporation.
1.882-4 Allowance of deductions and credits to foreign corporations.
1.882-4T Allowance of deductions and credits to foreign corporations 
          (temporary).
1.882-5 Determination of interest deduction.
1.883-0 Outline of major topics.
1.883-1 Exclusion of income from the international operation of ships or 
          aircraft.
1.883-2 Treatment of publicly-traded corporations.
1.883-3 Treatment of controlled foreign corporations.
1.883-4 Qualified shareholder stock ownership test.
1.883-5 Effective/applicability dates.
1.884-0 Overview of regulation provisions for section 884.
1.884-1 Branch profits tax.
1.884-2 Special rules for termination or incorporation of a U.S. trade 
          or business or liquidation or reorganization of a foreign 
          corporation or its domestic subsidiary.
1.884-2T Special rules for termination or incorporation of a U.S. trade 
          or business or liquidation or reorganization of a foreign 
          corporation or its domestic subsidiary (temporary).
1.884-3T Coordination of branch profits tax with second-tier withholding 
          (temporary). [Reserved]
1.884-4 Branch-level interest tax.
1.884-5 Qualified resident.

                        miscellaneous provisions

1.891 Statutory provisions; doubling of rates of tax on citizens and 
          corporations of certain foreign countries.
1.892-1T Purpose and scope of regulations (temporary regulations).
1.892-2T Foreign government defined (temporary regulations).
1.892-3 Income of foreign governments.
1.892-3T Income of foreign governments (temporary regulations).
1.892-4T Commercial activities (temporary regulations).
1.892-5 Controlled commercial entity.
1.892-5T Controlled commercial entity (temporary regulations).
1.892-6T Income of international organizations (temporary regulations).
1.892-7T Relationship to other Internal Revenue Code sections (temporary 
          regulations).
1.893-1 Compensation of employees of foreign governments or 
          international organizations.
1.894-1 Income affected by treaty.
1.895-1 Income derived by a foreign central bank of issue, or by Bank 
          for International Settlements, from obligations of the United 
          States or from bank deposits.
1.897-1 Taxation of foreign investment in United States real property 
          interests, definition of terms.
1.897-2 United States real property holding corporations.
1.897-3 Election by foreign corporation to be treated as a domestic 
          corporation under section 897(i).
1.897-4AT Table of contents (temporary).
1.897-5 Corporate distributions.
1.897-5T Corporate distributions (temporary).

[[Page 8]]

1.897-6T Nonrecognition exchanges applicable to corporations, their 
          shareholders, and other taxpayers, and certain transfers of 
          property in corporate reorganizations (temporary).
1.897-7T Treatment of certain partnership interests as entirely U.S. 
          real property interests under sections 897(g) and 1445(e) 
          (temporary).
1.897-8T Status as a U.S. real property holding corporation as a 
          condition for electing section 897(i) pursuant to Sec.  1.897-
          3 (temporary).
1.897-9T Treatment of certain interest in publicly traded corporations, 
          definition of foreign person, and foreign governments and 
          international organizations (temporary).

              Income From Sources Without the United States

                           foreign tax credit

1.901-1 Allowance of credit for taxes.
1.901-2 Income, war profits, or excess profits tax paid or accrued.
1.901-2A Dual capacity taxpayers.
1.901-3 Reduction in amount of foreign taxes on foreign mineral income 
          allowed as a credit.
1.901(m)-1T Definitions (temporary).
1.901(m)-2T Covered asset acquisitions and relevant foreign assets 
          (temporary).
1.901(m)-3T Disqualified tax amount and aggregate basis difference 
          carryover (temporary). [Reserved].
1.901(m)-4T Determination of basis difference (temporary).
1.901(m)-5T Basis difference taken into account (temporary).
1.901(m)-6T Successor rules (temporary).
1.901(m)-7T De minimis rules. [Reserved]
1.901(m)-8T Miscellaneous. [Reserved]
1.902-0 Outline of regulations provisions for section 902.
1.902-1 Credit for domestic corporate shareholder of a foreign 
          corporation for foreign income taxes paid by the foreign 
          corporation.
1.902-2 Treatment of deficits in post-1986 undistributed earnings and 
          pre-1987 accumulated profits of a first- or lower-tier 
          corporation for purposes of computing an amount of foreign 
          taxes deemed paid under Sec.  1.902-1.
1.902-3 Credit for domestic corporate shareholder of a foreign 
          corporation for foreign income taxes paid with respect to 
          accumulated profits of taxable years of the foreign 
          corporation beginning before January 1, 1987.
1.902-4 Rules for distributions attributable to accumulated profits for 
          taxable years in which a first-tier corporation was a less 
          developed country corporation.
1.903-1 Taxes in lieu of income taxes.
1.904-0 Outline of regulation provisions for section 904.
1.904-1 Limitation on credit for foreign taxes.
1.904-2 Carryback and carryover of unused foreign tax.
1.904-3 Carryback and carryover of unused foreign tax by husband and 
          wife.
1.904-4 Separate application of section 904 with respect to certain 
          categories of income.
1.904-5 Look-through rules as applied to controlled foreign corporations 
          and other entities.
1.904-6 Allocation and apportionment of taxes.
1.904-7 Transition rules.
1.904(b)- Outline of regulation provisions.
1.904(b)-1 Special rules for capital gains and losses.
1.904(b)-2 Special rules for application of section 904(b) to 
          alternative minimum tax foreign tax credit.
1.904(f)-1 Overall foreign loss and the overall foreign loss account.
1.904(f)-2 Recapture of overall foreign losses.
1.904(f)-3 Allocation of net operating losses and net capital losses.
1.904(f)-4 Recapture of foreign losses out of accumulation distributions 
          from a foreign trust.
1.904(f)-5 Special rules for recapture of overall foreign losses of a 
          domestic trust.
1.904(f)-6 Transitional rule for recapture of FORI and general 
          limitation overall foreign losses incurred in taxable years 
          beginning before January 1, 1983, from foreign source taxable 
          income subject to the general limitation in taxable years 
          beginning after December 31, 1982.
1.904(f)-7 Separate limitation loss and the separate limitation loss 
          account.
1.904(f)-8 Recapture of separate limitation loss accounts.
1.904(f)-9--1.904(f)-11 [Reserved]
1.904(f)-12 Transition rules.
1.904(g)-0 Outline of regulation provisions.
1.904(g)-1 Overall domestic loss and the overall domestic loss account.
1.904(g)-2 Recapture of overall domestic losses.
1.904(g)-3 Ordering rules for the allocation of net operating losses, 
          net capital losses, U.S. source losses, and separate 
          limitation losses, and for recapture of separate limitation 
          losses, overall foreign losses, and overall domestic losses.
1.904(i)-0 Outline of regulation provisions.
1.904(i)-1 Limitation on use of deconsolidation to avoid foreign tax 
          credit limitations.
1.904(j)-0 Outline of regulation provisions.
1.904(j)-1 Certain individuals exempt from foreign tax credit 
          limitations.
1.905-1 When credit for taxes may be taken.
1.905-2 Conditions of allowance of credit.

[[Page 9]]

1.905-3T Adjustments to the pools of foreign taxes and earnings and 
          profits when the allowable foreign tax credit changes 
          (temporary).
1.905-4T Notification of foreign tax redetermination (temporary).
1.905-5T Foreign tax redeterminations and currency translation rules for 
          foreign tax redeterminations occurring in taxable years 
          beginning prior to January 1, 1987 (temporary).
1.907-0 Outline of regulation provisions for section 907.
1.907(a)-0 Introduction (for taxable years beginning after December 31, 
          1982).
1.907(a)-1 Reduction in taxes paid on FOGEI (for taxable years beginning 
          after December 31, 1982).
1.907(b)-1 Reduction of creditable FORI taxes (for taxable years 
          beginning after December 31, 1982).
1.907(c)-1 Definitions relating to FOGEI and FORI (for taxable years 
          beginning after December 31, 1982).
1.907(c)-2 Section 907(c)(3) items (for taxable years beginning after 
          December 31, 1982).
1.907(c)-3 FOGEI and FORI taxes (for taxable years beginning after 
          December 31, 1982).
1.907(d)-1 Disregard of posted prices for purposes of chapter 1 of the 
          Code (for taxable years beginning after December 31, 1982).
1.907(e)-1 [Reserved].
1.907(f)-1 Carryback and carryover of credits disallowed by section 
          907(a) (for amounts carried between taxable years that each 
          begin after December 31, 1982).

    Authority: 26 U.S.C. 7805.
    Sections 1.851-3 and 1.851-5 are also issued under 26 U.S.C. 851(c).
    Section 1.852-11 is also issued under 26 U.S.C. 852(b)(3)(C), 
852(b)(8), and 852(c).
    Section 1.853-1 also issued under 26 U.S.C. 901(j).
    Section 1.853-2 also issued under 26 U.S.C. 901(j).
    Section 1.853-3 also issued under 26 U.S.C. 901(j).
    Section 1.853-4 also issued under 26 U.S.C. 901(j) and 26 U.S.C. 
6011.
    Section 1.860A-0 also issued under 26 U.S.C. 860G(e).
    Section 1.860A-1 also issued under 26 U.S.C. 860G(b) and 860G(e).
    Section 1.860D-1 also issued under 26 U.S.C. 860G(e).
    Section 1.860E-1 also issued under 26 U.S.C. 860E and 860G(e).
    Section 1.860E-2 also issued under 26 U.S.C. 860E(e).
    Section 1.860F-2 also issued under 26 U.S.C. 860G(e).
    Section 1.860F-4 also issued under 26 U.S.C. 860G(e) and 26 U.S.C. 
6230(k).
    Section 1.860F-4T also issued under 26 U.S.C. 860G(c)(3) and (e).
    Section 1.860G-1 also issued under 26 U.S.C. 860G(a)(1)(B) and (e).
    Section 1.860G-2 also issued under 26 U.S.C. 860G(e).
    Section 1.860G-3 also issued under 26 U.S.C. 860G(b) and 26 U.S.C. 
860G(e).
    Section 1.861-2 also issued under 26 U.S.C. 863(a).
    Section 1.861-3 also issued under 26 U.S.C. 863(a).
    Section 1.861-8 also issued under 26 U.S.C. 882(c).
    Sections 1.861-9 and 1.861-9T also issued under 26 U.S.C. 863(a), 26 
U.S.C. 864(e), 26 U.S.C. 865(i), and 26 U.S.C 7701(f).
    Section 1.861-10(e) also issued under 26 U.S.C. 863(a), 26 U.S.C. 
864(e), 26 U.S.C. 865(i) and 26 U.S.C. 7701(f).
    Section 1.861-11 also issued under 26 U.S.C. 863(a), 26 U.S.C. 
864(e), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f).
    Section 1.861-14 also issued under 26 U.S.C. 863(a), 26 U.S.C. 
864(e), 26 U.S.C. 865(i), and 26 U.S.C. 7701(f).
    Sections 1.861-8T through 1.861-14T also issued under 26 U.S.C. 
863(a), 26 U.S.C. 864(e), 26 U.S.C. 865(i) and 26 U.S.C. 7701(f).
    Section 1.863-1 also issued under 26 U.S.C. 863(a).
    Section 1.863-2 also issued under 26 U.S.C. 863.
    Section 1.863-3 also issued under 26 U.S.C. 863(a) and (b), and 26 
U.S.C. 936(h).
    Section 1.863-4 also issued under 26 U.S.C. 863.
    Section 1.863-6 also issued under 26 U.S.C. 863.
    Section 1.863-7 also issued under 26 U.S.C. 863(a) and 871(m).
    Section 1.863-8 also issued under 26 U.S.C. 863(a), (b) and (d).
    Section 1.863-9 also issued under 26 U.S.C. 863(a), (d) and (e).
    Section 1.864-5 also issued under 26 U.S.C. 7701(l).
    Section 1.864-8T also issued under 26 U.S.C. 864(d)(8).
    Section 1.865-1 also issued under 26 U.S.C. 863(a) and 865(j)(1).
    Section 1.865-2 also issued under 26 U.S.C. 863(a) and 865(j)(1).
    Section 1.871-1 also issued under 26 U.S.C. 7701(l).
    Section 1.871-7 also issued under 26 U.S.C. 7701(l).
    Section 1.871-9 also issued under 26 U.S.C. 7701(b)(11).
    Sections 1.871-15 and 1.871-15T also issued under 26 U.S.C. 871(m).
    Section 1.874-1 also issued under 26 U.S.C. 874.
    Section 1.881-2 also issued under 26 U.S.C. 7701(l).
    Section 1.881-3 also issued under 26 U.S.C. 7701(l).
    Section 1.881-4 also issued under 26 U.S.C. 7701(l).

[[Page 10]]

    Section 1.882-4 also issued under 26 U.S.C. 882(c).
    Section 1.882-5 also issued under 26 U.S.C. 882, 26 U.S.C. 864(e), 
26 U.S.C. 988(d), and 26 U.S.C. 7701(l).
    Section 1.883-1 is also issued under 26 U.S.C. 883.
    Section 1.883-2 is also issued under 26 U.S.C. 883.
    Section 1.883-3 is also issued under 26 U.S.C. 883.
    Section 1.883-4 is also issued under 26 U.S.C. 883.
    Section 1.883-5 is also issued under 26 U.S.C. 883.
    Section 1.884-0 also issued under 26 U.S.C. 884 (g).
    Section 1.884-1 also issued under 26 U.S.C. 884.
    Section 1.884-1 also issued under 26 U.S.C. 884 (g).
    Section 1.884-1 (d) also issued under 26 U.S.C. 884 (c) (2) (A).
    Section 1.884-1 (d) (13) (i) also issued under 26 U.S.C. 884 (c) 
(2).
    Section 1.884-1 (e) also issued under 26 U.S.C. 884 (c) (2) (B).
    Section 1.884-2 also issued under 26 U.S.C. 884(g).
    Section 1.884-2T also issued under 26 U.S.C. 884 (g).
    Section 1.884-4 also issued under 26 U.S.C. 884 (g).
    Section 1.884-5 also issued under 26 U.S.C. 884 (g).
    Section 1.884-5 (e) and (f) also issued under 26 U.S.C. 884 (e) (4) 
(C).
    Section 1.892-1T also issued under 26 U.S.C. 892(c).
    Section 1.892-2T also issued under 26 U.S.C. 892(c).
    Section 1.892-3T also issued under 26 U.S.C. 892(c).
    Section 1.892-4T also issued under 26 U.S.C. 892(c).
    Section 1.892-5 also issued under 26 U.S.C. 892(c).
    Section 1.892-5T also issued under 26 U.S.C. 892(c).
    Section 1.892-6T also issued under 26 U.S.C. 892(c).
    Section 1.892-7T also issued under 26 U.S.C. 892(c).
    Section 1.894-1 also issued under 26 U.S.C. 894 and 7701(l).
    Sections 1.897-5T, 1.897-6T and 1.897-7T also issued under 26 U.S.C. 
897 (d), (e), (g) and (j) and 26 U.S.C. 367(e)(2).
    Sections 1.901(m)-1T through -8T also issued under 26 U.S.C. 
901(m)(7).
    Section 1.901(m)-5T also issued under 26 U.S.C. 901(m)(3)(B)(ii).
    Sections 1.902-1 and 902-2 also issued under 26 U.S.C. 902(c)(7).
    Section 1.904-4 also issued under 26 U.S.C. 904(d)(6).
    Section 1.904-5 also issued under 26 U.S.C. 904(d)(6).
    Section 1.904-6 also issued under 26 U.S.C. 904(d)(6).
    Section 1.904-7 also issued under 26 U.S.C. 904(d)(6).
    Section 1.904(b)-1 also issued under 26 U.S.C. 1(h)(11)(C)(iv) and 
904(b)(2)(C).
    Section 1.904(b)-2 also issued under 26 U.S.C. 1(h)(11)(C)(iv) and 
904(b)(2)(C).
    Section 1.904(f)-(2) also issued under 26 U.S.C. 904 (f)(3)(b).
    Section 1.904(g)-3T also issued under 26 U.S.C. 904(g)(4).
    Section 1.904(i)-1 also issued under 26 U.S.C. 904(i).
    Sections 1.905-3T and 1.905-4T also issued under 26 U.S.C. 
989(c)(4).
    Section 1.907(b)-1 is also issued under 26 U.S.C. 907(b).
    Section 1.907(b)-1T also issued under 26 U.S.C. 907(b).

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

    REGULATED INVESTMENT COMPANIES AND REAL ESTATE INVESTMENT TRUSTS



Sec.  1.851-1  Definition of regulated investment company.

    (a) In general. The term ``regulated investment company'' is defined 
to mean any domestic corporation (other than a personal holding company 
as defined in section 542) which meets (1) the requirements of section 
851(a) and paragraph (b) of this section, and (2) the limitations of 
section 851(b) and Sec.  1.851-2. As to the definition of the term 
``corporation'', see section 7701(a)(3).
    (b) Requirement. To qualify as a regulated investment company, a 
corporation must be:
    (1) Registered at all times during the taxable year, under the 
Investment Company Act of 1940, as amended (15 U.S.C. 80a-1 to 80b-2), 
either as a management company or a unit investment trust, or
    (2) A common trust fund or similar fund excluded by section 3(c)(3) 
of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)) from the 
definition of ``investment company'' and not included in the definition 
of ``common trust fund'' by section 584(a).

[[Page 11]]



Sec.  1.851-2  Limitations.

    (a) Election to be a regulated investment company. Under the 
provisions of section 851(b)(1), a corporation, even though it satisfies 
the other requirements of part I, subchapter M, chapter 1 of the Code, 
for the taxable year, will not be considered a regulated investment 
company for such year, within the meaning of such part I, unless it 
elects to be a regulated investment company for such taxable year, or 
has made such an election for a previous taxable year which began after 
December 31, 1941. The election shall be made by the taxpayer by 
computing taxable income as a regulated investment company in its return 
for the first taxable year for which the election is applicable. No 
other method of making such election is permitted. An election once made 
is irrevocable for such taxable year and all succeeding taxable years.
    (b) Gross income requirement--(1) General rule. A corporation will 
not be a regulated investment company for a taxable year unless 90 
percent of its gross income for that year is income described in 
paragraph (b)(1)(i) or (ii) of this section. Any loss from the sale or 
other disposition of stock or securities is not taken into account in 
the gross income computation.
    (i) Gross income amounts. Income is described in this paragraph 
(b)(1)(i) if it is gross income derived from:
    (A) Dividends;
    (B) Interest;
    (C) Payments with respect to securities loans (as defined in section 
512(a)(5));
    (D) Gains from the sale or other disposition of stocks or securities 
(as defined in section 2(a)(36) of the Investment Company Act of 1940, 
as amended);
    (E) Gains from the sale or other disposition of foreign currencies; 
or
    (F) Other income (including but not limited to gains from options, 
futures, or forward contracts) derived with respect to a regulated 
investment company's business of investing in such stock, securities, or 
currencies.
    (ii) Income from a publicly traded partnership. Income is described 
in this paragraph (b)(1)(ii) if it is net income derived from an 
interest in a qualified publicly traded partnership (as defined in 
section 851(h)).
    (2) Special rules. (i) For purposes of section 851(b)(2)(A) and 
paragraph (b)(1)(i)(A) of this section, amounts included in gross income 
for the taxable year under section 951(a)(1)(A) or 1293(a) are treated 
as dividends only to the extent that, under section 959(a)(1) or 1293(c) 
(as the case may be), there is a distribution out of the earnings and 
profits of the taxable year that are attributable to the amounts 
included in gross income for the taxable year under section 951(a)(1)(A) 
or 1293(a). For allocation of distributions to earnings and profits of 
foreign corporations, see Sec.  1.959-3.
    (ii) For purposes of subdivision (i) of this subparagraph, if by 
reason of section 959(a)(1) a distribution of a foreign corporation's 
earnings and profits for a taxable year described in section 959(c)(2) 
is not included in a shareholder's gross income, then such distribution 
shall be allocated proportionately between amounts attributable to 
amounts included under each clause of section 951(a)(1)(A). Thus, for 
example, M is a United States shareholder in X Corporation, a controlled 
foreign corporation. M and X each use the calendar year as the taxable 
year. For 1977, M is required by section 951(a)(1)(a) to include $3,000 
in its gross income, $1,000 of which is included under clause (i) 
thereof. In 1977, M received a distribution described in section 
959(c)(2) of $2,700 out of X's earnings and profits for 1977, which is, 
by reason of section 959(a)(1), excluded from M's gross income. The 
amount of the distribution attributable to the amount included under 
section 951(a)(1)(A)(i) is $900, i.e., $2,700 multiplied by ($1,000/
$3,000).
    (iii) If an amount is included in gross income under section 
951(a)(1) or 1293(a) and is derived with respect to a corporation's 
business of investing in stock, securities, or currencies then the 
amount is other income described in section 851(b)(2)(A) and paragraph 
(b)(1)(i)(F) of this section. Notwithstanding paragraph (d) of this 
section, a taxpayer may rely on the rule in this paragraph (b)(2)(iii) 
for taxable years that begin after September 28, 2016.

[[Page 12]]

    (c) Diversification of investments. (1) Subparagraph (A) of section 
851(b)(4) requires that at the close of each quarter of the taxable year 
at least 50 percent of the value of the total assets of the taxpayer 
corporation be represented by one or more of the following:
    (i) Cash and cash items, including receivables;
    (ii) Government securities;
    (iii) Securities of other regulated investment companies; or
    (iv) Securities (other than those described in subdivisions (ii) and 
(iii) of this subparagraph) of any one or more issuers which meet the 
following limitations: (a) The entire amount of the securities of the 
issuer owned by the taxpayer corporation is not greater in value than 5 
percent of the value of the total assets of the taxpayer corporation, 
and (b) the entire amount of the securities of such issuer owned by the 
taxpayer corporation does not represent more than 10 percent of the 
outstanding voting securities of such issuer. For the modification of 
the percentage limitations applicable in the case of certain venture 
capital investment companies, see section 851(e) and Sec.  1.851-6.


Assuming that at least 50 percent of the value of the total assets of 
the corporation satisfies the requirements specified in this 
subparagraph, and that the limiting provisions of subparagraph (B) of 
section 851(b)(4) and subparagraph (2) of this paragraph are not 
violated, the corporation will satisfy the requirements of section 
851(b)(4), notwithstanding that the remaining assets do not satisfy the 
diversification requirements of subparagraph (A) of section 851(b)(4). 
For example, a corporation may own all the stock of another corporation, 
provided it otherwise meets the requirements of subparagraphs (A) and 
(B) of section 851(b)(4).
    (2) Subparagraph (B) of section 851(b)(4) prohibits the investment 
at the close of each quarter of the taxable year of more than 25 percent 
of the value of the total assets of the corporation (including the 50 
percent or more mentioned in subparagraph (A) of section 851(b)(4)) in 
the securities (other than Government securities or the securities of 
other regulated investment companies) of any one issuer, or of two or 
more issuers which the taxpayer company controls and which are engaged 
in the same or similar trades or businesses or related trades or 
businesses, including such issuers as are merely a part of a unit 
contributing to the completion and sale of a product or the rendering of 
a particular service. Two or more issuers are not considered as being in 
the same or similar trades or businesses merely because they are engaged 
in the broad field of manufacturing or of any other general 
classification of industry, but issuers shall be construed to be engaged 
in the same or similar trades or businesses if they are engaged in a 
distinct branch of business, trade, or manufacture in which they render 
the same kind of service or produce or deal in the same kind of product, 
and such service or products fulfill the same economic need. If two or 
more issuers produce more than one product or render more than one type 
of service, then the chief product or service of each shall be the basis 
for determining whether they are in the same trade or business.
    (d) Applicability date. The rules in paragraphs (b)(1) and (b)(2)(i) 
and (iii) of this section apply to taxable years that begin after June 
17, 2019.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6598, 27 FR 
4090, Apr. 28, 1962; T.D. 7555, 43 FR 32753, July 28, 1978; T.D. 9851, 
84 FR 9961, Mar. 19, 2019]



Sec.  1.851-3  Rules applicable to section 851(b)(3).

    (a) In general. In determining the value of the taxpayer's 
investment in the securities of an issuer, for purposes of subparagraph 
(B) of section 851(b)(3), there shall be included its proper proportion 
of the investment of any other corporation, a member of a controlled 
group, in the securities of such issuer. See Example 4 in Sec.  1.851-5. 
For purposes of Sec. Sec.  1.851-2, 1.851-4, 1.851-5, and 1.851-6, the 
terms ``controls,'' ``controlled group,'' and ``value'' have the meaning 
assigned to them by section 851(c). All other terms used in these 
sections have the same meaning as when used in the Investment Company 
Act of 1940 (15 U.S.C., chapter 2D), as amended.

[[Page 13]]

    (b) Effective/applicability dates. The rules of this section apply 
to quarters that begin on or after December 14, 2015. For purposes of 
applying the first sentence of section 851(d)(1) to a quarter that 
begins on or after March 14, 2016, the rules of this section apply in 
determining whether the taxpayer met the requirements of section 
851(b)(3) and (c) at the close of prior quarters.

[T.D. 9737, 80 FR 55245, Sept. 15, 2015]



Sec.  1.851-4  Determination of status.

    With respect to the effect which certain discrepancies between the 
value of its various investments and the requirements of section 
851(b)(4) and paragraph (c) of Sec.  1.851-2, or the effect that the 
elimination of such discrepancies will have on the status of a company 
as a regulated investment company for purposes of part I, subchapter M, 
chapter 1 of the Code, see section 851(d). A company claiming to be a 
regulated investment company shall keep sufficient records as to 
investments so as to be able to show that it has complied with the 
provisions of section 851 during the taxable year. Such records shall be 
kept at all times available for inspection by any internal revenue 
officer or employee and shall be retained so long as the contents 
thereof may become material in the administration of any internal 
revenue law.

[T.D. 6598, 27 FR 4090, Apr. 28, 1962]



Sec.  1.851-5  Examples.

    (a) Examples. The provisions of section 851 may be illustrated by 
the following examples:

    Example 1. (i) Investment Company W at the close of its first 
quarter of its taxable year has its assets invested as follows:

------------------------------------------------------------------------
                                                                Percent
------------------------------------------------------------------------
Cash.........................................................          5
Government securities........................................         10
Securities of regulated investment companies.................         20
Securities of Corporation A..................................         10
Securities of Corporation B..................................         15
Securities of Corporation C..................................         20
Securities of various corporations (not exceeding 5 percent           20
 of its assets in any one company)...........................
                                                              ----------
  Total......................................................        100
------------------------------------------------------------------------

    (ii) Investment Company W owns all of the voting stock of 
Corporations A and B, 15 percent of the voting stock of Corporation C, 
and less than 10 percent of the voting stock of regulated investment 
companies and various other corporations. Neither Corporation A nor 
Corporation B owns:
    (A) 20 percent or more of the voting stock of any other corporation;
    (B) Securities issued by Corporation C; or
    (C) Securities issued by any of the regulated investment companies 
or various corporations whose securities are owned by Investment Company 
W. Except for Corporation A and Corporation B, none of the corporations 
(including the regulated investment companies) is a member of a 
controlled group with Investment Company W.
    (iii) Investment Company W meets the requirements under section 
851(b)(3) at the end of its first quarter. It complies with subparagraph 
(A) of section 851(b)(3) because it has 55 percent of its assets 
invested as provided in that subparagraph. It complies with subparagraph 
(B) of section 851(b)(3) because it does not have more than 25 percent 
of its assets invested in the securities of any one issuer, of two or 
more issuers that it controls, or of one or more qualified publicly 
traded partnerships (as defined in section 851(h)).
    Example 2. (i) Investment Company V at the close of a particular 
quarter of the taxable year has its assets invested as follows:

------------------------------------------------------------------------
                                                                Percent
------------------------------------------------------------------------
Cash.........................................................         10
Government securities........................................         35
Securities of Corporation A..................................          7
Securities of Corporation B..................................         12
Securities of Corporation C..................................         15
Securities of Corporation D..................................         21
                                                              ----------
  Total......................................................        100
------------------------------------------------------------------------

    (ii) Investment Company V fails to meet the requirements of 
subparagraph (A) of section 851(b)(3) since its assets invested in 
Corporations A, B, C, and D exceed in each case 5 percent of the value 
of the total assets of the company at the close of the particular 
quarter.
    Example 3. (i) Investment Company X at the close of a particular 
quarter of the taxable year has its assets invested as follows:

------------------------------------------------------------------------
                                                                Percent
------------------------------------------------------------------------
Cash and Government securities...............................         20
Securities of Corporation A..................................          5
Securities of Corporation B..................................         10
Securities of Corporation C..................................         25
Securities of various corporations (not exceeding 5 percent           40
 of its assets in any one company)...........................
                                                              ----------
  Total......................................................        100
------------------------------------------------------------------------

    (ii) Investment Company X owns more than 20 percent of the voting 
power of Corporations B and C and less than 10 percent of the voting 
power of all of the other corporations. Corporation B manufactures 
radios

[[Page 14]]

and Corporation C acts as its distributor and also distributes radios 
for other companies. Investment Company X fails to meet the requirements 
of subparagraph (B) of section 851(b)(3) since it has 35 percent of its 
assets invested in the securities of two issuers which it controls and 
which are engaged in related trades or businesses.
    Example 4. (i) Investment Company Y at the close of a particular 
quarter of its taxable year has its assets invested as follows:

------------------------------------------------------------------------
                                                                Percent
------------------------------------------------------------------------
Cash and Government securities...............................         15
Securities of Corporation K (a regulated investment company).         30
Securities of Corporation A..................................         10
Securities of Corporation B..................................         20
Securities of various corporations (not exceeding 5 percent           25
 of its assets in any one company)...........................
                                                              ----------
  Total......................................................        100
------------------------------------------------------------------------

    (ii) Corporation K has 20 percent of its assets invested in 
Corporation L, and Corporation L has 40 percent of its assets invested 
in Corporation B. Corporation A also has 30 percent of its assets 
invested in Corporation B. Investment Company Y owns more than 20 
percent of the voting power of Corporations A and K. Corporation K owns 
more than 20 percent of the voting power of Corporation L.
    (iii) At the end of that quarter, Investment Company Y is 
disqualified under subparagraph (B)(i) of section 851(b)(3) because, 
after applying section 851(c)(1), more than 25 percent of the value of 
Investment Company Y's total assets is invested in the securities of 
Corporation B. This result is shown by the following calculation:

------------------------------------------------------------------------
                                                                Percent
------------------------------------------------------------------------
Percentage of assets invested directly in Corporation B......       20.0
Percentage invested indirectly through K and L (30% x 20% x          2.4
 40%)........................................................
Percentage invested indirectly through A (10% x 30%).........        3.0
                                                              ----------
  Total percentage of assets of Investment Company Y invested       25.4
   in Corporation B..........................................
------------------------------------------------------------------------

    Example 5. Investment Company Z, which keeps its books and makes its 
returns on the basis of the calendar year, at the close of the first 
quarter of 2016 meets the requirements of section 851(b)(3) and has 20 
percent of its assets invested in Corporation A. Later during the 
taxable year it makes distributions to its shareholders and because of 
such distributions, it finds at the close of the taxable year that it 
has more than 25 percent of its remaining assets invested in Corporation 
A. Investment Company Z does not lose its status as a regulated 
investment company for the taxable year 2016 because of such 
distributions, nor will it lose its status as a regulated investment 
company for any subsequent year solely as a result of such 
distributions. See section 851(d)(1).
    Example 6. Investment Company Q, which keeps its books and makes its 
returns on the basis of the calendar year, at the close of the first 
quarter of 2016 meets the requirements of section 851(b)(3) and has 20 
percent of its assets invested in Corporation P. At the close of the 
taxable year 2016, it finds that it has more than 25 percent of its 
assets invested in Corporation P. This situation results entirely from 
fluctuations in the market values of the securities in Investment 
Company Q's portfolio and is not due in whole or in part to the 
acquisition of any security or other property. Investment Company Q does 
not lose its status as a regulated investment company for the taxable 
year 2016 because of such fluctuations in the market values of the 
securities in its portfolio, nor will it lose its status as a regulated 
investment company for any subsequent year solely as a result of such 
market value fluctuations. See section 851(d)(1).
    Example 7. (i) Investment Company T at the close of a particular 
quarter of its taxable year has its assets invested as follows:

------------------------------------------------------------------------
                                                                Percent
------------------------------------------------------------------------
Cash and Government securities...............................         40
Securities of Corporation A..................................         20
Securities of various qualified publicly traded partnerships          15
 (within the meaning of sections 851(b)(3) and 851(h)).......
Securities of various corporations (not exceeding 5 percent           25
 of its assets in any one company)...........................
                                                              ----------
  Total......................................................        100
------------------------------------------------------------------------

    (ii) Investment Company T owns more than 20 percent of the voting 
power of Corporation A and less than 10 percent of the voting power of 
all of the other corporations. Corporation A has 80 percent of its 
assets invested in qualified publicly traded partnerships.
    (iii) Investment Company T is disqualified under subparagraph 
(B)(iii) of section 851(b)(3), because, after applying section 
851(c)(1), more than 25 percent of the value of Investment Company T's 
total assets is invested in the securities of one or more qualified 
publicly traded partnerships. This result is shown by the following 
calculation:

------------------------------------------------------------------------
                                                                Percent
------------------------------------------------------------------------
Percentage of assets invested directly in qualified publicly        15.0
 traded partnerships.........................................
Percentage invested in qualified publicly traded partnerships       16.0
 indirectly through A (20% x 80%)............................
                                                              ----------
  Total percentage of assets of Investment Company T invested       31.0
   in qualified publicly traded partnerships.................
------------------------------------------------------------------------


[[Page 15]]

    (b) Effective/applicability dates. The rules of this section apply 
to quarters that begin on or after December 14, 2015. For purposes of 
applying the first sentence of section 851(d)(1) to a quarter that 
begins on or after March 14, 2016, the rules of this section apply in 
determining whether the taxpayer met the requirements of section 
851(b)(3) and (c) at the close of prior quarters.

[T.D. 9737, 80 FR 55245, Sept. 15, 2015]



Sec.  1.851-6  Investment companies furnishing capital 
to development corporations.

    (a) Qualifying requirements. (1) In the case of a regulated 
investment company which furnishes capital to development corporations, 
section 851 (e) provides an exception to the rule relating to the 
diversification of investments, made applicable to regulated investment 
companies by section 851(b)(4)(A). This exception (as provided in 
paragraph (b) of this section) is available only to registered 
management investment companies which the Securities and Exchange 
Commission determines, in accordance with regulations issued by it, and 
certifies to the Secretary or his delegate, not earlier than 60 days 
before the close of the taxable year of such investment company, to be 
principally engaged in the furnishing of capital to other corporations 
which are principally engaged in the development or exploitation of 
inventions, technological improvements, new processes, or products not 
previously generally available.
    (2) For the purpose of the aforementioned determination and 
certification, unless the Securities and Exchange Commission determines 
otherwise, a corporation shall be considered to be principally engaged 
in the development or exploitation of inventions, technological 
improvements, new processes, or products not previously generally 
available, for at least 10 years after the date of the first acquisition 
of any security in such corporation or any predecessor thereof by such 
investment company if at the date of such acquisition the corporation or 
its predecessor was principally so engaged, and an investment company 
shall be considered at any date to be furnishing capital to any company 
whose securities it holds if within 10 years before such date it had 
acquired any of such securities, or any securities surrendered in 
exchange therefor, from such other company or its predecessor.
    (b) Exception to general rule. (1) The registered management 
investment company, which for the taxable year meets the requirements of 
paragraph (a) of this section, may (subject to the limitations of 
section 851(e)(2) and paragraph (c) of this section) in the computation 
of 50 percent of the value of its assets under section 851(b)(4)(A) and 
paragraph (c)(1) of Sec.  1.851-2 for any quarter of such taxable year, 
include the value of any securities of an issuer (whether or not the 
investment company owns more than 10 percent of the outstanding voting 
securities of such issuer) if at the time of the latest acquisition of 
any securities of such issuer the basis of all such securities in the 
hands of the investment company does not exceed 5 percent of the value 
of the total assets of the investment company at that time. The 
exception provided by section 851(e)(1) and this subparagraph is not 
applicable to the securities of an issuer if the investment company has 
continuously held any security of such issuer or of any predecessor 
company (as defined in paragraph (d) of this section) for 10 or more 
years preceding such quarter of the taxable year. The rule of section 
851(e)(1) with respect to the relationship of the basis of the 
securities of an issuer to the value of the total assets of the 
investment company is, in substance, a qualification of the 5-percent 
limitation in section 851(b)(4)(A)(ii) and paragraph (c)(1)(iv) of Sec.  
1.851-2. All other provisions and requirements of section 851 and 
Sec. Sec.  1.851-1 through 1.851-6 are applicable in determining whether 
such registered management investment company qualifies as a regulated 
investment company.
    (2) The application of subparagraph (1) of this paragraph may be 
illustrated by the following examples:

    Example 1. (i) The XYZ Corporation, a regulated investment company, 
qualified under section 851(e) as an investment company furnishing 
capital to development corporations. On June 30, 1954, the XYZ 
Corporation purchased 1,000 shares of the stock of the A Corporation at 
a cost of $30,000. On June 30, 1954,

[[Page 16]]

the value of the total assets of the XYZ Corporation was $1,000,000. Its 
investment in the stock of the A Corporation ($30,000) comprised 3 
percent of the value of its total assets, and it therefore met the 
requirements prescribed by section 851(b)(4)(A)(ii) as modified by 
section 851(e)(1).
    (ii) On June 30, 1955, the value of the total assets of the XYZ 
Corporation was $1,500,000 and the 1,000 shares of stock of the A 
Corporation which the XYZ Corporation owned appreciated in value so that 
they were then worth $60,000. On that date, the XYZ Investment Company 
increased its investment in the stock of the A Corporation by the 
purchase of an additional 500 shares of that stock at a total cost of 
$30,000. The securities of the A Corporation owned by the XYZ 
Corporation had a value of $90,000 (6 percent of the value of the total 
assets of the XYZ Corporation) which exceeded the limit provided by 
section 851(b)(4)(A)(ii). However, the investment of the XYZ Corporation 
in the A Corporation on June 30, 1955, qualified under section 
851(b)(4)(A) as modified by section 851(e)(1), since the basis of those 
securities to the investment company did not exceed 5 percent of the 
value of its total assets as of June 30, 1955, illustrated as follows:

Basis to the XYZ Corporation of the A Corporation's stock        $30,000
 acquired on June 30, 1954...................................
Basis of the 500 shares of the A Corporation's stock acquired     30,000
 by the XYZ Corporation on June 30, 1955.....................
                                                              ----------
 Basis of all stock of A Corporation.........................     60,000
 

Basis of stock of A Corporation ($60,000)/Value of XYZ Corporation's 
          total assets at June 30, 1955, time of the latest acquisition 
          ($1,500,000) = 4 percent
    Example 2. The same facts existed as in example 1, except that on 
June 30, 1955, the XYZ Corporation increased its investment in the stock 
of the A Corporation by the purchase of an additional 1,000 shares of 
that stock (instead of 500 shares) at a total cost of $60,000. No part 
of the investment of the XYZ Corporation in the A Corporation qualified 
under the 5 percent limitation provided by section 851(b)(4)(A) as 
modified by section 851(e)(1), illustrated as follows:

Basis to the XYZ Corporation of the 1,000 shares of the A        $30,000
 Corporation's stock acquired on June 30, 1954...............
Basis of the 1,000 shares of the A Corporation's stock            60,000
 acquired on June 30, 1955...................................
                                                              ----------
 Total.......................................................     90,000
 

Basis of stock of A Corporation ($90,000)/Value of XYZ Corporation's 
          total assets at June 30, 1955, time of the latest acquisition 
          ($1,500,000)= 6 percent
    Example 3. The same facts existed as in example 2 and on June 30, 
1956, the XYZ Corporation increased its investment in the stock of the A 
Corporation by the purchase of an additional 100 shares of that stock at 
a total cost of $6,000. On June 30, 1956, the value of the total assets 
of the XYZ Corporation was $2,000,000 and on that date the investment in 
the A Corporation qualified under section 851(b)(4)(A) as modified by 
section 851(e)(1) illustrated as follows:

Basis to the XYZ Corporation of investments in the A
 Corporation's stock:
  1,000 shares acquired June 30, 1954........................    $30,000
  1,000 shares acquired June 30, 1955........................     60,000
  100 shares acquired June 30, 1956..........................      6,000
                                                              ----------
 Total.......................................................     96,000
 

Basis of stock of A Corporation ($96,000)/Value of XYZ Corporation's 
          total assets at June 30, 1956, time of the latest acquisition 
          ($2,000,000) = 4.8 percent

    (c) Limitation. Section 851(e) and this section do not apply in the 
quarterly computation of 50 percent of the value of the assets of an 
investment company under subparagraph (A) of section 851(b)(4) and 
paragraph (c)(1) of Sec.  1.851-2 for any taxable year if at the close 
of any quarter of such taxable year more than 25 percent of the value of 
its total assets (including the 50 percent or more mentioned in such 
subparagraph (A)) is represented by securities (other than Government 
securities or the securities of other regulated investment companies) of 
issuers as to each of which such investment company (1) holds more than 
10 percent of the outstanding voting securities of such issuer, and (2) 
has continuously held any security of such issuer (or any security of a 
predecessor of such issuer) for 10 or more years preceding such quarter, 
unless the value of its total assets so represented is reduced to 25 
percent or less within 30 days after the close of such quarter.
    (d) Definition of predecessor company. As used in section 851(e) and 
this section, the term ``predecessor company'' means any corporation the 
basis of whose securities in the hands of the investment company was, 
under the provisions of section 358 or corresponding provisions of prior 
law, the same in whole or in part as the basis of any of the securities 
of the issuer and any corporation with respect to whose securities any 
of the securities of the issuer were received directly or indirectly by 
the investment company in a transaction or series of transactions 
involving nonrecognition of gain or loss in whole or in part. The other 
terms used in this section have the same meaning

[[Page 17]]

as when used in section 851(b)(4). See paragraph (c) of Sec.  1.851-2 
and Sec.  1.851-3.



Sec.  1.851-7  Certain unit investment trusts.

    (a) In general. For purposes of the Internal Revenue Code, a unit 
investment trust (as defined in paragraph (d) of this section) shall not 
be treated as a person (as defined in section 7701(a)(1)) except for 
years ending before January 1, 1969. A holder of an interest in such a 
trust will be treated as directly owning the assets of such trust for 
taxable years of such holder which end with or within any year of the 
trust to which section 851(f) and this section apply.
    (b) Treatment of unit investment trust. A unit investment trust 
shall not be treated as an individual, a trust estate, partnership, 
association, company, or corporation for purposes of the Internal 
Revenue Code. Accordingly, a unit investment trust is not a taxpayer 
subject to taxation under the Internal Revenue Code. No gain or loss 
will be recognized by the unit investment trust if such trust 
distributes a holder's proportionate share of the trust assets in 
exchange for his interest in the trust. Also, no gain or loss will be 
recognized by the unit investment trust if such trust sells the holder's 
proportionate share of the trust assets and distributes the proceeds 
from such share to the holder in exchange for his interest in the trust.
    (c) Treatment of holder of interest in unit investment trust. (1) 
Each holder of an interest in a unit investment trust shall be treated 
(to the extent of such interest) as owning a proportionate share of the 
assets of the trust. Accordingly, if the trust distributes to the holder 
of an interest in such trust his proportionate share of the trust assets 
in exchange for his interest in the trust, no gain or loss shall be 
recognized by such holder (or by any other holder of an interest in such 
trust). For purposes of this paragraph, each purchase of an interest in 
the trust by the holder will be considered a separate interest in the 
trust. Items of income, gain, loss, deduction, or credit received by the 
trust or a custodian thereof shall be taxed to the holders of interests 
in the trust (and not to the trust) as though they had received their 
proportionate share of the items directly on the date such items were 
received by the trust or custodian.
    (2) The basis of the assets of such trust which are treated under 
subparagraph (1) of this paragraph as being owned by the holder of an 
interest in such trust shall be the same as the basis of his interest in 
such trust. Accordingly, the amount of the gain or loss recognized by 
the holder upon the sale by the unit investment trust of the holder's 
pro rata share of the trust assets shall be determined with reference 
the basis, of his interest in the trust. Also, the basis of the assets 
received by the holder, if the trust distributes a holder's pro rata 
share of the trust assets in exchange for his interest in the trust, 
will be the same as the basis of his interest in the trust. If the unit 
investment trust sells less than all of the holder's pro rata share of 
the trust assets and the holder retains an interest in the trust, the 
amount of the gain or loss recognized by the holder upon the sale shall 
be determined with reference to the basis of his interest in the assets 
sold by the trust, and the basis of his interest in the trust shall be 
reduced accordingly. If the trust distributes a portion of the holder's 
pro rata share of the trust assets in exchange for a portion of his 
interest in the trust, the basis of the assets received by the holder 
shall be determined with reference to the basis of his interest in the 
assets distributed by the trust, and the basis of his interest in the 
trust shall be reduced accordingly. For purposes of this subparagraph 
the basis of the holder's interest in assets sold by the trust or 
distributed to him shall be an amount which bears the same relationship 
to the basis of his total interest in the trust that the fair market 
value of the assets so sold or distributed bears to the fair market 
value of such total interest in the trust, such fair market value to be 
determined on the date of such sale or distribution.
    (3) The period for which the holder of an interest in such trust has 
held the assets of the trust which are treated under subparagraph (1) of 
this paragraph as being owned by him is the

[[Page 18]]

same as the period for which such holder has held his interest in such 
trust. Accordingly, the character of the gain, loss, deduction, or 
credit recognized by the holder upon the sale by the unit investment 
trust of the holder's proportionate share of the trust assets shall be 
determined with reference to the period for which he has held his 
interest in the trust. Also, the holding period of the assets received 
by the holder if the trust distributes the holder's proportionate share 
of the trust assets in exchange for his interest in the trust will 
include the period for which the holder has held his interest in the 
trust.
    (4) The application of the provisions of this paragraph may be 
illustrated by the following example:

    Example. B entered a periodic payment plan of a unit investment 
trust (as defined in paragraph (d) of this section) with X Bank as 
custodian and Z as plan sponsor. Under this plan, upon B's demand, X 
must either redeem B's interest at a price substantially equal to the 
fair market value of the number of shares in Y, a management company, 
which are credited to B's account by X in connection with the unit 
investment trust, or at B's option distribute such shares of Y to B. B's 
plan provides for quarterly payments of $1,000. On October 1, 1969, B 
made his initial quarterly payment of $1,000 and X credited B's account 
with 110 shares of Y. On December 1, 1969, Y declared and paid a 
dividend of 25 cents per share, 5 cents of which was designated as a 
capital gain dividend pursuant to section 852(b)(3) and Sec.  1.852-4. X 
credited B's account with $27.50 but did not distribute the money to B 
in 1969. On December 31, 1969, X charged B's account with $1 for 
custodial fees for calendar year 1969. On January 1, 1970, B paid X 
$1,000 and X credited B's account with 105 shares of Y. On April 1, 
1970, B paid X $1,000 and X credited B's account with 100 shares of Y. B 
must include in his tax return for 1969 a dividend of $22 and a long-
term capital gain of $5.50. In addition, B is entitled to deduct the 
annual custodial fee of $1 under section 212 of the Code.
    (a) On April 4, 1970, at B's request, X sells the shares of Y 
credited to B's account (315 shares) for $10 per share and distributes 
the proceeds ($3,150) to B together with the remaining balance of $26.50 
in B's account. The receipt of the $26.50 does not result in any tax 
consequences to B. B recognizes a long-term capital gain of $100 and a 
short- term capital gain of $50, computed as follows:
    (1) B is treated as owning 110 shares of Y as of October 1, 1969. 
The basis of these shares is $1,000, and they were sold for $1,100 (110 
shares at $10 per share). Therefore, B recognizes a gain from the sale 
or exchange of a capital asset held for more than 6 months in the amount 
of $100.
    (2) B is treated as owning 105 shares of Y as of January 1, 1970, 
and 100 shares as of April 1, 1970. With respect to the shares acquired 
on April 1, 1970, there is no gain recognized as the shares were sold 
for $1,000, which is B's basis of the shares. The shares acquired on 
January 1, 1970, were sold for $1,050 (105 shares at $10 per share), and 
B's basis of these shares is $1,000. Therefore, B recognizes a gain of 
$50 from the sale or exchange of a capital asset held for not more than 
6 months.
    (b) On April 4, 1970, at B's request, X distributes to B the shares 
of Y credited to his account and $26.50 in cash. The receipt of the 
$26.50 does not result in any tax consequences to B. B does not 
recognize gain or loss on the distribution of the shares of Y to him. 
The bases and holding periods of B's interests in Y are as follows:

------------------------------------------------------------------------
                                                        Date
                  Number of shares                    acquired    Basis
------------------------------------------------------------------------
110................................................     10-1-69    $9.09
105................................................      1-1-70     9.52
100................................................      4-1-70    10.00
------------------------------------------------------------------------

    (d) Definition. A unit investment trust to which this section refers 
is a business arrangement (other than a segregated asset account, 
whether or not it holds assets pursuant to a variable annuity contract, 
under the insurance laws or regulations of a State) which (except for 
taxable years ending before Jan. 1, 1969)--
    (1) Is a unit investment trust (as defined in the Investment Company 
Act of 1940);
    (2) Is registered under such Act;
    (3) Issues periodic payment plan certificates (as defined in such 
Act) in one or more series;
    (4) Possesses, as substantially all of its assets, as to all such 
series, securities issued by--
    (i) A single management company (as defined in such Act), and 
securities acquired pursuant to subparagraph (5) of this paragraph, or
    (ii) A single other corporation; and
    (5) Has no power to invest in any other securities except securities 
issued by a single other management company, when permitted by such Act 
or the rules and regulations of the Securities and Exchange Commission.
    (e) Investment in two single management companies. (1) A unit 
investment trust may possess securities issued by

[[Page 19]]

two or more separate single management companies (as defined in such 
Act) if--
    (i) The trust issues a separate series of periodic payment plan 
certificates (as defined in such Act) with respect to the securities of 
each separate single management company which it possesses; and
    (ii) None of the periodic payment plan certificates issued by the 
trust permits joint acquisition of an interest in each series nor the 
application of payments in whole or in part first to a series issued by 
one of the single management companies and then to any other series 
issued by any other single management company.
    (2) If a unit investment trust possesses securities of two or more 
separate single management companies as described in subparagraph (1) of 
this paragraph and issues a separate series of periodic payment plan 
certificates with respect to the securities of each such management 
company, then the holder of an interest in a series shall be treated as 
the owner of the securities in the single management company represented 
by such interest.
    (i) A holder of an interest in a series of periodic payment plan 
certificates of a trust who transfers or sells his interest in the 
series in exchange for an interest in another series of periodic payment 
plan certificates of the trust shall recognize the gain or loss realized 
from the transfer or sale as if the trust had sold the shares credited 
to his interests in the series at fair market value and distributed the 
proceeds of the sale to him.
    (ii) The basis of the interests in the series so acquired by the 
holder shall be the fair market value of his interests in the series 
transferred or sold.
    (iii) The period for which the holder has held his interest in the 
series so acquired shall be measured from the date of his acquisition of 
his interest in that series.
    (f) Cross references. (1) For reporting requirements imposed on 
custodians of unit investment trusts described in this section, see 
Sec. Sec.  1.852-4, 1.852-9, 1.853-3, 1.854-2, and 1.6042-2.
    (2) For rules relating to redemptions of certain unit investment 
trusts not described in this section, see Sec.  1.852-10.

[T.D. 7187, 37 FR 13254, July 6, 1972, as amended by T.D. 7187, 37 FR 
20688, Oct. 3, 1972]



Sec.  1.852-1  Taxation of regulated investment companies.

    (a) Requirements applicable thereto--(1) In general. Section 852(a) 
denies the application of the provisions of part I, subchapter M, 
chapter 1 of the Code (other than section 852(c), relating to earnings 
and profits), to a regulated investment company for a taxable year 
beginning after February 28, 1958, unless--
    (i) The deduction for dividends paid for such taxable year as 
defined in section 561 (computed without regard to capital gain 
dividends) is equal to at least 90 percent of its investment company 
taxable income for such taxable year (determined without regard to the 
provisions of section 852(b)(2)(D) and paragraph (d) of Sec.  1.852-3); 
and
    (ii) The company complies for such taxable year with the provisions 
of Sec.  1.852-6 (relating to records required to be maintained by a 
regulated investment company).


See section 853(b)(1)(B) and paragraph (a) of Sec.  1.853-2 for amounts 
to be added to the dividends paid deduction, and section 855 and Sec.  
1.855-1, relating to dividends paid after the close of the taxable year.
    (2) Special rule for taxable years of regulated investment companies 
beginning before March 1, 1958. The provisions of part I of subchapter M 
(including section 852(c)) are not applicable to a regulated investment 
company for a taxable year beginning before March 1, 1958, unless such 
company meets the requirements of section 852(a) and subparagraph (1) 
(i) and (ii) of this paragraph.
    (b) Failure to qualify. If a regulated investment company does not 
meet the requirements of section 852(a) and paragraph (a)(1) (i) and 
(ii) of this section for the taxable year, it will, even though it may 
otherwise be classified as a regulated investment company, be taxed in 
such year as an ordinary corporation and not as a regulated investment 
company. In such case, none of

[[Page 20]]

the provisions of part I of subchapter M (other than section 852(c) in 
the case of taxable years beginning after February 28, 1958) will be 
applicable to it. For the rules relating to the applicability of section 
852(c), see Sec.  1.852-5.

[T.D. 6598, 27 FR 4091, Apr. 28, 1962]



Sec.  1.852-2  Method of taxation of regulated investment companies.

    (a) Imposition of normal tax and surtax. Section 852(b)(1) imposes a 
normal tax and surtax, computed at the rates and in the manner 
prescribed in section 11, on the investment company taxable income, as 
defined in section 852(b)(2) and Sec.  1.852-3, for each taxable year of 
a regulated investment company. The tax is imposed as if the investment 
company taxable income were the taxable income referred to in section 
11. In computing the normal tax under section 11, the regulated 
investment company's taxable income and the dividends paid deduction 
(computed without regard to the capital gains dividends) shall both be 
reduced by the deduction for partially tax-exempt interest provided by 
section 242.
    (b) Taxation of capital gains--(1) In general. Section 852(b)(3)(A) 
imposes (i) in the case of a taxable year beginning before January 1, 
1970, a tax of 25 percent, or (ii) in the case of a taxable year 
beginning after December 31, 1969, a tax determined as provided in 
section 1201(a) and paragraph (a)(3) of Sec.  1.1201-1, on the excess, 
if any, of the net long-term capital gain of a regulated investment 
company (subject to tax under part I, subchapter M, chapter 1 of the 
Code) over the sum of its net short-term capital loss and its deduction 
for dividends paid (as defined in section 561) determined with reference 
to capital gain dividends only. For the definition of capital gain 
dividend paid by a regulated investment company, see section 
852(b)(3)(C) and paragraph (c) of Sec.  1.852-4. In the case of a 
taxable year ending after December 31, 1969, and beginning before 
January 1, 1975, such deduction for dividends paid shall first be made 
from the amount subject to tax in accordance with section 1201(a)(1)(B), 
to the extent thereof, and then from the amount subject to tax in 
accordance with section 1201(a)(1)(A). See Sec.  1.852-10, relating to 
certain distributions in redemption of interests in unit investment 
trusts which, for purposes of the deduction for dividends paid with 
reference to capital gain dividends only, are not considered 
preferential dividends under section 562(c). See section 855 and Sec.  
1.855-1, relating to dividends paid after the close of the taxable year.
    (2) Undistributed capital gains--(i) In general. A regulated 
investment company (subject to tax under part I of subchapter M) may, 
for taxable years beginning after December 31, 1956, designate under 
section 852(b)(3)(D) an amount of undistributed capital gains to each 
shareholder of the company. For the definition of the term 
``undistributed capital gains'' and for the treatment of such amounts by 
a shareholder, see paragraph (b)(2) of Sec.  1.852-4. For the rules 
relating to the method of making such designation, the returns to be 
filed, and the payment of the tax in such cases, see paragraph (a) of 
Sec.  1.852-9.
    (ii) Effect on earnings and profits of a regulated investment 
company. If a regulated investment company designates an amount as 
undistributed capital gains for a taxable year, the earnings and profits 
of such regulated investment company for such taxable year shall be 
reduced by the total amount of the undistributed capital gains so 
designated. In such case, its capital account shall be increased--
    (a) In the case of a taxable year ending before January 1, 1970, by 
75 percent of the total amount designated,
    (b) In the case of a taxable year ending after December 31, 1969, 
and beginning before January 1, 1975, by the total amount designated 
decreased by the amount of tax imposed by section 852(b)(3)(A) with 
respect to such amount, or
    (c) In the case of a taxable year beginning after December 31, 1974, 
by 70 percent of the total amount designated. The earnings and profits 
of a regulated investment company shall not be reduced by the amount of 
tax which is imposed by section 852(b)(3)(A) on an amount designated as 
undistributed capital gains and which is paid by

[[Page 21]]

the corporation but deemed paid by the shareholder.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6598, 27 FR 
4091, Apr. 28, 1962; T.D. 6921, 32 FR 8754, June 20, 1967; T.D. 7337, 39 
FR 44972, Dec. 30, 1974]



Sec.  1.852-3  Investment company taxable income.

    Section 852(b)(2) requires certain adjustments to be made to convert 
taxable income of the investment company to investment company taxable 
income, as follows:
    (a) The excess, if any, of the net long-term capital gain over the 
net short-term capital loss shall be excluded;
    (b) The net operating loss deduction provided in section 172 shall 
not be allowed;
    (c) The special deductions provided in part VIII (section 241 and 
following, except section 248), subchapter B, chapter 1 of the Code, 
shall not be allowed. Those not allowed are the deduction for partially 
tax-exempt interest provided by section 242, the deductions for 
dividends received provided by sections 243, 244, and 245, and the 
deduction for certain dividends paid provided by section 247. However, 
the deduction provided by section 248 (relating to organizational 
expenditures), otherwise allowable in computing taxable income, shall 
likewise be allowed in computing the investment company taxable income. 
See section 852(b)(1) and paragraph (a) of Sec.  1.852-2 for treatment 
of the deduction for partially tax-exempt interest (provided by section 
242) for purposes of computing the normal tax under section 11;
    (d) The deduction for dividends paid (as defined in section 561) 
shall be allowed, but shall be computed without regard to capital gains 
dividends (as defined in section 852(b)(3)(C) and paragraph (c) of Sec.  
1.852-4); and
    (e) The taxable income shall be computed without regard to section 
443(b). Thus, the taxable income for a period of less than 12 months 
shall not be placed on an annual basis even though such short taxable 
year results from a change of accounting period.



Sec.  1.852-4  Method of taxation of shareholders of regulated 
investment companies.

    (a) Ordinary income. (1) Except as otherwise provided in paragraph 
(b) of this section (relating to capital gains), a shareholder receiving 
dividends from a regulated investment company shall include such 
dividends in gross income for the taxable year in which they are 
received.
    (2) See section 853 (b)(2) and (c) and paragraph (b) of Sec.  1.853-
2 and Sec.  1.853-3 for the treatment by shareholders of dividends 
received from a regulated investment company which has made an election 
under section 853(a) with respect to the foreign tax credit. See section 
854 and Sec. Sec.  1.854-1 through 1.854-3 for limitations applicable to 
dividends received from regulated investment companies for the purpose 
of the credit under section 34 (for dividends received on or before 
December 31, 1964), the exclusion from gross income under section 116, 
and the deduction under section 243. See section 855 (b) and (d) and 
paragraphs (c) and (f) of Sec.  1.855-1 for treatment by shareholders of 
dividends paid by a regulated investment company after the close of the 
taxable year in the case of an election under section 855(a).
    (b) Capital gains--(1) In general. Under section 852(b)(3)(B), 
shareholders of a regulated investment company who receive capital gain 
dividends (as defined in paragraph (c) of this section), in respect of 
the capital gains of an investment company for a taxable year for which 
it is taxable under part I, subchapter M, chapter 1 of the Code, as a 
regulated investment company, shall treat such capital gain dividends as 
gains from the sale or exchange of capital assets held for more than 1 
year (6 months for taxable years beginning before 1977; 9 months for 
taxable years beginning in 1977) and realized in the taxable year of the 
shareholder in which the dividend was received. In the case of dividends 
with respect to any taxable year of a regulated investment company 
ending after December 31, 1969, and beginning before January 1, 1975, 
the portion of a shareholder's capital gain dividend to which section 
1201(d) (1) or (2) applies is the portion

[[Page 22]]

so designated by the regulated investment company pursuant to paragraph 
(c)(2) of this section.
    (2) Undistributed capital gains. (i) A person who is a shareholder 
of a regulated investment company at the close of a taxable year of such 
company for which it is taxable under part I of subchapter M shall 
include in his gross income as a gain from the sale or exchange of a 
capital asset held for more than 1 year (6 months for taxable years 
beginning before 1977; 9 months for taxable years beginning in 1977) any 
amount of undistributed capital gains. The term ``undistributed capital 
gains'' means the amount designated as undistributed capital gains in 
accordance with paragraph (a) of Sec.  1.852-9, but the amount so 
designated shall not exceed the shareholder's proportionate part of the 
amount subject to tax under section 852(b)(3)(A). Such amount shall be 
included in gross income for the taxable year of the shareholder in 
which falls the last day of the taxable year of the regulated investment 
company in respect of which the undistributed capital gains were 
designated. The amount of such gains designated under paragraph (a) of 
Sec.  1.852-9 as gain described in section 1201(d) (1) or (2) shall be 
included in the shareholder's gross income as gain described in section 
1201(d) (1) or (2). For certain administrative provisions relating to 
undistributed capital gains, see Sec.  1.852-9.
    (ii) Any shareholder required to include an amount of undistributed 
capital gains in gross income under section 852(b)(3)(D)(i) and 
subdivision (i) of this subparagraph shall be deemed to have paid for 
his taxable year for which such amount is so includible--
    (a) In the case of an amount designated with respect to a taxable 
year of the company ending before January 1, 1970, a tax equal to 25 
percent of such amount.
    (b) In the case of a taxable year of the company ending after 
December 31, 1969, and beginning before January 1, 1975, a tax equal to 
the tax designated under paragraph (a)(1) of Sec.  1.852-9 by the 
regulated investment company as his proportionate share of the capital 
gains tax paid with respect to such amount, or
    (c) In the case of an amount designated with respect to a taxable 
year of the company beginning after December 31, 1974, a tax equal to 30 
percent of such amount.


Such shareholder is entitled to a credit or refund of the tax so deemed 
paid in accordance with the rules provided in paragraph (c)(2) of Sec.  
1.852-9.
    (iii) Any shareholder required to include an amount of undistributed 
capital gains in gross income under section 852(b)(3)(D)(i) and 
subdivision (i) of this subparagraph shall increase the adjusted basis 
of the shares of stock with respect to which such amount is so 
includible--
    (a) In the case of an amount designated with respect to a taxable 
year of the company ending before January 1, 1970, by 75 percent of such 
amount.
    (b) In the case of an amount designated with respect to a taxable 
year of the company ending after December 31, 1969, and beginning before 
January 1, 1975, by the amount designated under paragraph (a)(1)(iv) of 
Sec.  1.852-9 by the regulated investment company, or
    (c) In the case of an amount designated with respect to a taxable 
year of the company beginning after December 31, 1974, by 70 percent of 
such amount.
    (iv) For purposes of determining whether the purchaser or seller of 
a share or regulated investment company stock is the shareholder at the 
close of such company's taxable year who is required to include an 
amount of undistributed capital gains in gross income, the amount of the 
undistributed capital gains shall be treated in the same manner as a 
cash dividend payable to shareholders of record at the close of the 
company's taxable year. Thus, if a cash dividend paid to shareholders of 
record as of the close of the regulated investment company's taxable 
year would be considered income to the purchaser, then the purchaser is 
also considered to be the shareholder of such company at the close of 
its taxable year for purposes of including an amount of undistributed 
capital gains in gross income. If, in such a case, notice on Form 2439 
is, pursuant to paragraph (a)(1) of Sec.  1.852-9, mailed by the 
regulated investment company to the seller, then the seller

[[Page 23]]

shall be considered the nominee of the purchaser and, as such, shall be 
subject to the provisions in paragraph (b) of Sec.  1.852-9. For rules 
for determining whether a dividend is income to the purchaser or seller 
of a share of stock, see paragraph (c) of Sec.  1.61-9.
    (3) Partners and partnerships. If the shareholder required to 
include an amount of undistributed capital gains in gross income under 
section 852(b)(3)(D) and subparagraph (2) of this paragraph is a 
partnership, such amount shall be included in the gross income of the 
partnership for the taxable year of the partnership in which falls the 
last day of the taxable year of the regulated investment company in 
respect of which the undistributed capital gains were designated. The 
amount so includible by the partnership shall be taken into account by 
the partners as distributive shares of the partnership gains and losses 
from sales or exchanges of capital assets held for more than 1 year (6 
months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) pursuant to section 702(a)(2) and paragraph 
(a)(2) of Sec.  1.702-1. The tax with respect to the undistributed 
capital gains is deemed paid by the partnership (under section 
852(b)(3)(D)(ii) and subparagraph (2)(ii) of this paragraph), and the 
credit or refund of such tax shall be taken into account by the partners 
in accordance with section 702(a)(8) and paragraph (a)(8)(ii) of Sec.  
1.702-1 and paragraph (c)(2) of Sec.  1.852-9. In accordance with 
section 705(a), the partners shall increase the basis of their 
partnership interests under section 705(a)(1) by the distributive shares 
of such gains, and shall decrease the basis of their partnership 
interests by the distributive shares of the amount of the tax under 
section 705(a)(2)(B) (relating to certain nondeductible expenditures) 
and paragraph (a)(3) of Sec.  1.705-1.
    (4) Nonresident alien individuals. If the shareholder required to 
include an amount of undistributed capital gains in gross income under 
section 852(b)(3)(D) and subparagraph (2) of this paragraph is a 
nonresident alien individual, such shareholder shall be treated, for 
purposes of section 871 and the regulations thereunder, as having 
realized a long-term capital gain in such amount on the last day of the 
taxable year of the regulated investment company in respect of which the 
undistributed capital gains were designated.
    (5) Effect on earnings and profits of corporate shareholders of a 
regulated investment company. If a shareholder required to include an 
amount of undistributed capital gains in gross income under section 
852(b)(3)(D) and subparagraph (2) of this paragraph is a corporation, 
such corporation, in computing its earnings and profits for the taxable 
year for which such amount is so includible, shall treat such amount as 
if it had actually been received and the taxes paid shall include any 
amount of tax liability satisfied by a credit under section 852(b)(3)(D) 
and subparagraph (2) of this paragraph.
    (c) Definition of capital gain dividend--(1) General rule. A capital 
gain dividend, as defined in section 852(b)(3)(C), is any dividend or 
part thereof which is designated by a regulated investment company as a 
capital gain dividend in a written notice mailed to its shareholders 
within the period specified in paragraph (c)(4) of this section. If the 
aggregate amount so designated with respect to the taxable year 
(including capital gain dividends paid after the close of the taxable 
year pursuant to an election under section 855) is greater than the 
excess of the net long-term capital gain over the net short-term capital 
loss of the taxable year, the portion of each distribution which shall 
be a capital gain dividend shall be only that proportion of the amount 
so designated which such excess of the net long-term capital gain over 
the net short-term capital loss bears to the aggregate amount so 
designated. For example, a regulated investment company making its 
return on the calendar year basis advised its shareholders by written 
notice mailed December 30, 1955, that of a distribution of $500,000 made 
December 15, 1955, $200,000 constituted a capital gain dividend, 
amounting to $2 per share. It was later discovered that an error had 
been made in determining the excess of the net long-term capital gain 
over the net short-term capital loss of the taxable year, and that such 
excess was $100,000 instead of $200,000. In such case each

[[Page 24]]

shareholder would have received a capital gain dividend of $1 per share 
instead of $2 per share.
    (2) Shareholder of record custodian of certain unit investment 
trusts. In any case where a notice is mailed pursuant to subparagraph 
(1) of this paragraph by a regulated investment company with respect to 
a taxable year of the regulated investment company ending after December 
8, 1970, to a shareholder of record who is a nominee acting as a 
custodian of a unit investment trust described in section 851(f)(1) and 
paragraph (d) of Sec.  1.851-7, the nominee shall furnish each holder of 
an interest in such trust with a written notice mailed on or before the 
55th day following the close of the regulated investment company's 
taxable year. The notice shall designate the holder's proportionate 
share of the capital gain dividend shown on the notice received by the 
nominee pursuant to subparagraph (1) of this paragraph. The notice shall 
include the name and address of the nominee identified as such. This 
subparagraph shall not apply if the regulated investment company agrees 
with the nominee to satisfy the notice requirements of subparagraph (1) 
of this paragraph with respect to each holder of an interest in the unit 
investment trust whose shares are being held by the nominee as custodian 
and, not later than 45 days following the close of the company's taxable 
year, files with the Internal Revenue Service office where the company's 
income tax return is to be filed for the taxable year, a statement that 
the holders of the unit investment trust with whom the agreement was 
made have been directly notified by the regulated investment company. 
Such statement shall include the name, sponsor, and custodian of each 
unit investment trust whose holders have been directly notified. The 
nominee's requirements under this paragraph shall be deemed met if the 
regulated investment company transmits a copy of such statement to the 
nominee within such 45-day period; provided however, if the regulated 
investment company fails or is unable to satisfy the requirements of 
this subparagraph with respect to the holders of interest in the unit 
investment trust, it shall so notify the Internal Revenue Service within 
45 days following the close of its taxable year. The custodian shall, 
upon notice by the Internal Revenue Service that the regulated 
investment company has failed to comply with the agreement, satisfy the 
requirements of this subparagraph within 30 days of such notice. If a 
notice under paragraph (c)(1) of this section is mailed within the 120-
day period following the date of a determination pursuant to paragraph 
(c)(4)(ii) of this section, the 120-day period and the 130-day period 
following the date of the determination shall be substituted for the 45-
day period and the 55-day period following the close of the regulated 
investment company's taxable year prescribed by this subparagraph (2).
    (3) Subsection (d) gain for certain taxable years. In the case of 
capital gain dividends with respect to any taxable year of a regulated 
investment company ending after December 31, 1969, and beginning before 
January 1, 1975 (including capital gain dividends paid after the close 
of the taxable year pursuant to an election under section 855), the 
company must include in its written notice under paragraph (c)(1) of 
this section a statement showing the shareholder's proportionate share 
of the capital gain dividend which is gain described in section 
1201(d)(1) and his proportionate share of such dividend which is gain 
described in section 1201(d)(2). In determining the portion of the 
capital gain dividend which, in the hands of a shareholder, is gain 
described in section 1201(d) (1) or (2), the regulated investment 
company shall consider that capital gain dividends for a taxable year 
are first made from its long-term capital gains for such year which are 
not described in section 1201(d) (1) or (2), to the extent thereof, and 
then from its long-term capital gains for such year which are described 
in section 1201(d) (1) or (2). A shareholder's proportionate share of 
gains which are described in section 1201(d)(1) is the amount which 
bears the same ratio to the amount paid to him as a capital gain 
dividend in respect of such year as (i) the aggregate amount of the 
company's gains which are described in section 1201(d)(1) and paid to 
all shareholders bears to (ii) the aggregate amount of the capital gain 
dividend

[[Page 25]]

paid to all shareholders in respect of such year. A shareholder's 
proportionate share of gains which are described in section 1201(d)(2) 
shall be determined in a similar manner. Every regulated investment 
company shall keep a record of the proportion of each capital gain 
dividend (to which this paragraph applies) which is gain described in 
section 1201(d) (1) or (2). If, for his taxable year, a shareholder must 
include in his gross income a capital gain dividend to which this 
paragraph applies, he shall attach to his income tax return for such 
taxable year a statement showing, with respect to the total of such 
dividends for such taxable year received from each regulated investment 
company, the name and address of the regulated investment company from 
which such dividends are received, the amount of such dividends, the 
portion of such dividends which was designated as gain described in 
section 1201(d)(1), and the portion of such dividends which was 
designated as gain described in section 1201(d)(2).
    (4) Mailing of written notice to shareholders. (i) Except as 
provided in paragraph (c)(4)(ii) of this section, the written notice 
designating a dividend or part thereof as a capital gain dividend must 
be mailed to the shareholders not later than 45 days (30 days for a 
taxable year ending before February 26, 1964) after the close of the 
taxable year of the regulated investment company.
    (ii) If a determination (as defined in section 860(e)) after 
November 6, 1978, increases the excess for the taxable year of the net 
capital gain over the deduction for capital gains dividends paid, then a 
regulated investment company may designate all or part of any dividend 
as a capital gain dividend in a written notice mailed to its 
shareholders at any time during the 120-day period immediately following 
the date of the determination. The aggregate amount designated during 
this period may not exceed this increase. A dividend may be designated 
if it is actually paid during the taxable year, is one paid after the 
close of the taxable year to which section 855 applies, or is a 
deficiency dividend (as defined in section 860(f)), including a 
deficiency dividend paid by an acquiring corporation to which section 
381(c)(25) applies. The date of a determination is established under 
Sec.  1.860-2(b)(1).
    (d) Special treatment of loss on the sale or exchange of regulated 
investment company stock held less than 31 days--(1) In general. Under 
section 852(b)(4), if any person, with respect to a share of regulated 
investment company stock acquired by such person after December 31, 
1957, and held for a period of less than 31 days, is required by section 
852(b)(3) (B) or (D) to include in gross income as a gain from the sale 
or exchange of a capital asset held for more than six months--
    (i) The amount of a capital gain dividend, or
    (ii) An amount of undistributed capital gains,


then such person shall, to the extent of such amount, treat any loss on 
the sale or exchange of such share of stock as a loss from the sale or 
exchange of a capital asset held for more than 1 year (6 months for 
taxable years beginning before 1977; 9 months for taxable years 
beginning in 1977). Such special treatment with respect to the sale of 
regulated investment company stock held for a period of less than 31 
days is applicable to losses for taxable years ending after December 31, 
1957.
    (2) Determination of holding period. The rules contained in section 
246(c)(3) (relating to the determination of holding periods for purposes 
of the deduction for dividends received) shall be applied in determining 
whether, for purposes of section 852(b)(4) and this paragraph, a share 
of regulated investment company stock has been held for a period of less 
than 31 days. In applying those rules, however, ``30 days'' shall be 
substituted for the number of days specified in subparagraph (B) of 
section 246(c)(3).
    (3) Example. The application of section 852(b)(4) and this paragraph 
may be illustrated by the following example:

    Example. On December 15, 1958, A purchased a share of stock in the X 
regulated investment company for $20. The X regulated investment company 
declared a capital gain dividend of $2 per share to shareholders of 
record on December 31, 1958. A, therefore, received a capital gain 
dividend of $2 which, pursuant to section 852(b)(3)(B), he must treat as 
a gain from the sale or exchange of

[[Page 26]]

a capital asset held for more than 6 months. On January 5, 1959, A sold 
his share of stock in the X regulated investment company for $17.50, 
which sale resulted in a loss of $2.50. Under section 852(b)(4) and this 
paragraph, A must treat $2 of such loss (an amount equal to the capital 
gain dividend received with respect to such share of stock) as a loss 
from the sale or exchange of a capital asset held for more than 6 
months.

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; 860(e) (92 Stat. 2849, 26 
U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6531, 26 FR 
413, Jan. 19, 1961; T.D. 6598, 27 FR 4091, Apr. 28, 1962; T.D. 6777, 29 
FR 17809, Dec. 16, 1964; T.D. 6921, 32 FR 8755, June 20, 1967; T.D. 
7187, 37 FR 13256, July 6, 1972; T.D. 7337, 39 FR 44972, Dec. 30, 1974; 
T.D. 7728, 45 FR 72650, Nov. 3, 1980; T.D. 7936, 49 FR 2106, Jan. 18, 
1984]



Sec.  1.852-5  Earnings and profits of a regulated investment company.

    (a) Any regulated investment company, whether or not such company 
meets the requirements of section 852(a) and paragraphs (a)(1) (i) and 
(ii) of Sec.  1.852-1, shall apply paragraph (b) of this section in 
computing its earnings and profits for a taxable year beginning after 
February 28, 1958. However, for a taxable year of a regulated investment 
company beginning before March 1, 1958, paragraph (b) of this section 
shall apply only if the regulated investment company meets the 
requirements of section 852(a) and paragraphs (a)(1) (i) and (ii) of 
Sec.  1.852-1.
    (b) In the determination of the earnings and profits of a regulated 
investment company, section 852(c) provides that such earnings and 
profits for any taxable year (but not the accumulated earnings and 
profits) shall not be reduced by any amount which is not allowable as a 
deduction in computing its taxable income for the taxable year. Thus, if 
a corporation would have had earnings and profits of $500,000 for the 
taxable year except for the fact that it had a net capital loss of 
$100,000, which amount was not deductible in determining its taxable 
income, its earnings and profits for that year if it is a regulated 
investment company would be $500,000. If the regulated investment 
company had no accumulated earnings and profits at the beginning of the 
taxable year, in determining its accumulated earnings and profits as of 
the beginning of the following taxable year, the earnings and profits 
for the taxable year to be considered in such computation would amount 
to $400,000 assuming that there had been no distribution from such 
earnings and profits. If distributions had been made in the taxable year 
in the amount of the earnings and profits then available for 
distribution, $500,000, the corporation would have as of the beginning 
of the following taxable year neither accumulated earnings and profits 
nor a deficit in accumulated earnings and profits, and would begin such 
year with its paid-in capital reduced by $100,000, an amount equal to 
the excess of the $500,000 distributed over the $400,000 accumulated 
earnings and profits which would otherwise have been carried into the 
following taxable year.



Sec.  1.852-6  Records to be kept for purpose of determining whether 
a corporation claiming to be a regulated investment company 
is a personal holding company.

    (a) Every regulated investment company shall maintain in the 
internal revenue district in which it is required to file its income tax 
return permanent records showing the information relative to the actual 
owners of its stock contained in the written statements required by this 
section to be demanded from the shareholders. The actual owner of stock 
includes the person who is required to include in gross income in his 
return the dividends received on the stock. Such records shall be kept 
at all times available for inspection by any internal revenue officer or 
employee, and shall be retained so long as the contents thereof may 
become material in the administration of any internal revenue law.
    (b) For the purpose of determining whether a domestic corporation 
claiming to be a regulated investment company is a personal holding 
company as defined in section 542, the permanent records of the company 
shall show the maximum number of shares of the corporation (including 
the number and face value of securities convertible into stock of the 
corporation) to be considered as actually or constructively owned by 
each of the actual owners of any of its stock at any time during the

[[Page 27]]

last half of the corporation's taxable year, as provided in section 544.
    (c) Statements setting forth the information (required by paragraph 
(b) of this section) shall be demanded not later than 30 days after the 
close of the corporation's taxable year as follows:
    (1) In the case of a corporation having 2,000 or more record owners 
of its stock on any dividend record date, from each record holder of 5 
percent or more of its stock; or
    (2) In the case of a corporation having less than 2,000 and more 
than 200 record owners of its stock, on any dividend record date, from 
each record holder of 1 percent or more of its stock; or
    (3) In the case of a corporation having 200 or less record owners of 
its stock, on any dividend record date, from each record holder of one-
half of 1 percent or more of its stock.


When making demand for the written statements required of each 
shareholder by this paragraph, the company shall inform each of the 
shareholders of his duty to submit as a part of his income tax return 
the statements which are required by Sec.  1.852-7 if he fails or 
refuses to comply with such demand. A list of the persons failing or 
refusing to comply in whole or in part with a company's demand shall be 
maintained as a part of its record required by this section. A company 
which fails to keep such records to show the actual ownership of its 
outstanding stock as are required by this section shall be taxable as an 
ordinary corporation and not as a regulated investment company.



Sec.  1.852-7  Additional information required in returns of shareholders.

    Any person who fails or refuses to comply with the demand of a 
regulated investment company for the written statements which Sec.  
1.852-6 requires the company to demand from its shareholders shall 
submit as a part of his income tax return a statement showing, to the 
best of his knowledge and belief--
    (a) The number of shares actually owned by him at any and all times 
during the period for which the return is filed in any company claiming 
to be a regulated investment company;
    (b) The dates of acquisition of any such stock during such period 
and the names and addresses of persons from whom it was acquired;
    (c) The dates of disposition of any such stock during such period 
and the names and addresses of the transferees thereof;
    (d) The names and addresses of the members of his family (as defined 
in section 544(a)(2)); the names and addresses of his partners, if any, 
in any partnership; and the maximum number of shares, if any, actually 
owned by each in any corporation claiming to be a regulated investment 
company, at any time during the last half of the taxable year of such 
company;
    (e) The names and addresses of any corporation, partnership, 
association, or trust in which he had a beneficial interest to the 
extent of at least 10 percent at any time during the period for which 
such return is made, and the number of shares of any corporation 
claiming to be a regulated investment company actually owned by each;
    (f) The maximum number of shares (including the number and face 
value of securities convertible into stock of the corporation) in any 
domestic corporation claiming to be a regulated investment company to be 
considered as constructively owned by such individual at any time during 
the last half of the corporation's taxable year, as provided in section 
544 and the regulations thereunder; and
    (g) The amount and date of receipt of each dividend received during 
such period from every corporation claiming to be a regulated investment 
company.



Sec.  1.852-8  Information returns.

    Nothing in Sec. Sec.  1.852-6 and 1.852-7 shall be construed to 
relieve regulated investment companies or their shareholders from the 
duty of filing information returns required by regulations prescribed 
under the provisions of subchapter A, chapter 61 of the Code.



Sec.  1.852-9  Special procedural requirements applicable to designation 
under section 852(b)(3)(D).

    (a) Regulated investment company--(1) Notice to shareholders. (i) A 
designation of undistributed capital gains under section 852(b)(3)(D) 
and paragraph

[[Page 28]]

(b)(2)(i) of Sec.  1.852-2 shall be made by notice on Form 2439 mailed 
by the regulated investment company to each person who is a shareholder 
of record of the company at the close of the company's taxable year. The 
notice on Form 2439 shall show the name, address, and employer 
identification number of the regulated investment company; the taxable 
year of the company for which the designation is made; the name, 
address, and identifying number of the shareholder; the amount 
designated by the company for inclusion by the shareholder in computing 
his long-term capital gains; and the tax paid with respect thereto by 
the company which is deemed to have been paid by the shareholder.
    (ii) In the case of a designation of undistributed capital gains 
with respect to a taxable year of the regulated investment company 
ending after December 31, 1969, and beginning before January 1, 1975, 
Form 2439 shall also show the shareholder's proportionate share of such 
gains which is gain described in section 1201(d)(1), his proportionate 
share of such gains which is gain described in section 1201(d)(2), and 
the amount (determined pursuant to subdivision (iv) of this 
subparagraph) by which the shareholder's adjusted basis in his shares 
shall be increased.
    (iii) In determining under subdivision (ii) of this subparagraph the 
portion of the undistributed capital gains which, in the hands of the 
shareholder, is gain described in section 1201(d) (1) or (2), the 
company shall consider that capital gain dividends for a taxable year 
are made first from its long-term capital gains for such year which are 
not described in section 1201(d) (1) or (2), to the extent thereof, and 
then from its long-term capital gains for such year which are described 
in section 1201(d) (1) or (2). A shareholder's proportionate share of 
undistributed capital gains for a taxable year which is gain described 
in section 1201(d)(1) is the amount which bears the same ratio to the 
amount included in his income as designated undistributed capital gains 
for such year as (a) the aggregate amount of the company's gains for 
such year which are described in section 1201(d)(1) and designated as 
undistributed capital gains bears to (b) the aggregate amount of the 
company's gains for such year which are designated as undistributed 
capital gains. A shareholder's proportionate share of gains which are 
described in section 1201(d)(2) shall be determined in a similar manner. 
Every regulated investment company shall keep a record of the proportion 
of undistributed capital gains (to which this subdivision applies) which 
is gain described in section 1201(d) (1) or (2).
    (iv) In the case of a designation of undistributed capital gains for 
any taxable year ending after December 31, 1969, and beginning before 
January 1, 1975, Form 2439 shall also show with respect to the 
undistributed capital gains of each shareholder the amount by which such 
shareholder's adjusted basis in his shares shall be increased under 
section 852(b)(3)(D)(iii). The amount by which each shareholders' 
adjusted basis in his shares shall be increased is the amount includible 
in his gross income with respect to such shares under section 
852(b)(3)(D)(i) less the tax which the shareholder is deemed to have 
paid with respect to such shares. The tax which each shareholder is 
deemed to have paid with respect to such shares is the amount which 
bears the same ratio to the amount of the tax imposed by section 
852(b)(3)(A) for such year with respect to the aggregate amount of the 
designated undistributed capital gains as the amount of such gains 
includible in the shareholder's gross income bears to the aggregate 
amount of such gains so designated.
    (v) Form 2439 shall be prepared in triplicate, and copies B and C of 
the form shall be mailed to the shareholder on or before the 45th day 
(30th day for a taxable year ending before February 26, 1964) following 
the close of the company's taxable year. Copy A of each Form 2439 must 
be associated with the duplicate copy of the undistributed capital gains 
tax return of the company (Form 2438), as provided in subparagraph 
(2)(ii) of this paragraph.
    (2) Return of undistributed capital gains tax--(i) Form 2438. Every 
regulated investment company which designates undistributed capital 
gains for any taxable year beginning after December 31, 1956, in 
accordance with subparagraph (1) of this paragraph, shall

[[Page 29]]

file for such taxable year an undistributed capital gains tax return on 
Form 2438 including on such return the total of its undistributed 
capital gains so designated and the tax with respect thereto. The return 
on Form 2438 shall be prepared in duplicate and shall set forth fully 
and clearly the information required to be included therein. The 
original of Form 2438 shall be filed on or before the 30th day after the 
close of the company's taxable year with the internal revenue officer 
designated in instructions applicable to Form 2438. The duplicate copy 
of form 2438 for the taxable year shall be attached to and filed with 
the income tax return of the company on Form 1120 for such taxable year.
    (ii) Copies A of Form 2439. For each taxable year which ends on or 
before December 31, 1965, there shall be submitted with the company's 
return on Form 2438 all copies A of Form 2439 furnished by the company 
to its shareholders in accordance with subparagraph (1) of this 
paragraph. For each taxable year which ends after December 31, 1965, 
there shall be submitted with the duplicate copy of the company's return 
on Form 2438, which is attached to and filed with the income tax return 
of the company on Form 1120 for the taxable year, all copies A of Form 
2439 furnished by the company to its shareholders in accordance with 
subparagraph (1) of this paragraph. The copies A of Form 2439 shall be 
accompanied by lists (preferably in the form of adding machine tapes) of 
the amounts of undistributed capital gains and of the tax paid with 
respect thereto shown on such forms. The totals of the listed amounts of 
undistributed capital gains and of tax paid with respect thereto must 
agree with the corresponding entries on Form 2438.
    (3) Payment of tax. The tax required to be returned on Form 2438 
shall be paid by the regulated investment company on or before the 30th 
day after the close of the company's taxable year to the internal 
revenue officer with whom the return on Form 2438 is filed.
    (b) Shareholder of record not actual owner--(1) Notice to actual 
owner. In any case in which a notice on Form 2439 is mailed pursuant to 
paragraph (a)(1) of this section by a regulated investment company to a 
shareholder of record who is a nominee of the actual owner or owners of 
the shares of stock to which the notice relates, the nominee shall 
furnish to each such actual owner notice of the owner's proportionate 
share of the amounts of undistributed capital gains and tax with respect 
thereto, as shown on the Form 2439 received by the nominee from the 
regulated investment company. The nominee's notice to the actual owner 
shall be prepared in triplicate on Form 2439 and shall contain the 
information prescribed in paragraph (a)(1) of this section, except that 
the name and address of the nominee, identified as such, shall be 
entered on the form in addition to, and in the space provided for, the 
name and address of the regulated investment company, and the amounts of 
undistributed capital gains and tax with respect thereto entered on the 
form shall be the actual owner's proportionate share of the 
corresponding items shown on the nominee's notice from the regulated 
investment company. Copies B and C of the Form 2439 prepared by the 
nominee shall be mailed to the actual owner--
    (i) For taxable years of regulated investment companies ending after 
February 25, 1964, on or before the 75th day (55th day in the case of a 
nominee who is acting as a custodian of a unit investment trust 
described in section 851(f)(1) and paragraph (d) of Sec.  1.851-7 for 
taxable years of regulated investment companies ending after December 8, 
1970, and 135th day if the nominee is a resident of a foreign country) 
following the close of the regulated investment company's taxable year, 
or
    (ii) For taxable years of regulated investment companies ending 
before February 26, 1964, on or before the 60th day (120th day if the 
nominee is a resident of a foreign country) following the close of the 
regulated investment company's taxable year.
    (2) Transmittal of Form 2439. The nominee shall enter the word 
``Nominee'' in the upper right hand corner of copy B of the notice on 
Form 2439 received by him from the regulated investment company, and on 
or before the appropriate day specified in subdivision (i) or (ii) of 
subparagraph (1) of this paragraph shall transmit such

[[Page 30]]

copy B, together with all copies A of Form 2439 prepared by him pursuant 
to subparagraph (1) of this paragraph, to the internal revenue officer 
with whom his income tax return is required to be filed.
    (3) Custodian of certain unit investment trusts. The requirements of 
this paragraph shall not apply to a nominee who is acting as a custodian 
of the unit investment trust described in section 851(f)(1) and 
paragraph (d) of Sec.  1.851-7 provided that the regulated investment 
company agrees with the nominee to satisfy the notice requirements of 
paragraph (a) of this section with respect to each holder of an interest 
in the unit investment trust whose shares are being held by such nominee 
as custodian and on or before the 45th day following the close of the 
company's taxable year, files with the Internal Revenue Service office 
where the company's income tax return is to be filed for the taxable 
year, a statement that the holders of the unit investment trust with 
whom the agreement was made have been directly notified by the regulated 
investment company. Such statement shall include the name, sponsor, and 
custodian of each unit investment trust whose holders have been directly 
notified. The nominee's requirements under this paragraph shall be 
deemed met if the regulated investment company transmits a copy of such 
statement to the nominee within such 45-day period; provided however, if 
the regulated investment company fails or is unable to satisfy the 
requirements of this paragraph with respect to the holders of interest 
in the unit investment trust, it shall so notify the Internal Revenue 
Service within 45 days following the close of its taxable year. The 
custodian shall, upon notice by the Internal Revenue Service that the 
regulated investment company has failed to comply with the agreement, 
satisfy the requirements of this paragraph within 30 days of such 
notice.
    (c) Shareholders--(1) Return and Recordkeeping Requirements--(i) 
Return requirements for taxable years beginning before January 1, 2002. 
For taxable years beginning before January 1, 2002, the copy B of Form 
2439 furnished to a shareholder by the regulated investment company or 
by a nominee, as provided in Sec.  1.852-9(a) or (b) shall be attached 
to the income tax return of the shareholder for the taxable year in 
which the amount of undistributed capital gains is includible in gross 
income as provided in Sec.  1.852-4(b)(2).
    (ii) Recordkeeping requirements for taxable years beginning after 
December 31, 2001. For taxable years beginning after December 31, 2001, 
the shareholder shall retain a copy of Form 2439 for as long as its 
contents may become material in the administration of any internal 
revenue law.
    (2) Credit or refund--(i) In general. The amount of the tax paid by 
the regulated investment company with respect to the undistributed 
capital gains required under section 852(b)(3)(D) and paragraph (b)(2) 
of Sec.  1.852-4 to be included by a shareholder in his computation of 
long-term capital gains for any taxable year is deemed paid by such 
shareholder under section 852(b)(3)(D)(ii) and such payment constitutes, 
for purposes of section 6513(a) (relating to time tax considered paid), 
an advance payment in like amount of the tax imposed under chapter 1 of 
the Code for such taxable year. In the case of an overpayment of tax 
within the meaning of section 6401, see section 6402 and the regulations 
in part 301 of this chapter (Regulations on Procedure and 
Administration) for rules applicable to the treatment of an overpayment 
of tax and section 6511 and the regulations in part 301 of this chapter 
(Regulations on Procedure and Administration) with respect to the 
limitations applicable to the credit or refund of an overpayment of tax.
    (ii) Form to be used. Claim for refund or credit of the tax deemed 
to have been paid by a shareholder with respect to an amount of 
undistributed capital gains shall be made on the shareholder's income 
tax return for the taxable year in which such amount of undistributed 
capital gains is includable in gross income. In the case of a 
shareholder which is a partnership, claim shall be made by the partners 
on their income tax returns for refund or credit of their distributive 
shares of the tax deemed to have been paid by the partnership. In the 
case of a shareholder which is exempt from tax under section

[[Page 31]]

501(a) and to which section 511 does not apply for the taxable year, 
claim for refund of the tax deemed to have been paid by such shareholder 
on an amount of undistributed capital gains for such year shall be made 
on Form 843 and copy B of Form 2439 furnished to such shareholder shall 
be attached to its claim. For other rules applicable to the filing of 
claims for credit or refund of an overpayment of tax, see Sec.  
301.6402-2 of this chapter (Regulations on Procedure and 
Administration), relating to claims for credit or refund, and Sec.  
301.6402-3 of this chapter, relating to special rules applicable to 
income tax.
    (3) Records. The shareholder is required to keep copy C of the Form 
2439 furnished for the regulated investment company's taxable years 
ending after December 31, 1969, and beginning before January 1, 1975, as 
part of his records to show increases in the adjusted basis of his 
shares in such company.
    (d) Penalties. For criminal penalties for willful failure to file a 
return, supply information, or pay tax, and for filing a false or 
fraudulent return, statement, or other document, see sections 7203, 
7206, and 7207.

[T.D. 6500, 25 FR 11710, Nov. 26, 1960, as amended by T.D. 6921, 32 FR 
8755, June 20, 1967; T.D. 7012, 34 FR 7688, May 15, 1969; T.D. 7187, 37 
FR 13256, July 6, 1972; T.D. 7332, 39 FR 44217, Dec. 23, 1974; T.D. 
7337, 39 FR 44973, Dec. 30, 1974; T.D. 8989, 67 FR 20031, Apr. 24, 2002; 
T.D. 9040, 68 FR 4921, Jan. 31, 2003]



Sec.  1.852-10  Distributions in redemption of interests 
in unit investment trusts.

    (a) In general. In computing that part of the excess of its net 
long-term capital gain over net short-term capital loss on which it must 
pay a capital gains tax, a regulated investment company is allowed under 
section 852(b)(3)(A)(ii) a deduction for dividends paid (as defined in 
section 561) determined with reference to capital gains dividends only. 
Section 561(b) provides that in determining the deduction for dividends 
paid, the rules provided in section 562 are applicable. Section 562(c) 
(relating to preferential dividends) provides that the amount of any 
distribution shall not be considered as a dividend unless such 
distribution is pro-rata, with no preference to any share of stock as 
compared with other shares of the same class except to the extent that 
the former is entitled to such preference.
    (b) Redemption distributions made by unit investment trust--(1) In 
general. Where a unit investment trust (as defined in paragraph (c) of 
this section) liquidates part of its portfolio represented by shares in 
a management company in order to make a distribution to a holder of an 
interest in the trust in redemption of part or all of such interest, and 
by so doing, the trust realizes net long-term capital gain, that portion 
of the distribution by the trust which is equal to the amount of the net 
long-term capital gain realized by the trust on the liquidation of the 
shares in the management company will not be considered a preferential 
dividend under section 562(c). For example, where the entire amount of 
net long-term capital gain realized by the trust on such a liquidation 
is distributed to the redeeming interest holder, the trust will be 
allowed the entire amount of net long-term capital gain so realized in 
determining the deduction under section 852(b)(3)(A)(ii) for dividends 
paid determined with reference to capital gains dividends only. This 
paragraph and section 852(d) shall apply only with respect to the 
capital gain net income (net capital gain for taxable years beginning 
before January 1, 1977) realized by the trust which is attributable to a 
redemption by a holder of an interest in such trust. Such dividend may 
be designated as a capital gain dividend by a written notice to the 
certificate holder. Such designation should clearly indicate to the 
holder that the holder's gain or loss on the redemption of the 
certificate may differ from such designated amount, depending upon the 
holder's basis for the redeemed certificate, and that the holder's own 
records are to be used in computing the holder's gain or loss on the 
redemption of the certificate.
    (2) Example. The application of the provisions of this paragraph may 
be illustrated by the following example:

    Example. B entered into a periodic payment plan contract with X as 
custodian and Z as plan sponsor under which he purchased a plan 
certificate of X. Under this contract,

[[Page 32]]

upon B's demand, X must redeem B's certificate at a price substantially 
equal to the value of the number of shares in Y, a management company, 
which are credited to B's account by X in connection with the unit 
investment trust. Except for a small amount of cash which X is holding 
to satisfy liabilities and to invest for other plan certificate holders, 
all of the assets held by X in connection with the trust consist of 
shares in Y. Pursuant to the terms of the periodic payment plan 
contract, 100 shares of Y are credited to B's account. Both X and Y have 
elected to be treated as regulated investment companies. On March 1, 
1965, B notified X that he wished to have his entire interest in the 
unit investment trust redeemed. In order to redeem B's interest, X 
caused Y to redeem 100 shares of Y which X held. At the time of 
redemption, each share of Y had a value of $15. X then distributed the 
$1,500 to B. X's basis for each of the Y shares which was redeemed was 
$10. Therefore, X realized a long-term capital gain of $500 ($5 x 100 
shares) which is attributable to the redemption by B of his interest in 
the trust. Under section 852(d), the $500 capital gain distributed to B 
will not be considered a preferential dividend. Therefore, X is allowed 
a deduction of $500 under section 852(b)(3)(A)(ii) for dividends paid 
determined with reference to capital gains dividends only, with the 
result that X will not pay a capital gains tax with respect to such 
amount.

    (c) Definition of unit investment trust. A unit investment trust to 
which paragraph (a) of this section refers is a business arrangement 
which--
    (1) Is registered under the Investment Company Act of 1940 as a unit 
investment trust;
    (2) Issues periodic payment plan certificates (as defined in such 
Act);
    (3) Possesses, as substantially all of its assets, securities issued 
by a management company (as defined in such Act);
    (4) Qualifies as a regulated investment company under section 851; 
and
    (5) Complies with the requirements provided for by section 852(a).


Paragraph (a) of this section does not apply to a unit investment trust 
described in section 851(f)(1) and paragraph (d) of Sec.  1.851-7.

[T.D. 6921, 32 FR 8755, June 20, 1967, as amended by T.D. 7187, 37 FR 
13527, July 6, 1972; T.D. 7728, 45 FR 72650, Nov. 3, 1980]



Sec.  1.852-11  Treatment of certain losses attributable to periods 
after October 31 of a taxable year.

    (a) Outline of provisions. This paragraph lists the provisions of 
this section.

    (a) Outline of provisions.
    (b) Scope.
    (1) In general.
    (2) Limitation on application of section.
    (c) Post-October capital loss defined.
    (1) In general.
    (2) Methodology.
    (3) October 31 treated as last day of taxable year for purpose of 
determining taxable income under certain circumstances.
    (i) In general.
    (ii) Effect on gross income.
    (d) Post-October currency loss defined.
    (1) Post-October currency loss.
    (2) Net foreign currency loss.
    (3) Foreign currency gain or loss.
    (e) Limitation on capital gain dividends.
    (1) In general.
    (2) Amount taken into account in current year.
    (i) Net capital loss.
    (ii) Net long-term capital loss.
    (3) Amount taken into account in succeeding year.
    (f) Regulated investment company may elect to defer certain losses 
for purposes of determining taxable income.
    (1) In general.
    (2) Effect of election in current year.
    (3) Amount of loss taken into account in current year.
    (i) If entire amount of net capital loss deferred.
    (ii) If part of net capital loss deferred.
    (A) In general.
    (B) Character of capital loss not deferred.
    (iii) If entire amount of net long-term capital loss deferred.
    (iv) If part of net long-term capital loss deferred.
    (v) If entire amount of post-October currency loss deferred.
    (vi) If part of post-October currency loss deferred.
    (4) Amount of loss taken into account in succeeding year and 
subsequent years.
    (5) Effect on gross income.
    (g) Earnings and profits.
    (1) General rule.
    (2) Special rule--treatment of losses that are deferred for purposes 
of determining taxable income.
    (h) Examples.
    (i) Procedure for making election.
    (1) In general.
    (2) When applicable instructions not available.
    (j) Transition rules.
    (1) In general.

[[Page 33]]

    (2) Retroactive election.
    (i) In general.
    (ii) Deadline for making election.
    (3) Amended return required for succeeding year in certain 
circumstances.
    (i) In general.
    (ii) Time for filing amended return.
    (4) Retroactive dividend.
    (i) In general.
    (ii) Method of making election.
    (iii) Deduction for dividends paid.
    (A) In general.
    (B) Limitation on ordinary dividends.
    (C) Limitation on capital gain dividends.
    (D) Effect on other years.
    (iv) Earnings and profits.
    (v) Receipt by shareholders.
    (vi) Foreign tax election.
    (vii) Example.
    (5) Certain distributions may be designated retroactively as capital 
gain dividends.
    (k) Effective date.

    (b) Scope--(1) In general. This section prescribes the manner in 
which a regulated investment company must treat a post-October capital 
loss (as defined in paragraph (c) of this section) or a post-October 
currency loss (as defined in paragraph (d)(1) of this section) for 
purposes of determining its taxable income, its earnings and profits, 
and the amount that it may designate as capital gain dividends for the 
taxable year in which the loss is incurred and the succeeding taxable 
year (the ``succeeding year'').
    (2) Limitation on application of section. This section shall not 
apply to any post-October capital loss or post-October currency loss of 
a regulated investment company attributable to a taxable year for which 
an election is in effect under section 4982(e)(4) of the Code with 
respect to the company.
    (c) Post-October capital loss defined--(1) In general. For purposes 
of this section, the term post-October capital loss means--
    (i) Any net capital loss attributable to the portion of a regulated 
investment company's taxable year after October 31; or
    (ii) If there is no such net capital loss, any net long-term capital 
loss attributable to the portion of a regulated investment company's 
taxable year after October 31.
    (2) Methodology. The amount of any net capital loss or any net long-
term capital loss attributable to the portion of the regulated 
investment company's taxable year after October 31 shall be determined 
in accordance with general tax law principles (other than section 1212) 
by treating the period beginning on November 1 of the taxable year of 
the regulated investment company and ending on the last day of such 
taxable year as though it were the taxable year of the regulated 
investment company. For purposes of this paragraph (c)(2), any item 
(other than a capital loss carryover) that is required to be taken into 
account or any rule that must be applied, for purposes of section 4982, 
on October 31 as if it were the last day of the regulated investment 
company's taxable year must also be taken into account or applied in the 
same manner as required under section 4982, both on October 31 and again 
on the last day of the regulated investment company's taxable year.
    (3) October 31 treated as last day of taxable year for purpose of 
determining taxable income under certain circumstances--(i) In general. 
If a regulated investment company has a post-October capital loss for a 
taxable year, any item that must be marked to market for purposes of 
section 4982 on October 31 as if it were the last day of the regulated 
investment company's taxable year must also be marked to market on 
October 31 and again on the last day of the regulated investment 
company's taxable year for purposes of determining its taxable income. 
If the regulated investment company does not have a post-October capital 
loss for a taxable year, the regulated investment company must treat 
items that must be marked to market for purposes of section 4982 on 
October 31 as if it were the last day of the regulated investment 
company's taxable year as marked to market only on the last day of its 
taxable year for purposes of determining its taxable income.
    (ii) Effect on gross income. The marking to market of any item on 
October 31 of a regulated investment company's taxable year for purposes 
of determining its taxable income under paragraph (c)(3)(i) of this 
section shall not affect the amount of the gross income of such company 
for such taxable year for purposes of section 851(b) (2) or (3).
    (d) Post-October currency loss defined. For purposes of this 
section--

[[Page 34]]

    (1) Post-October currency loss. The term post-October currency loss 
means any net foreign currency loss attributable to the portion of a 
regulated investment company's taxable year after October 31. For 
purposes of the preceding sentence, principles similar to those of 
paragraphs (c)(2) and (c)(3) of this section shall apply.
    (2) Net foreign currency loss. The term ``net foreign currency 
loss'' means the excess of foreign currency losses over foreign currency 
gains.
    (3) Foreign currency gain or loss. The terms ``foreign currency 
gain'' and ``foreign currency loss'' have the same meaning as provided 
in section 988(b).
    (e) Limitation on capital gain dividends--(1) In general. For 
purposes of determining the amount a regulated investment company may 
designate as capital gain dividends for a taxable year, the amount of 
net capital gain for the taxable year shall be determined without regard 
to any post-October capital loss for such year.
    (2) Amount taken into account in current year--(i) Net capital loss. 
If the post-October capital loss referred to in paragraph (e)(1) of this 
section is a post-October capital loss as defined in paragraph (c)(1)(i) 
of this section, the net capital gain of the company for the taxable 
year in which the loss arose shall be determined without regard to any 
capital gains or losses (both long-term and short-term) taken into 
account in computing the post-October capital loss for the taxable year.
    (ii) Net long-term capital loss. If the post-October capital loss 
referred to in paragraph (e)(1) of this section is a post-October 
capital loss as defined in paragraph (c)(1)(ii) of this section, the net 
capital gain of the company for the taxable year in which the loss arose 
shall be determined without regard to any long-term capital gain or loss 
taken into account in computing the post-October capital loss for the 
taxable year.
    (3) Amount taken into account in succeeding year. If a regulated 
investment company has a post-October capital loss (as defined in 
paragraph (c)(1)(i) or (c)(1)(ii) of this section) for any taxable year, 
then, for purposes of determining the amount the company may designate 
as capital gain dividends for the succeeding year, the net capital gain 
for the succeeding year shall be determined by treating all gains and 
losses taken into account in computing the post-October capital loss as 
arising on the first day of the succeeding year.
    (f) Regulated investment company may elect to defer certain losses 
for purposes of determining taxable income--(1) In general. A regulated 
investment company may elect, in accordance with the procedures of 
paragraph (i) of this section, to compute its taxable income for a 
taxable year without regard to part or all of any post-October capital 
loss or post-October currency loss for that year.
    (2) Effect of election in current year. The taxable income of a 
regulated investment company for a taxable year to which an election 
under paragraph (f)(1) of this section applies shall be computed without 
regard to that part of any post-October capital loss or post-October 
currency loss to which the election applies.
    (3) Amount of loss taken into account in current year--(i) If entire 
amount of net capital loss deferred. If a regulated investment company 
elects, under paragraph (f)(1) of this section, to defer the entire 
amount of a post-October capital loss as defined in paragraph (c)(1)(i) 
of this section, the taxable income of the company for the taxable year 
in which the loss arose shall be determined without regard to any 
capital gains or losses (both long-term and short-term) taken into 
account in computing the post-October capital loss for the taxable year.
    (ii) If part of net capital loss deferred--(A) In general. If a 
regulated investment company elects, under paragraph (f)(1) of this 
section, to defer less than the entire amount of a post-October capital 
loss as defined in paragraph (c)(1)(i) of this section, the taxable 
income of the company for the taxable year in which the loss arose shall 
be determined by including an amount of capital loss taken into account 
in computing the post-October capital loss for the taxable year equal to 
the amount of the post-October capital loss that is not deferred. No 
amount of capital gain taken into account in computing the

[[Page 35]]

post-October capital loss for the taxable year shall be taken into 
account in the determination.
    (B) Character of capital loss not deferred. The capital loss 
includible in the taxable income of the company under this paragraph 
(f)(3)(ii) for the taxable year in which the loss arose shall consist 
first of any short-term capital losses to the extent thereof, and then 
of any long-term capital losses, taken into account in computing the 
post-October capital loss for the taxable year.
    (iii) If entire amount of net long-term capital loss deferred. If a 
regulated investment company elects, under paragraph (f)(1) of this 
section, to defer the entire amount of a post-October capital loss as 
defined in paragraph (c)(1)(ii) of this section, the taxable income of 
the company for the taxable year in which the loss arose shall be 
determined without regard to any long-term capital gains or losses taken 
into account in computing the post-October capital loss for the taxable 
year.
    (iv) If part of net long-term capital loss deferred. If a regulated 
investment company elects, under paragraph (f)(1) of this section, to 
defer less than the entire amount of a post-October capital loss as 
defined in paragraph (c)(1)(ii) of this section, the taxable income of 
the company for the taxable year in which the loss arose shall be 
determined by including an amount of long-term capital loss taken into 
account in computing the post-October capital loss for the taxable year 
equal to the amount of the post-October capital loss that is not 
deferred. No amount of long term capital gain taken into account in 
computing the post-October capital loss for the taxable year shall be 
taken into account in the determination.
    (v) If entire amount of post-October currency loss deferred. If a 
regulated investment company elects, under paragraph (f)(1) of this 
section, to defer the entire amount of a post-October currency loss, the 
taxable income of the company for the taxable year in which the loss 
arose shall be determined without regard to any foreign currency gains 
or losses taken into account in computing the post-October currency loss 
for the taxable year.
    (vi) If part of post-October currency loss deferred. If a regulated 
investment company elects, under paragraph (f)(1) of this section, to 
defer less than the entire amount of a post-October currency loss, the 
taxable income of the company for the taxable year in which the loss 
arose shall be determined by including an amount of foreign currency 
loss taken into account in computing the post-October currency loss for 
the taxable year equal to the amount of the post-October currency loss 
that is not deferred. No amount of foreign currency gain taken into 
account in computing the post-October currency loss for the taxable year 
shall be taken into account in the determination.
    (4) Amount of loss taken into account in succeeding year and 
subsequent years. If a regulated investment company has a post-October 
capital loss or a post-October currency loss for any taxable year and an 
election under paragraph (f)(1) is made for that year, then, for 
purposes of determining the taxable income of the company for the 
succeeding year and all subsequent years, all capital gains and losses 
taken into account in determining the post-October capital loss, and all 
foreign currency gains and losses taken into account in determining the 
post-October currency loss, that are not taken into account under the 
rules of paragraph (f)(3) of this section in determining the taxable 
income of the regulated investment company for the taxable year in which 
the loss arose shall be treated as arising on the first day of the 
succeeding year.
    (5) Effect on gross income. An election by a regulated investment 
company to defer any post-October capital loss or any post-October 
currency loss for a taxable year under paragraph (f)(1) of this section 
shall not affect the amount of the gross income of such company for such 
taxable year (or the succeeding year) for purposes of section 851(b) (2) 
or (3).
    (g) Earnings and profits--(1) General rule. The earnings and profits 
of a regulated investment company for a taxable year are determined 
without regard to any post-October capital loss or post-October currency 
loss for that

[[Page 36]]

year. If a regulated investment company distributes with respect to a 
calendar year amounts in excess of the limitation described in the 
succeeding sentence, then, with respect to those excess amounts, for the 
taxable year with respect to which the amounts are distributed, the 
earnings and profits of the company are computed without regard to the 
preceding sentence. The limitation described in this sentence is the 
amount that would be the required distribution for that calendar year 
under section 4982 if ``100 percent'' were substituted for each 
percentage set forth in section 4982(b)(1).
    (2) Special Rule--Treatment of losses that are deferred for purposes 
of determining taxable income. If a regulated investment company elects 
to defer, under paragraph (f)(1) of this section, any part of a post-
October capital loss or post-October currency loss arising in a taxable 
year, then, for both the taxable year in which the loss arose and the 
succeeding year, both the earnings and profits and the accumulated 
earnings and profits of the company are determined as if the part of the 
loss so deferred had arisen on the first day of the succeeding year.
    (h) Examples. The provisions of paragraphs (e), (f), and (g) of this 
section may be illustrated by the following examples. For each example, 
assume that X is a regulated investment company that computes its income 
on a calendar year basis, and that no election is in effect under 
section 4982(e)(4).

    Example 1. X has a $25 net foreign currency gain, a $50 net short-
term capital loss, and a $75 net long-term capital gain for the post-
October period of 1988. X has no post-October currency loss and no post-
October capital loss for 1988, and this section does not apply.
    Example 2. X has the following capital gains and losses for the 
periods indicated:

------------------------------------------------------------------------
                                                        Long-    Short-
                                                        term      term
------------------------------------------------------------------------
01/01 to 10/31/88...................................      115        80
                                                          (15)      (20)
                                                     -------------------
                                                          100        60
                                                     ===================
11/01 to 12/31/88...................................       75       150
                                                         (150)      (50)
                                                     -------------------
                                                          (75)      100
                                                     ===================
01/01 to 10/31/89...................................       30        40
                                                           (5)      (20)
                                                     -------------------
                                                           25        20
                                                     ===================
11/01 to 12/31/89...................................       35       100
                                                           (0)      (50)
                                                     -------------------
                                                           35        50
------------------------------------------------------------------------


X has a post-October capital loss of $75 for its 1988 taxable year due 
to a net long-term capital loss for the post-October period of 1988. X 
does not make an election under paragraph (f)(1) of this section.
    (i) Capital gain dividends. X may designate up to $100 as a capital 
gain dividend for 1988 because X must disregard the $75 long-term 
capital gain and the $150 long-term capital loss for the post-October 
period of 1988 in computing its net capital gain for this purpose. In 
computing its net capital gain for 1989 for the purposes of determining 
the amount it may designate as a capital gain dividend for 1989, X must 
take into account the $75 long-term capital gain and the $150 long-term 
capital loss for the post-October period of 1988 in addition to the 
long-term and short-term capital gains and losses for 1989. Accordingly, 
X may not designate any amount as a capital gain dividend for 1989.
    (ii) Taxable income. X must include the $75 long-term capital gain 
and the $150 long-term capital loss for its post-October period of 1988 
in its taxable income for 1988 because it did not make an election under 
paragraph (f)(1) of this section for 1988. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $25 and a net short-
term capital gain of $160. X's taxable income for 1989 will include a 
net capital gain of $60 and a net short-term capital gain of $70.
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $75 long-term capital gain and 
the $150 long-term capital loss for the post-October period of 1988. X 
must, however, include the $75 long-term capital gain and $150 long-term 
capital loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $260 of 
capital gain in its earnings and profits for 1988, includes $185 in its 
accumulated earnings and profits for 1988, and includes $130 of capital 
gain in its earnings and profits for 1989.
    Example 3. Same facts as example 2, except that X elects to defer 
the entire $75 post-October capital loss for 1988 under paragraph (f)(1) 
of this section for purposes of determining its taxable income for 1988.
    (i) Capital gain dividends. Same result as in example 2.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $75 long-term capital gain and the $150 long-term 
capital loss for the post-October period of 1988 because it made an 
election to defer

[[Page 37]]

the entire $75 post-October capital loss for 1988 under paragraph (f)(1) 
of this section. Accordingly, X's taxable income for 1988 will include a 
net capital gain of $100 and a net short-term capital gain of $160. X 
must include the $75 long-term capital gain and the $150 long-term 
capital loss for the post-October period of 1988 in its taxable income 
for 1989 in addition to the long-term and short-term capital gains and 
losses for 1989. Accordingly, X's taxable income for 1989 will include a 
net long-term capital loss of $15 and a net short-term capital gain of 
$70.
    (iii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $75 long-term capital gain and $150 long-term capital loss 
for the post-October period of 1988. In determining both its earnings 
and profits and its accumulated earnings and profits for 1989, X must 
include (in addition to the long-term and short-term capital gains and 
losses for 1989) the $75 long-term capital gain and $150 long-term 
capital loss for the post-October period of 1988 as if those deferred 
gains and losses arose on January 1, 1989. Thus, X will include $260 of 
capital gain in its earnings and profits for 1988 and $55 of capital 
gain in its earnings and profits for 1989.
    Example 4. Same facts as example 2, except that X elects to defer 
only $50 of the post-October capital loss for 1988 under paragraph 
(f)(1) of this section for purposes of determining its taxable income 
for 1988.
    (i) Capital gain dividends. Same results as in example 2.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $75 long-term capital gain and $125 of the $150 
long-term capital loss for the post-October period of 1988 because it 
made an election to defer $50 of the $75 post-October capital loss for 
1988 under paragraph (f)(1) of this section. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $75 and a net short-
term capital gain of $160. X must include the $75 long-term capital gain 
and $125 of the $150 long-term capital loss for the post-October period 
of 1988 in its taxable income for 1989 in addition to the long-term and 
short-term capital gains and losses for 1989. Accordingly, X's taxable 
income for 1989 will include a net capital gain of $10 and a net short-
term capital gain of $70.
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $75 long-term capital gain and 
the $150 long-term capital loss for the post-October period of 1988. X 
must include $25 of the $150 long-term capital loss for the post-October 
period of 1988 in determining its accumulated earnings and profits for 
1988. In determining both its earnings and profits and its accumulated 
earnings and profits for 1989, X must include (in addition to the long-
term and short-term capital gains and losses for 1989) the $75 long-term 
capital gain and $125 of the $150 long-term capital loss for the post-
October period of 1988 as if those deferred gains and losses arose on 
January 1, 1989. Thus, X includes $260 of capital gain in its earnings 
and profits for 1988, includes $235 in its accumulated earnings and 
profits for 1988, and includes $80 of capital gain in its earnings and 
profits for 1989.
    Example 5. X has the following capital gains and losses for the 
periods indicated:

------------------------------------------------------------------------
                                                        Long-    Short-
                                                        term      term
------------------------------------------------------------------------
01/01 to 10/31/88...................................      115        80
                                                          (15)      (20)
                                                     -------------------
                                                          100        60
                                                     ===================
11/01 to 12/31/88...................................      150        50
                                                          (75)     (150)
                                                     -------------------
                                                           75      (100)
                                                     ===================
01/01 to 10/31/89...................................       30        40
                                                           (5)      (20)
                                                     -------------------
                                                           25        20
                                                     ===================
11/01 to 12/31/89...................................       35       100
                                                           (0)      (50)
                                                     -------------------
                                                           35        50
------------------------------------------------------------------------


X has a post-October capital loss of $25 for its 1988 taxable year due 
to a net capital loss for the post-October period of 1988. X does not 
make an election under paragraph (f)(1) of this section.
    (i) Capital gain dividends. X may designate up to $100 as a capital 
gain dividend for 1988 because X must disregard the $150 long-term 
capital gain, the $75 long-term capital loss, the $50 short-term capital 
gain, and the $150 short-term capital loss for the post-October period 
of 1988 in computing its net capital gain for this purpose. In computing 
its net capital gain for 1989 for purposes of determining the amount it 
may designate as a capital gain dividend for 1989, X must take into 
account the $150 long-term capital gain, the $75 long-term capital loss, 
the $50 short-term capital gain, and the $150 short-term capital loss 
for the post-October period of 1988 in addition to the long-term and 
short-term capital gains and losses for 1989. Accordingly, X may 
designate up to $105 as a capital gain dividend for 1989.
    (ii) Taxable income. X must include the $150 long-term capital gain, 
the $75 long-term capital loss, the $50 short-term capital gain, and the 
$150 short-term capital loss for the post-October period of 1988 in its 
taxable income for 1988 because it did not make an election under 
paragraph (f)(1) of this section for 1988. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $135 (consisting of a 
net long-term capital gain of $175 and a net short-term capital loss of 
$40).

[[Page 38]]

X's taxable income for 1989 will include a net capital gain of $60 and a 
net short-term capital gain of $70.
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $150 long-term capital gain, the 
$75 long-term capital loss, the $50 short-term capital gain, and the 
$150 short-term capital loss for the post-October period of 1988. X 
must, however, include the $150 long-term capital gain, the $75 long-
term capital loss, the $50 short-term capital gain, and the $150 short-
term capital loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $160 of 
capital gain in its earnings and profits for 1988, includes $135 in its 
accumulated earnings and profits for 1988, and includes $130 of capital 
gain in its earnings and profits for 1989.
    Example 6. Same facts as example 5, except that X elects to defer 
the entire $25 post-October capital loss for 1988 under paragraph (f)(1) 
of this section for purposes of determining its taxable income for 1988.
    (i) Capital gain dividends. Same result as in example 5.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $150 long-term capital gain, the $75 long-term 
capital loss, the $50 short-term capital gain, and the $150 short-term 
capital loss for the post-October period of 1988 because it made an 
election to defer the entire $25 post-October capital loss for 1988 
under paragraph (f)(1) of this section. Accordingly, X's taxable income 
for 1988 will include a net capital gain of $100 and a net short-term 
capital gain of $60. X must include the $150 long-term capital gain, the 
$75 long-term capital loss, the $50 short-term capital gain, and the 
$150 short-term capital loss for the post-October period of 1988 in its 
taxable income for 1989 in addition to the long-term and short-term 
capital gains and losses for 1989. Accordingly, X's taxable income for 
1989 will include a net capital gain of $105 (consisting of a net long-
term capital gain of $135 and a net short-term capital loss of $30).
    (iii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $150 long-term capital gain, the $75 long-term capital 
loss, the $50 short-term capital gain, and the $150 short-term capital 
loss for the post-October period of 1988. In determining both its 
earnings and profits and its accumulated earnings and profits for 1989, 
X must include (in addition to the long-term and short-term capital 
gains and losses for 1989) the $150 long-term capital gain, the $75 
long-term capital loss, the $50 short-term capital gain, and the $150 
short-term capital loss for the post-October period of 1988 as if those 
deferred gains and losses arose on January 1, 1989. Thus, X will include 
$160 of capital gain in its earnings and profits for 1988 and $105 of 
capital gain in its earnings and profits for 1989.
    Example 7. Same facts as example 5, except that X elects to defer 
only $20 of the post-October capital loss for 1988 under paragraph 
(f)(1) of this section for purposes of determining its taxable income 
for 1988.
    (i) Capital gain dividends. Same result as in example 5.
    (ii) Taxable income. X must compute its taxable income for 1988 by 
including $5 of the $150 short-term capital loss for the post-October 
period of 1988, but without regard to the $150 long-term capital gain, 
the $75 long-term capital loss, the $50 short-term capital gain, and 
$145 of the $150 short-term capital loss for the post-October period of 
1988 because it made an election to defer $20 of the $25 post-October 
capital loss for 1988 under paragraph (f)(1) of this section. 
Accordingly, X's taxable income for 1988 will include a net capital gain 
of $100 and a net short-term capital gain of $55. X must include the 
$150 long-term capital gain, the $75 long-term capital loss, the $50 
short-term capital gain, and $145 of the $150 short-term capital loss 
for the post-October period of 1988 in its taxable income for 1989 in 
addition to the long-term and short-term capital gains and losses for 
1989. Accordingly, X's taxable income for 1989 will include a net 
capital gain of $110 (consisting of a long-term capital gain of $135 and 
a net short-term capital loss of $25).
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $150 long-term capital gain, the 
$75 long-term capital loss, the $50 short-term capital gain, and the 
$150 short-term capital loss for the post-October period of 1988. In 
determining its accumulated earnings and profits for 1988, X must 
include $5 of the $150 short-term capital loss for the post-October 
period of 1988. In determining its accumulated earnings and profits for 
1989, X must include (in addition to the long-term and short-term 
capital gains and losses for 1989) the $150 long-term capital gain, the 
$75 long-term capital loss, the $50 short-term capital gain, and $145 of 
the $150 short-term capital loss for the post-October period of 1988 as 
if those deferred gains and losses arose on January 1, 1989. Thus, X 
includes $160 of capital gain in its earnings and profits for 1988, 
includes $155 in its accumulated earnings and profits for 1988, and 
includes $110 of capital gain in its earnings and profits for 1989.
    Example 8. X has the following capital gains and losses for the 
periods indicated:

------------------------------------------------------------------------
                                                        Long-    Short-
                                                        term      term
------------------------------------------------------------------------
01/01 to 10/31/88...................................      115        80
                                                          (15)      (20)
                                                     -------------------
                                                          100        60
                                                     ===================
11/01 to 12/31/88...................................       15        25

[[Page 39]]

 
                                                          (75)      (10)
                                                     -------------------
                                                          (60)       15
                                                     ===================
01/01 to 10/31/89...................................       80        50
                                                           (5)     (100)
                                                     -------------------
                                                           75       (50)
                                                     ===================
11/01 to 12/31/89...................................       85        40
                                                           (0)      (20)
                                                     -------------------
                                                           85        20
------------------------------------------------------------------------


X has a post-October capital loss of $45 for its 1988 taxable year due 
to a net capital loss for the post-October period of 1988. X does not 
make an election under paragraph (f)(1) of this section.
    (i) Capital gain dividends. X may designate up to $100 as a capital 
gain dividend for 1988 because X must disregard the $15 long-term 
capital gain, the $75 long-term capital loss, the $25 short-term capital 
gain, and the $10 short-term capital loss for the post-October period of 
1988 in computing its net capital gain for this purpose. In computing 
its net capital gain for 1989 for purposes of determining the amount it 
may designate as a capital gain dividend for 1989, X must take into 
account the $15 long-term capital gain, the $75 long-term capital loss, 
the $25 short-term capital gain, and the $10 short-term capital loss for 
the post-October period of 1988 in addition to the long-term and short-
term capital gains and losses for 1989. Accordingly, X may designate up 
to $85 as a capital gain dividend for 1989.
    (ii) Taxable income. X must include the $15 long-term capital gain, 
the $75 long-term capital loss, the $25 short-term capital gain, and the 
$10 short-term capital loss for the post-October period of 1988 in its 
taxable income for 1988 because it did not make an election under 
paragraph (f)(1) of this section for 1988. Accordingly, X's taxable 
income for 1988 will include a net capital gain of $40 and a net short-
term capital gain of $75. X's taxable income for 1989 will include a net 
capital gain of $130 for 1989 (consisting of a net long-term capital 
gain of $160 and a net short-term capital loss of $30).
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $15 long-term capital gain, the 
$75 long-term capital loss, the $25 short-term capital gain, and the $10 
short-term capital loss for the post-October period of 1988. X must, 
however, include the $15 long-term capital gain, the $75 long-term 
capital loss, the $25 short-term capital gain, and the $10 short-term 
capital loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $160 of 
capital gain in its earnings and profits for 1988, includes $115 in its 
accumulated earnings and profits for 1988, and includes $130 of capital 
gain in its earnings and profits for 1989.
    Example 9. Same facts as example 8, except that X elects to defer 
the entire $45 post-October capital loss for 1988 under paragraph (f)(1) 
of this section for purposes of determining its taxable income for 1988.
    (i) Capital gain dividends. Same result as in example 8.
    (ii) Taxable income. X must compute its taxable income for 1988 
without regard to the $15 long-term capital gain, the $75 long-term 
capital loss, the $25 short-term capital gain, and the $10 short-term 
capital loss for the post-October period of 1988 because it made an 
election to defer the entire $45 post-October capital loss for 1988 
under paragraph (f)(1) of this section. Accordingly, X's taxable income 
for 1988 will include a net capital gain of $100 and a net short-term 
capital gain of $60. X must include the $15 long-term capital gain, the 
$75 long-term capital loss, the $25 short-term capital gain, and the $10 
short-term capital loss for the post-October period of 1988 in its 
taxable income for 1989 in addition to the long-term and short-term 
capital gains and losses for 1989. Accordingly, X's taxable income for 
1989 will include a net capital gain of $85 (consisting of a net long-
term capital gain of $100 and a net short-term capital loss of $15).
    (iii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $15 long-term capital gain, the $75 long-term capital 
loss, the $25 short-term capital gain, and the $10 short-term capital 
loss for the post-October period of 1988. In determining both its 
earnings and profits and its accumulated earnings and profits for 1989, 
X must include (in addition to the long-term and short-term capital 
gains and losses for 1989) the $15 long-term capital gain, the $75 long-
term capital loss, the $25 short-term capital gain, and the $10 short-
term capital loss for the post-October period of 1988 as if those 
deferred gains and losses arose on January 1, 1989. Thus, X will include 
$160 of capital gain in its earnings and profits for 1988 and $85 of 
capital gain in its earnings and profits for 1989.
    Example 10. Same facts as example 8, except that X elects to defer 
only $30 of the post-October capital loss for 1988 under paragraph 
(f)(1) of this section for purposes of determining its taxable income 
for 1988.
    (i) Capital gain dividends. Same result as in example 8.
    (ii) Taxable income. X must compute its taxable income for 1988 by 
including $5 of the $75 long-term capital loss and the $10 short-term 
capital loss for the post-October period of 1988, but without regard to 
the $15 long-term capital gain, $70 of the $75 long-term capital loss, 
and the $25 short-term capital

[[Page 40]]

gain for the post-October period of 1988 because it made an election to 
defer $30 of the $45 post-October capital loss for 1988 under paragraph 
(f)(1) of this section. Accordingly, X's taxable income for 1988 will 
include a net capital gain of $95 and a net short-term capital gain of 
$50. X must include the $15 long-term capital gain, $70 of the $75 long-
term capital loss, and the $25 short-term capital gain for the post-
October period of 1988 in its taxable income for 1989 in addition to the 
long-term and short-term capital gains and losses for 1989. Accordingly, 
X's taxable income for 1989 will include a net capital gain of $100 
(consisting of a net long-term capital gain of $105 and a net short-term 
capital loss of $5).
    (iii) Earnings and profits. X must determine its earnings and 
profits for 1988 without regard to the $15 long-term capital gain, the 
$75 long-term capital loss, the $25 short-term capital gain, and the $10 
short-term capital loss for the post-October period of 1988. In 
determining its accumulated earnings and profits for 1988, X must 
include $5 of the $75 long-term capital loss and the $10 short-term 
capital loss for the post-October period of 1988. In determining both 
its earnings and profits and its accumulated earnings and profits for 
1989, X must include (in addition to the long-term and short-term 
capital gains and losses for 1989) the $15 long-term capital gain, $70 
of the $75 long-term capital loss, and the $25 short-term capital gain 
for the post-October period of 1988 as if those deferred gains and 
losses arose on January 1, 1989. Thus, X includes $160 of capital gain 
in its earnings and profits for 1988, includes $145 in its accumulated 
earnings and profits for 1989, and includes $100 of capital gain in its 
earnings and profits for 1989 (consisting of a net long-term capital 
gain of $105 and a net short-term capital loss of $5).
    Example 11. X has the following foreign currency gains and losses 
attributable to the periods indicated:

01/01 to 10/31/88....................................................200
11/01 to 12/31/88..................................................(100)
01/01 to 10/31/89....................................................110
11/01 to 12/31/89.....................................................40


X has a $100 post-October currency loss for its 1988 taxable year due to 
a net foreign currency loss for the post-October period of 1988. X does 
not make an election under paragraph (f)(1) of this section.
    (i) Taxable income. X must compute its taxable income for 1988 by 
including the $100 foreign currency loss for the post-October period of 
1988 because it did not make an election under paragraph (f)(1) of this 
section. Accordingly, X's taxable income for 1988 will include a net 
foreign currency gain of $100. X's taxable income for 1989 will include 
a net foreign currency gain of $150.
    (ii) Earnings and profits. X must determine its earnings and profits 
for 1988 without regard to the foreign currency loss for the post-
October period of 1988. X must, however, include the $100 foreign 
currency loss for the post-October period 1988 in determining its 
accumulated earnings and profits for 1988. Thus, X includes $200 of 
foreign currency gain in its earnings and profits for 1988, includes 
$100 in its accumulated earnings and profits for 1988, and includes $150 
of foreign currency gain in its earnings and profits for 1989.
    Example 12. Same facts as example 11, except that X elects to defer 
the entire $100 post-October currency loss for 1988 under paragraph 
(f)(1) of this section for purposes of determining its taxable income 
for 1988.
    (i) Taxable income. X must compute its taxable income for 1988 
without regard to the $100 foreign currency loss for the post-October 
period of 1988 because it made an election to defer the entire $100 
post-October currency loss for 1988 under paragraph (f)(1) of this 
section. Accordingly, X's taxable income for 1988 will include a net 
foreign currency gain of $200. X's taxable income for 1989 will include 
a net foreign currency gain of $50 because X must compute its taxable 
income for 1989 by including the $100 foreign currency loss for the 
post-October period of 1988 in addition to the foreign currency gains 
and losses for 1989.
    (ii) Earnings and profits. For 1988, X must determine both its 
earnings and profits and its accumulated earnings and profits without 
regard to the $100 foreign currency loss for the post-October period of 
1988. In determining both its earnings and profits and its accumulated 
earnings and profits for 1989, X must include (in addition to the 
foreign currency gains and losses for 1989) the $100 foreign currency 
loss for the post-October period 1988 as if that deferred loss arose on 
January 1, 1989. Thus, X will include $200 of foreign currency gain in 
its earnings and profits for 1988 and $50 of foreign currency gain in 
its earnings and profits for 1989.
    Example 13. Same facts as example 11, except that X elects to defer 
only $75 of the post-October currency loss under paragraph (f)(1) of 
this section for purposes of determining its taxable income for 1988.
    (i) Taxable income. X must compute its taxable income for 1988 by 
including $25 of the $100 foreign currency loss for the post-October 
period of 1988, but without regard to $75 of the $100 foreign currency 
loss for the post-October period of 1988 because it made an election to 
defer $75 of the $100 post-October currency loss for 1988 under 
paragraph (f)(1) of this section. Accordingly, X's taxable income for 
1988 will include a net foreign currency gain of $175. X's taxable 
income will include a net foreign currency gain of $75 for

[[Page 41]]

1989 because X must compute its taxable income for 1989 by including $75 
of the $100 foreign currency loss for the post-October period of 1988 in 
addition to the foreign currency gains and losses for 1989.
    (ii) Earnings and profits. X must determine its earnings and profits 
for 1988 without regard to the $100 foreign currency loss for the post-
October period of 1988. X must, however, inlcude $25 of the $100 foreign 
currency loss for the post-October period of 1988 in determining its 
accumulated earnings and profits for 1988. In determining both its 
earnings and profits and its accumulated earnings and profits for 1989, 
X must include (in addition to the foreign currency gains and losses for 
1989) the $75 of the $100 foreign currency loss for the post-October 
period of 1988 as if that loss arose on January 1, 1989. Thus, X 
includes $200 of foreign currency gain in its earnings and profits for 
1988, includes $175 in its accumulated earnings and profits for 1988, 
and includes $75 of foreign currency gain in its earnings and profits 
for 1989.

    (i) Procedure for making election--(1) In general. Except as 
provided in paragraph (i)(2) of this section, a regulated investment 
company may make an election under paragraph (f)(1) of this section for 
a taxable year to which this section applies by completing its income 
tax return (including any necessary schedules) for that taxable year in 
accordance with the instructions for the form that are applicable to the 
election.
    (2) When applicable instructions not available. If the instructions 
for the income tax returns of regulated investment companies for a 
taxable year to which this section applies do not reflect the provisions 
of this section, a regulated investment company may make an election 
under paragraph (f)(1) of this section for that year by entering the 
appropriate amounts on its income tax return (including any necessary 
schedules) for that year, and by attaching a written statement to the 
return that states--
    (i) The taxable year for which the election under this section is 
made;
    (ii) The fact that the regulated investment company elects to defer 
all or a part of its post-October capital loss or post-October currency 
loss for that taxable year for purposes of computing its taxable income 
under the terms of this section;
    (iii) The amount of the post-October capital loss or post-October 
currency loss that the regulated investment company elects to defer for 
that taxable year; and
    (iv) The name, address, and employer identification number of the 
regulated investment company.
    (j) Transition rules--(1) In general. For a taxable year ending 
before March 2, 1990 in which a regulated investment company incurred a 
post-October capital loss or post-October currency loss, the company may 
use any method that is consistently applied and in accordance with 
reasonable business practice to determine the amounts taken into account 
in that taxable year for purposes of paragraphs (e)(2), (f)(3), and (g) 
of this section and to determine the amount taken into account in the 
succeeding year for purposes of paragraphs (e)(3), (f)(4), and (g) of 
this section. For example, for purposes of paragraph (e), a taxpayer may 
use a method that treats as incurred in a taxable year all capital gains 
taken into account in computing the post-October capital loss for that 
year and an amount of capital loss for such period equal to the amount 
of such gains and that treats the remaining amount of capital loss for 
such period as arising on the first day of the succeeding year.


Similarly, for purposes of paragraph (e)(3), a taxpayer may use a method 
that treats as arising on the first day of the succeeding year only the 
excess of the capital losses from sales or exchanges after October 31 
over the capital gains for such period (that is, the net capital loss or 
net long-term capital loss for such period).
    (2) Retroactive election--(i) In general. A regulated investment 
company may make an election (a ``retroactive election'') under 
paragraph (f)(1) for a taxable year with respect to which it has filed 
an income tax return on or before May 1, 1990 (a ``retroactive election 
year'') by filing an amended return (including any necessary schedules) 
for the retroactive election year reflecting the appropriate amounts and 
by attaching a written statement to the return that complies with the 
requirements of paragraph (i)(2) of this section.
    (ii) Deadline for making election. A retroactive election may be 
made no later than December 31, 1990.

[[Page 42]]

    (3) Amended return required for succeeding year in certain 
circumstances--(i) In general. If, at the time a regulated investment 
company makes a retroactive election under this section, it has already 
filed an income tax return for the succeeding year, the company must 
file an amended return for such succeeding year reflecting the 
appropriate amounts.
    (ii) Time for filing amended return. An amended return required 
under paragraph (j)(3)(i) of this section must be filed together with 
the amended return described in paragraph (j)(2)(i).
    (4) Retroactive dividend--(i) In general. A regulated investment 
company that makes a retroactive election under this section for a 
retroactive election year may elect to treat any dividend (or portion 
thereof) declared and paid (or treated as paid under section 852(b)(7)) 
by the regulated investment company after the retroactive election year 
and on or before December 31, 1990 as having been paid during the 
retroactive election year (a ``retroactive dividend''). This election 
shall be irrevocable with respect to the retroactive dividend to which 
it applies.
    (ii) Method of making election. The election under this paragraph 
(j)(4) must be made by the regulated investment company by treating the 
dividend (or portion thereof) to which the election applies as a 
dividend paid during the retroactive election year in computing its 
deduction for dividends paid in its tax returns for all applicable years 
(including the amended return(s) required to be filed under paragraphs 
(j)(2) and (3) of this section).
    (iii) Deduction for dividends paid--(A) In general. Subject to the 
rules of sections 561 and 562, a regulated investment company shall 
include the amount of any retroactive dividend in computing its 
deduction for dividends paid for the retroactive election year. No 
deduction for dividends paid shall be allowed under this paragraph 
(j)(4)(iii)(A) for any amount not paid (or treated as paid under section 
852(b)(7)) on or before December 31, 1990.
    (B) Limitation on ordinary dividends. The amount of retroactive 
dividends (other than retroactive dividends qualifying as capital gain 
dividends) paid for a retroactive election year under this section shall 
not exceed the increase, if any, in the investment company taxable 
income of the regulated investment company (determined without regard to 
the deduction for dividends paid (as defined in section 561)) that is 
attributable solely to the regulated investment company having made the 
retroactive election.
    (C) Limitation on capital gain dividends. The amount of retroactive 
dividends qualifying as capital gain dividends paid for a retroactive 
election year under this section shall not exceed the increase, if any, 
in the amount of the excess described in section 852(b)(3)(A) (relating 
to the excess of the net capital gain over the deduction for capital 
gain dividends paid) that is attributable solely to the regulated 
investment company having made the retroactive election.
    (D) Effect on other years. A retroactive dividend shall not be 
includible in computing the deduction for dividends paid for--
    (1) The taxable year in which such distribution is actually paid (or 
treated as paid under section 852(b)(7)); or
    (2) Under section 855(a), the taxable year preceding the retroactive 
election year.
    (iv) Earnings and profits. A retroactive dividend shall be 
considered as paid out of the earnings and profits of the retroactive 
election year (computed with the application of sections 852(c) and 855, 
Sec.  1.852-5, Sec.  1.855-1, and this section), and not out of the 
earnings and profits of the taxable year in which the distribution is 
actually paid (or treated as paid under section 852(b)(7)).
    (v) Receipt by shareholders. Except as provided in section 
852(b)(7), a retroactive dividend shall be included in the gross income 
of the shareholders of the regulated investment company for the taxable 
year in which the dividend is received by them.
    (vi) Foreign tax election. If a regulated investment company to 
which section 853 (relating to foreign taxes) is applicable for a 
retroactive election year elects to treat a dividend paid (or treated as 
paid under section 852(b)(7)) during the taxable year as a retroactive 
dividend, the shareholders of the

[[Page 43]]

regulated investment company shall consider the amounts described in 
section 853(b)(2) allocable to such distribution as paid or received, as 
the case may be, in the shareholder's taxable year in which the 
distribution is made.
    (vii) Example. The provisions of this paragraph (j)(4) may be 
illustrated by the following example:

    Example. X is a regulated investment company that computes its 
income on a calendar year basis. No election is in effect under section 
4982(e)(4). X has the following income for 1988:

                    Foreign Currency Gains and Losses

                            Gains and Losses

Jan. 1-Oct. 31--100
Nov. 1-Dec. 31--(75)

                        Capital Gains and Losses

Jan. 1-Oct. 31--short term, 100; long term, 100
Nov. 1-Dec. 31--short term, 50; long term, (100)

    (A) X had investment company taxable income of $175 and no net 
capital gain for 1988 for taxable income purposes. X distributed $175 of 
investment company taxable income as an ordinary dividend for 1988.
    (B) If X makes a retroactive election under this section to defer 
the entire $75 post-October currency loss and the entire $50 post-
October capital loss for the post-October period of its 1988 taxable 
year for purposes of computing its taxable income, that deferral 
increases X's investment company taxable income for 1988 by $25 (due to 
an increase in foreign currency gain of $75 and a decrease in short-term 
capital gain of $50) to $200 and increases the excess described in 
section 852(b)(3)(A) for 1988 by $100 from $0 to $100. The amount that X 
may treat as a retroactive ordinary dividend is limited to $25, and the 
amount that X may treat as a retroactive capital gain dividend is 
limited to $100.

    (5) Certain distributions may be designated retroactively as capital 
gain dividends. To the extent that a regulated investment company 
designated as capital gain dividends for a taxable year less than the 
maximum amount permitted under paragraph (e) of this section for that 
taxable year, the regulated investment company may designate an 
additional amount of dividends paid (or treated as paid under sections 
852(b)(7) or 855, or paragraph (j)(4) of this section) for the taxable 
year as capital gain dividends, notwithstanding that a written notice 
was not mailed to its shareholders within 60 days after the close of the 
taxable year in which the distribution was paid (or treated as paid 
under section 852(b)(7)).
    (k) Effective date. the provisions of this section shall apply to 
taxable years ending after October 31, 1987.

[T.D. 8287, 55 FR 3213, Jan. 31, 1990; 55 FR 7891, Mar. 6, 1990; 55 FR 
11110, Mar. 26, 1990. Redesignated and amended by T.D. 8320, 55 FR 
50176, Dec. 5, 1990; 56 FR 2808, Jan. 24, 1991; 56 FR 8130, Feb. 27, 
1991]



Sec.  1.852-12  Non-RIC earnings and profits.

    (a) Applicability of section 852(a)(2)(A)--(1) In general. An 
investment company does not satisfy section 852(a)(2)(A) unless--
    (i) Part I of subchapter M applied to the company for all its 
taxable years ending on or after November 8, 1983; and
    (ii) For each corporation to whose earnings and profits the 
investment company succeeded by the operation of section 381, part I of 
subchapter M applied for all the corporation's taxable years ending on 
or after November 8, 1983.
    (2) Special rule. See section 1071(a)(5)(D) of the Tax Reform Act of 
1984, Public Law 98-369 (98 Stat. 1051), for a special rule which treats 
part I of subchapter M as having applied to an investment company's 
first taxable year ending after November 8, 1983.
    (b) Applicability of section 852(a)(2)(B)--(1) In general. An 
investment company does not satisfy section 852(a)(2)(B) unless, as of 
the close of the taxable year, it has no earnings and profits other than 
earnings and profits that--
    (i) Were earned by a corporation in a year for which part I of 
subchapter M applied to the corporation and, at all times thereafter, 
were the earnings and profits of a corporation to which part I of 
subchapter M applied;
    (ii) By the operation of section 381 pursuant to a transaction that 
occurred before December 22, 1992, became the earnings and profits of a 
corporation to which part I of subchapter M applied and, at all times 
thereafter, were the earnings and profits of a corporation to which part 
I of subchapter M applied;

[[Page 44]]

    (iii) Were accumulated in a taxable year ending before January 1, 
1984, by a corporation to which part I of subchapter M applied for any 
taxable year ending before November 8, 1983; or
    (iv) Were accumulated in the first taxable year of an investment 
company that began business in 1983 and that was not a successor 
corporation.
    (2) Prior law. For purposes of paragraph (b) of this section, a 
reference to part I of subchapter M includes a reference to the 
corresponding provisions of prior law.
    (c) Effective date. This regulation is effective for taxable years 
ending on or after December 22, 1992.
    (d) For treatment of net built-in gain assets of a C corporation 
that become assets of a RIC, see Sec.  1.337(d)-5T.

[T.D. 8483, 58 FR 43798, Aug. 18, 1993; 58 FR 49352, Sept. 22, 1993; 
T.D. 8872, 65 FR 5777, Feb. 7, 2000]



Sec.  1.853-1  Foreign tax credit allowed to shareholders.

    (a) In general. Under section 853, a regulated investment company, 
meeting the requirements set forth in section 853(a) and paragraph (b) 
of this section, may make an election with respect to the income, war-
profits, and excess profits taxes described in section 901(b)(1) which 
it pays to foreign countries or possessions of the United States during 
the taxable year, including such taxes as are deemed paid by it under 
the provisions of any income tax convention to which the United States 
is a party. If an election is made, the shareholders of the regulated 
investment company shall apply their proportionate share of such foreign 
taxes paid, or deemed to have been paid by it pursuant to any income tax 
convention, as either a credit (under section 901) or as a deduction 
(under section 164(a)) as provided by section 853(b)(2) and paragraph 
(b) of Sec.  1.853-2. The election is not applicable with respect to 
taxes deemed to have been paid under section 902 (relating to the credit 
allowed to corporate stockholders of a foreign corporation for taxes 
paid by such foreign corporation). In addition, the election is not 
applicable to any tax with respect to which the regulated investment 
company is not allowed a credit by reason of any provision of the 
Internal Revenue Code other than section 853(b)(1), including, but not 
limited to, section 901(j), section 901(k), or section 901(l).
    (b) Requirements. To qualify for the election provided in section 
853(a), a regulated investment company (1) must have more than 50 
percent of the value of its total assets, at the close of the taxable 
year for which the election is made, invested in stocks and securities 
of foreign corporations, and (2) must also, for that year, comply with 
the requirements prescribed in section 852(a) and paragraph (a) of Sec.  
1.852-1. The term ``value'', for purposes of the first requirement, is 
defined in section 851(c)(4). For the definition of foreign corporation, 
see section 7701(a).
    (c) Effective/applicability date. The final sentence of paragraph 
(a) of this section is applicable for RIC taxable years ending on or 
after December 31, 2007.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 9357, 72 FR 48553, Aug. 24, 2007]



Sec.  1.853-2  Effect of election.

    (a) Regulated investment company. A regulated investment company 
making a valid election with respect to a taxable year under the 
provisions of section 853(a) is, for such year, denied both the 
deduction for foreign taxes provided by section 164(a) and the credit 
for foreign taxes provided by section 901 with respect to all income, 
war-profits, and excess profits taxes (described in section 901(b)(1)) 
which it has paid to any foreign country or possession of the United 
States. See section 853(b)(1)(A). However, under section 853(b)(1)(B), 
the regulated investment company is permitted to add the amount of such 
foreign taxes paid to its dividends paid deduction for that taxable 
year. See paragraph (a) of Sec.  1.852-1.
    (b) Shareholder. Under section 853(b)(2), a shareholder of an 
investment company, which has made the election under section 853, is, 
in effect, placed in the same position as a person directly owning stock 
in foreign corporations, in that he must include in his gross income (in 
addition to taxable dividends actually received) his proportionate share 
of such foreign taxes paid

[[Page 45]]

and must treat such amount as foreign taxes paid by him for the purposes 
of the deduction under section 164(a) and the credit under section 901. 
For such purposes he must treat as gross income from a foreign country 
or possession of the United States (1) his proportionate share of the 
taxes paid by the regulated investment company to such foreign country 
or possession and (2) the portion of any dividend paid by the investment 
company which represents income derived from such sources.
    (c) Dividends paid after the close of the taxable year. For 
additional rules applicable to certain distributions made after the 
close of the taxable year which may be designated as income received 
from sources within and taxes paid to foreign countries or possessions 
of the United States, see section 855(d) and paragraph (f) of Sec.  
1.855-1.
    (d) Example. This section is illustrated by the following example:

    Example. (i) Facts. X Corporation, a regulated investment company 
with 250,000 shares of common stock outstanding, has total assets, at 
the close of the taxable year, of $10 million ($4 million invested in 
domestic corporations, $3.5 million in Foreign Country A corporations, 
and $2.5 million in Foreign Country B corporations). X Corporation 
received dividend income of $800,000 from the following sources: 
$300,000 from domestic corporations, $250,000 from Country A 
corporations, and $250,000 from Country B corporations. All dividends 
from Country A corporations and from Country B corporations were 
properly characterized as income from sources without the United States. 
The dividends from Country A corporations were subject to a 10 percent 
withholding tax ($25,000) and the dividends from Country B corporations 
were subject to a 20 percent withholding tax ($50,000). X Corporation's 
only expenses for the taxable year were $80,000 of operation and 
management expenses related to both its U.S. and foreign investments. In 
this case, Corporation X properly apportioned the $80,000 expense based 
on the relative amounts of its U.S. and foreign source gross income. 
Thus, $50,000 in expense was apportioned to foreign source income 
($80,000 x $500,000 / $800,000, total expense times the fraction of 
foreign dividend income over total dividend income) and $30,000 in 
expense was apportioned to U.S. source income ($80,000 x $300,000 / 
$800,000, total expense times the fraction of U.S. source dividend 
income over total dividend income). During the taxable year, X 
Corporation distributed to its shareholders the entire $645,000 income 
that was available for distribution ($800,000, less $80,000 in expenses, 
less $75,000 in foreign taxes withheld).
    (ii) Section 853 election. X Corporation meets the requirements of 
section 851 to be considered a RIC for the taxable year and the 
requirements of section 852(a) for part 1 of subchapter M to apply for 
the taxable year. X Corporation notifies each shareholder by mail, 
within the time prescribed by section 853(c), that by reason of the 
election the shareholders are to treat as foreign taxes paid $0.30 per 
share of stock ($75,000 of foreign taxes paid, divided by the 250,000 
shares of stock outstanding). The shareholders must report as income 
$2.88 per share ($2.58 of dividends actually received plus the $0.30 
representing foreign taxes paid). Of the $2.88 per share, $1.80 per 
share ($450,000 of foreign source taxable income divided by 250,000 
shares) is to be considered as received from foreign sources. The $1.80 
consists of $0.30, the foreign taxes treated as paid by the shareholder 
and $1.50, the portion of the dividends received by the shareholder from 
the RIC that represents income of the RIC treated as derived from 
foreign sources ($500,000 of foreign source income, less $50,000 of 
expense apportioned to foreign source income, less $75,000 of foreign 
tax withheld, which is $375,000, divided by 250,000 shares).

    (e) Effective/applicability date. Paragraph (d) of this section is 
applicable for RIC taxable years ending on or after December 31, 2007. 
Notwithstanding the preceding sentence, for a taxable year that ends on 
or after December 31, 2007, and begins before August 24, 2007, a 
taxpayer may rely on this section as it was in effect on August 23, 
2007.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 9357, 72 FR 48553, Aug. 24, 2007]



Sec.  1.853-3  Notice to shareholders.

    (a) General rule. If a regulated investment company makes an 
election under section 853(a), in the manner provided in Sec.  1.853-4, 
the regulated investment company is required under section 853(c) to 
furnish its shareholders with a written notice mailed not later than 60 
days after the close of its taxable year. The notice must designate the 
shareholder's portion of creditable foreign taxes paid to foreign 
countries or possessions of the United States and the portion of the 
dividend that represents income derived from sources within each country 
that is attributable to a period during which section 901(j) applies to 
such country, if any,

[[Page 46]]

and the portion of the dividend that represents income derived from 
other foreign countries and possessions of the United States. For 
purposes of section 853(b)(2) and Sec.  1.853-2(b), the amount that a 
shareholder may treat as the shareholder's proportionate share of 
foreign taxes paid and the amount to be included as gross income derived 
from any foreign country that is attributable to a period during which 
section 901(j) applies to such country or gross income from sources 
within other foreign countries or possessions of the United States shall 
not exceed the amount so designated by the regulated investment company 
in such written notice. If, however, the amount designated by the 
regulated investment company in the notice exceeds the shareholder's 
proper proportionate share of foreign taxes or gross income from sources 
within foreign countries or possessions of the United States, the 
shareholder is limited to the amount correctly ascertained.
    (b) Shareholder of record custodian of certain unit investment 
trusts. In any case where a notice is mailed pursuant to paragraph (a) 
of this section by a regulated investment company with respect to a 
taxable year of the regulated investment company ending after December 
8, 1970 to a shareholder of record who is a nominee acting as a 
custodian of a unit investment trust described in section 851(f)(1) and 
paragraph (b) of Sec.  1.851-7, the nominee shall furnish each holder of 
an interest in such trust with a written notice mailed on or before the 
70th day following the close of the regulated investment company's 
taxable year. The notice shall designate the holder's proportionate 
share of the amounts of creditable foreign taxes paid to foreign 
countries or possessions of the United States and the holder's 
proportionate share of the dividend that represents income derived from 
sources within each country that is attributable to a period during 
which section 901(j) applies to such country, if any, and the holder's 
proportionate share of the dividend that represents income derived from 
other foreign countries or possessions of the United States shown on the 
notice received by the nominee pursuant to paragraph (a) of this 
section. This paragraph shall not apply if the regulated investment 
company agrees with the nominee to satisfy the notice requirements of 
paragraph (a) of this section with respect to each holder of an interest 
in the unit investment trust whose shares are being held by the nominee 
as custodian and not later than 45 days following the close of the 
company's taxable year, files with the Internal Revenue Service office 
where such company's return for the taxable year is to be filed, a 
statement that the holders of the unit investment trust with whom the 
agreement was made have been directly notified by the regulated 
investment company. Such statement shall include the name, sponsor, and 
custodian of each unit investment trust whose holders have been directly 
notified. The nominee's requirements under this paragraph shall be 
deemed met if the regulated investment company transmits a copy of such 
statement to the nominee within such 60-day period: Provided however, if 
the regulated investment company fails or is unable to satisfy the 
requirements of this paragraph with respect to the holders of interest 
in the unit investment trust, it shall so notify the Internal Revenue 
Service within 60 days following the close of its taxable year. The 
custodian shall, upon notice by the Internal Revenue Service that the 
regulated investment company has failed to comply with the agreement, 
satisfy the requirements of this paragraph within 30 days of such 
notice.
    (c) Effective/applicability date. This section is applicable for RIC 
taxable years ending on or after December 31, 2007. Notwithstanding the 
preceding sentence, for a taxable year that ends on or after December 
31, 2007, and begins before August 24, 2007, a taxpayer may rely on this 
section as it was in effect on August 23, 2007.

[T.D. 7187, 37 FR 13257, July 6, 1972, as amended by T.D. 9357, 72 FR 
48554, Aug. 24, 2007]



Sec.  1.853-4  Manner of making election.

    (a) General rule. To make an election under section 853 for a 
taxable year, a regulated investment company must file a statement of 
election as part of its Federal income tax return for the taxable year. 
The statement of election

[[Page 47]]

must state that the regulated investment company elects the application 
of section 853 for the taxable year and agrees to provide the 
information required by paragraph (c) of this section.
    (b) Irrevocability of the election. The election shall be made with 
respect to all foreign taxes described in paragraph (c)(2) of this 
section, and must be made not later than the time prescribed for filing 
the return (including extensions). This election, if made, shall be 
irrevocable with respect to the dividend (or portion thereof), and the 
foreign taxes paid with respect thereto, to which the election applies.
    (c) Required information. A regulated investment company making an 
election under section 853 must provide the following information:
    (1) The total amount of taxable income received in the taxable year 
from sources within foreign countries and possessions of the United 
States and the amount of taxable income received in the taxable year 
from sources within each such foreign country or possession.
    (2) The total amount of income, war profits, or excess profits taxes 
(described in section 901(b)(1)) to which the election applies that were 
paid in the taxable year to such foreign countries or possessions and 
the amount of such taxes paid to each such foreign country or 
possession.
    (3) The amount of income, war profits, or excess profits taxes paid 
during the taxable year to which the election does not apply by reason 
of any provision of the Internal Revenue Code other than section 853(b), 
including, but not limited to, section 901(j), section 901(k), or 
section 901(l).
    (4) The date, form, and contents of the notice to its shareholders.
    (5) The proportionate share of creditable foreign taxes paid to each 
such foreign country or possession during the taxable year and foreign 
income received from sources within each such foreign country or 
possession during the taxable year attributable to one share of stock of 
the regulated investment company.
    (d) Time and manner of providing information. The information 
specified in paragraph (c) of this section must be provided at the time 
and in the manner prescribed by the Commissioner and, unless otherwise 
prescribed, must be provided on or with a modified Form 1118 ``Foreign 
Tax Credit--Corporations'' filed as part of the RIC's timely filed 
Federal income tax return for the taxable year.
    (e) Effective/applicability date. This section is applicable for RIC 
taxable years ending on or after December 31, 2007. Notwithstanding the 
preceding sentence, for a taxable year that ends on or after December 
31, 2007, and begins before August 24, 2007, a taxpayer may rely on this 
section as it was in effect on August 23, 2007.

[T.D. 9357, 72 FR 48554, Aug. 24, 2007]



Sec.  1.854-1  Limitations applicable to dividends received 
from regulated investment company.

    (a) In general. Section 854 provides special limitations applicable 
to dividends received from a regulated investment company for purposes 
of the exclusion under section 116 for dividends received by 
individuals, the deduction under section 243 for dividends received by 
corporations, and, in the case of dividends received by individuals 
before January 1, 1965, the credit under section 34.
    (b) Capital gain dividend. Under the provisions of section 854(a) a 
capital gain dividend as defined in section 852(b)(3) and paragraph (c) 
of Sec.  1.852-4 shall not be considered a dividend for purposes of the 
exclusion under section 116, the deduction under section 243, and, in 
the case of taxable years ending before January 1, 1965, the credit 
under section 34.
    (c) Rule for dividends other than capital gain dividends. (1) 
Section 854(b)(1) limits the amount that may be treated as a dividend 
(other than a capital gain dividend) by the shareholder of a regulated 
investment company, for the purposes of the credit, exclusion, and 
deduction specified in paragraph (b) of this section, where the 
investment company receives substantial amounts of income (such as 
interest, etc.) from sources other than dividends from domestic 
corporations, which dividends qualify for the exclusion under section 
116.
    (2) Where the ``aggregate dividends received'' (as defined in 
section

[[Page 48]]

854(b)(3)(B) and paragraph (b) of Sec.  1.854-3) during the taxable year 
by a regulated investment company (which meets the requirements of 
section 852(a) and paragraph (a) of Sec.  1.852-1 for the taxable year 
during which it paid such dividend) are less than 75 percent of its 
gross income for such taxable year (as defined in section 854(b)(3)(A) 
and paragraph (a) of Sec.  1.854-3), only that portion of the dividend 
paid by the regulated investment company which bears the same ratio to 
the amount of such dividend paid as the aggregate dividends received by 
the regulated investment company, during the taxable year, bears to its 
gross income for such taxable year (computed without regard to gains 
from the sale or other disposition of stocks or securities) may be 
treated as a dividend for purposes of such credit, exclusion, and 
deduction.
    (3) Subparagraph (2) of this paragraph may be illustrated by the 
following example:

    Example. The XYZ regulated investment company meets the requirements 
of section 852(a) for the taxable year and has received income from the 
following sources:

Capital gains (from the sale of stock or securities).........   $100,000
Dividends (from domestic sources other than dividends             70,000
 described in section 116(b))................................
Dividend (from foreign corporations).........................      5,000
Interest.....................................................     25,000
                                                              ----------
 Total.......................................................    200,000
Expenses.....................................................     20,000
                                                              ----------
Taxable income...............................................    180,000
 


The regulated investment company decides to distribute the entire 
$180,000. It distributes a capital gain dividend of $100,000 and a 
dividend of ordinary income of $80,000. The aggregate dividends received 
by the regulated investment company from domestic corporations ($70,000) 
is less than 75 percent of its gross income ($100,000) computed without 
regard to capital gains from sales of securities. Therefore, an 
apportionment is required. Since $70,000 is 70 percent of $100,000, out 
of every $1 dividend of ordinary income paid by the regulated investment 
company only 70 cents would be available for the credit, exclusion, or 
deduction referred to in section 854(b)(1). The capital gains dividend 
and the dividend received from foreign corporations are excluded from 
the computation.

    (d) Dividends received from a regulated investment company during 
taxable years of shareholders ending after July 31, 1954, and subject to 
the Internal Revenue Code of 1939. For the application of section 854 to 
taxable years of shareholders of a regulated investment company ending 
after July 31, 1954, and subject to the Internal Revenue Code of 1939, 
see Sec.  1.34-5 and Sec.  1.116-2.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6921, 32 FR 
8756, June 20, 1967]



Sec.  1.854-2  Notice to shareholders.

    (a) General rule. Section 854(b)(2) provides that the amount that a 
shareholder may treat as a dividend for purposes of the exclusion under 
section 116 for dividends received by individuals, the deduction under 
section 243 for dividends received by corporation, and, in the case of 
dividends received by individuals before January 1, 1965, the credit 
under section 34, shall not exceed the amount so designated by the 
company in a written notice to its shareholders mailed not later than 45 
days (30 days for a taxable year ending before Feb. 26, 1964) after the 
close of the company's taxable year. If, however, the amount so 
designated by the company in the notice exceeds the amount which may be 
treated by the shareholder as a dividend for such purposes, the 
shareholder is limited to the amount as correctly ascertained under 
section 854(b)(1) and paragraph (c) of Sec.  1.854-1.
    (b) Shareholder of record custodian of certain unit investment 
trusts. In any case where a notice is mailed pursuant to paragraph (a) 
of this section by a regulated investment company with respect to a 
taxable year of the regulated investment company ending after December 
8, 1970 to a shareholder of record who is a nominee acting as a 
custodian of a unit investment trust described in section 851(f)(1) and 
paragraph (d) of Sec.  1.851-7, the nominee shall furnish each holder of 
an interest in such trust with a written notice mailed on or before the 
55th day following the close of the regulated investment company's 
taxable year. The notice shall designate the holder's proportionate 
share of the amounts that may be treated as a dividend for purposes of 
the exclusion under section 116 for dividends received by individuals 
and the deduction under section 243 for dividends received by 
corporations shown on the notice received by the nominee

[[Page 49]]

pursuant to paragraph (a) of this section. This notice shall include the 
name and address of the nominee identified as such. This paragraph shall 
not apply if the regulated investment company agrees with the nominee to 
satisfy the notice requirements of paragraph (a) of this section with 
respect to each holder of an interest in the unit investment trust whose 
shares are being held by the nominee as custodian and not later than 45 
days following the close of the company's taxable year, files with the 
Internal Revenue Service office where such company's return is to be 
filed for the taxable year, a statement that the holders of the unit 
investment trust with whom the agreement was made have been directly 
notified by the regulated investment company. Such statement shall 
include the name, sponsor, and custodian of each unit investment trust 
whose holders have been directly notified. The nominee's requirements 
under this paragraph shall be deemed met if the regulated investment 
company transmits a copy of such statement to the nominee within such 
45-day period; provided however, if the regulated investment company 
fails or is unable to satisfy the requirements of this paragraph with 
respect to the holders of interest in the unit investment trust, it 
shall so notify the Internal Revenue Service within 45 days following 
the close of its taxable year. The custodian shall, upon notice by the 
Internal Revenue Service that the regulated investment company has 
failed to comply with the agreement, satisfy the requirements of this 
paragraph within 30 days of such notice.

[T.D. 7187, 37 FR 13257, July 6, 1972]



Sec.  1.854-3  Definitions.

    (a) For the purpose of computing the limitation prescribed by 
section 854(b)(1)(B) and paragraph (c) of Sec.  1.854-1, the term 
``gross income'' does not include gain from the sale or other 
disposition of stock or securities. However, capital gains arising from 
the sale or other disposition of capital assets, other than stock or 
securities, shall not be excluded from gross income for this purpose.
    (b) The term ``aggregate dividends received'' includes only 
dividends received from domestic corporations other than dividends 
described in section 116(b) (relating to dividends not eligible for 
exclusion from gross income). Accordingly, dividends received from 
foreign corporations will not be included in the computation of 
``aggregate dividends received''. In determining the amount of any 
dividend for purposes of this section, the rules provided in section 
116(c) (relating to certain distributions) shall apply.



Sec.  1.855-1  Dividends paid by regulated investment company 
after close of taxable year.

    (a) General rule. In--
    (1) Determining under section 852(a) and paragraph (a) of Sec.  
1.852-1 whether the deduction for dividends paid during the taxable year 
(without regard to capital gain dividends) by a regulated investment 
company equals or exceeds 90 percent of its investment company taxable 
income (determined without regard to the provisions of section 
852(b)(2)(D)),
    (2) Computing its investment company taxable income (under section 
852(b)(2) and Sec.  1.852-3), and
    (3) Determining the amount of capital gain dividends (as defined in 
section 852(b)(3) and paragraph (c) of Sec.  1.852-4 paid during the 
taxable year, any dividend (or portion thereof) declared by the 
investment company either before or after the close of the taxable year 
but in any event before the time prescribed by law for the filing of its 
return for the taxable year (including the period of any extension of 
time granted for filing such return) shall, to the extent the company so 
elects in such return, be treated as having been paid during such 
taxable year. This rule is applicable only if the entire amount of such 
dividend is actually distributed to the shareholders in the 12-month 
period following the close of such taxable year and not later than the 
date of the first regular dividend payment made after such declaration.
    (b) Election--(1) Method of making election. The election must be 
made in the return filed by the company for the taxable year. The 
election shall be made by the taxpayer (the regulated investment 
company) by treating the dividend (or portion thereof) to which

[[Page 50]]

such election applies as a dividend paid during the taxable year in 
computing its investment company taxable income, or if the dividend (or 
portion thereof) to which such election applies is to be designated by 
the company as a capital gain dividend, in computing the amount of 
capital gain dividends paid during such taxable year. The election 
provided in section 855(a) may be made only to the extent that the 
earnings and profits of the taxable year (computed with the application 
of section 852(c) and Sec.  1.852-5) exceed the total amount of 
distributions out of such earnings and profits actually made during the 
taxable year (not including distributions with respect to which an 
election has been made for a prior year under section 855(a)). The 
dividend or portion thereof, with respect to which the regulated 
investment company has made a valid election under section 855(a), shall 
be considered as paid out of the earnings and profits of the taxable 
year for which such election is made, and not out of the earnings and 
profits of the taxable year in which the distribution is actually made.
    (2) Irrevocability of the election. After the expiration of the time 
for filing the return for the taxable year for which an election is made 
under section 855(a), such election shall be irrevocable with respect to 
the dividend or portion thereof to which it applies.
    (c) Receipt by shareholders. Under section 855(b), the dividend or 
portion thereof, with respect to which a valid election has been made, 
will be includible in the gross income of the shareholders of the 
regulated investment company for the taxable year in which the dividend 
is received by them.
    (d) Examples. The application of paragraphs (a), (b), and (c) of 
this section may be illustrated by the following examples:

    Example 1. The X Company, a regulated investment company, had 
taxable income (and earnings or profits) for the calendar year 1954 of 
$100,000. During that year the company distributed to shareholders 
taxable dividends aggregating $88,000. On March 10, 1955, the company 
declared a dividend of $37,000 payable to shareholders on March 20, 
1955. Such dividend consisted of the first regular quarterly dividend 
for 1955 of $25,000 plus an additional $12,000 representing that part of 
the taxable income for 1954 which was not distributed in 1954. On March 
15, 1955, the X Company filed its federal income tax return and elected 
therein to treat $12,000 of the total dividend of $37,000 to be paid to 
shareholders on March 20, 1955, as having been paid during the taxable 
year 1954. Assuming that the X Company actually distributed the entire 
amount of the dividend of $37,000 on March 20, 1955, an amount equal to 
$12,000 thereof will be treated for the purposes of section 852(a) as 
having been paid during the taxable year 1954. Such amount ($12,000) 
will be considered by the X Company as a distribution out of the 
earnings and profits for the taxable year 1954, and will be treated by 
the shareholders as a taxable dividend for the taxable year in which 
such distribution is received by them.
    Example 2. The Y Company, a regulated investment company, had 
taxable income (and earnings or profits) for the calendar year 1954 of 
$100,000, and for 1955 taxable income (and earnings or profits) of 
$125,000. On January 1, 1954, the company had a deficit in its earnings 
and profits accumulated since February 28, 1913, of $115,000. During the 
year 1954 the company distributed to shareholders taxable dividends 
aggregating $85,000. On March 5, 1955, the company declared a dividend 
of $65,000 payable to shareholders on March 31, 1955. On March 15, 1955, 
the Y Company filed its federal income tax return in which it included 
$40,000 of the total dividend of $65,000 payable to shareholders on 
March 31, 1955, as a dividend paid by it during the taxable year 1954. 
On March 31, 1955, the Y Company distributed the entire amount of the 
dividend of $65,000 declared on March 5, 1955. The election under 
section 855(a) is valid only to the extent of $15,000, the amount of the 
undistributed earnings and profits for 1954 ($100,000 earnings and 
profits less $85,000 distributed during 1954). The remainder ($50,000) 
of the $65,000 dividend paid on March 31, 1955, could not be the subject 
of an election, and such amount will be regarded as a distribution by 
the Y Company out of earnings and profits for the taxable year 1955. 
Assuming that the only other distribution by the Y Company during 1955 
was a distribution of $75,000 paid as a dividend on October 31, 1955, 
the total amount of the distribution of $65,000 paid on March 31, 1955, 
is to be treated by the shareholders as taxable dividends for the 
taxable year in which such dividend is received. The Y Company will 
treat the amount of $15,000 as a distribution of the earnings or profits 
of the company for the taxable year 1954, and the remaining $50,000 as a 
distribution of the earnings or profits for the year 1955. The 
distribution of $75,000 on October 31, 1955, is, of course, a taxable 
dividend out of the earnings and profits for the year 1955.


[[Page 51]]


    (e) Notice to shareholders. Section 855(c) provides that in the case 
of dividends, with respect to which a regulated investment company has 
made an election under section 855(a), any notice to shareholders 
required under subchapter M, chapter 1 of the Code, with respect to such 
amounts, shall be made not later than 45 days (30 days for a taxable 
year ending before February 26, 1964) after the close of the taxable 
year in which the distribution is made. Thus, the notice requirements of 
section 852(b)(3)(C) and paragraph (c) of Sec.  1.852-4 with respect to 
capital gain dividends, section 853(c) and Sec.  1.853-3 with respect to 
allowance to shareholder of foreign tax credit, and section 854(b)(2) 
and Sec.  1.854-2 with respect to the amount of a distribution which may 
be treated as a dividend, may be satisfied with respect to amounts to 
which section 855(a) and this section apply if the notice relating to 
such amounts is mailed to the shareholders not later than 45 days (30 
days for a taxable year ending before February 26, 1964) after the close 
of the taxable year in which the distribution is made. If the notice 
under section 855(c) relates to an election with respect to any capital 
gain dividends, such capital gain dividends shall be aggregated by the 
investment company with the designated capital gain dividends actually 
paid during the taxable year to which the election applies (not 
including such dividends with respect to which an election has been made 
for a prior year under section 855) for the purpose of determining 
whether the aggregate of the designated capital gain dividends with 
respect to such taxable year of the company is greater than the excess 
of the net long-term capital gain over the net short-term capital loss 
of the company. See section 852(b)(3)(C) and paragraph (c) of Sec.  
1.852-4.
    (f) Foreign tax election. Section 855(d) provides that in the case 
of an election made under section 853 (relating to foreign taxes), the 
shareholder of the investment company shall consider the foreign income 
received, and the foreign tax paid, as received and paid, respectively, 
in the shareholder's taxable year in which distribution is made.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 6921, 32 FR 
8757, June 20, 1967]

                      Real Estate Investment Trusts



Sec.  1.856-0  Revenue Act of 1978 amendments not included.

    The regulations under part II of subchapter M of the Code do not 
reflect the amendments made by the Revenue Act of 1978, other than the 
changes made by section 362 of the Act, relating to deficiency 
dividends.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. 856(f)(2)); sec. 856 (g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954; 860(e) (92 Stat. 2849, 26 U.S.C. 860(e)); 
sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7767, 46 FR 11265, Feb. 6, 1981, as amended by T.D. 7936, 49 FR 
2106, Jan. 18, 1984]



Sec.  1.856-1  Definition of real estate investment trust.

    (a) In general. The term ``real estate investment trust'' means a 
corporation, trust, or association which (1) meets the status conditions 
in section 856(a) and paragraph (b) of this section, and (2) satisfies 
the gross income and asset diversification requirements under the 
limitations of section 856(c) and Sec.  1.856-2. (See, however, 
paragraph (f) of this section, relating to the requirement that, for 
taxable years beginning before October 5, 1976, a real estate investment 
trust must be an unincorporated trust or unincorporated association).
    (b) Qualifying conditions. To qualify as a ``real estate investment 
trust'', an organization must be one--
    (1) Which is managed by one or more trustees or directors,
    (2) The beneficial ownership of which is evidenced by transferable 
shares or by transferable certificates of beneficial interest,

[[Page 52]]

    (3) Which would be taxable as a domestic corporation but for the 
provisions of part II, subchapter M, chapter 1 of the Code,
    (4) Which, in the case of a taxable year beginning before October 5, 
1976, does not hold any property (other than foreclosure property) 
primarily for sale to customers in the ordinary course of its trade or 
business,
    (5) Which is neither (i) a financial institution to which section 
585, 586, or 593 applies, nor (ii) an insurance company to which 
subchapter L applies,
    (6) The beneficial ownership of which is held by 100 or more 
persons, and
    (7) Which would not be a personal holding company (as defined in 
section 542) if all of its gross income constituted personal holding 
company income (as defined in section 543).
    (c) Determination of status. The conditions described in 
subparagraphs (1) through (5) of paragraph (b) of this section must be 
met during the entire taxable year and the condition described in 
subparagraph (6) of paragraph (b) of this section must exist during at 
least 335 days of a taxable year of 12 months or during a proportionate 
part of a taxable year of less than 12 months. The days during which the 
latter condition must exist need not be consecutive. In determining the 
minimum number of days during which the condition described in paragraph 
(b)(6) of this section is required to exist in a taxable year of less 
than 12 months, fractional days shall be disregarded. For example, in a 
taxable year of 310 days, the actual number of days prescribed would be 
284 \38/73\ days (\310/365\ of 335). The fractional day is disregarded 
so that the required condition in such taxable year need exist for only 
284 days.
    (d) Rules applicable to status requirements. For purposes of 
determining whether an organization meets the conditions and 
requirements in section 856(a), the following rules shall apply.
    (1) Trustee. The term ``trustee'' means a person who holds legal 
title to the property of the real estate investment trust, and has such 
rights and powers as will meet the requirement of ``centralization of 
management'' under paragraph (c) of Sec.  301.7701-2 of this chapter 
(Regulations on Procedure and Administration). Thus, the trustee must 
have continuing exclusive authority over the management of the trust, 
the conduct of its affairs, and (except as limited by section 856(d)(3) 
and Sec.  1.856-4) the management and disposition of the trust property. 
For example, such authority will be considered to exist even though the 
trust instrument grants to the shareholders any or all of the following 
rights and powers: To elect or remove trustees; to terminate the trust; 
and to ratify amendments to the trust instrument proposed by the 
trustee. The existence of a mere fiduciary relationship does not, in 
itself, make one a trustee for purposes of section 856(a)(1). The 
trustee will be considered to hold legal title to the property of the 
trust, for purposes of this subparagraph, whether the title is held in 
the name of the trust itself, in the name of one or more of the 
trustees, or in the name of a nominee for the exclusive benefit of the 
trust.
    (2) Beneficial ownership. Beneficial ownership shall be evidenced by 
transferable shares, or by transferable certificates of beneficial 
interest, and (subject to the provisions of paragraph (c) of this 
section) must be held by 100 or more persons, determined without 
reference to any rules of attribution. Provisions in the trust 
instrument or corporate charter or bylaws which permit the trustee or 
directors to redeem shares or to refuse to transfer shares in any case 
where the trustee or directors, in good faith, believe that a failure to 
redeem shares or that a transfer of shares would result in the loss of 
status as a real estate investment trust will not render the shares 
``nontransferable.'' For purposes of the regulations under part II of 
subchapter M, the terms ``stockholder,'' ``stockholders,'' 
``shareholder,'' and ``shareholders'' include holders of beneficial 
interest in a real estate investment trust, the terms ``stock,'' 
``shares,'' and ``shares of stock'' include certificates of beneficial 
interest, and the term ``shares'' includes shares of stock.
    (3) Unincorporated organization taxable as a domestic corporation. 
The determination of whether an unincorporated organization would be 
taxable as a domestic corporation, in the absence of the provisions of 
part II of subchapter

[[Page 53]]

M, shall be made in accordance with the provisions of section 7701(a) 
(3) and (4) and the regulations thereunder and for such purposes an 
otherwise qualified real estate investment trust is deemed to satisfy 
the ``objective to carry on business'' requirement of paragraph (a) of 
Sec.  301.7701-2 of this chapter. (Regulations on Procedure and 
Administration).
    (4) Property held for sale to customers. In the case of a taxable 
year beginning before October 5, 1976, a real estate investment trust 
may not hold any property (other than foreclosure property) primarily 
for sale to customers in the ordinary course of its trade or business. 
Whether property is held for sale to customers in the ordinary course of 
the trade or business of a real estate investment trust depends upon the 
facts and circumstances in each case.
    (5) Personal holding company. A corporation, trust, or association, 
even though it may otherwise meet the requirements of part II of 
subchapter M, will not be a real estate investment trust if, by 
considering all of its gross income as personal holding company income 
under section 543, it would be a personal holding company as defined in 
section 542. Thus, if at any time during the last half of the trust's 
taxable year more than 50 percent in value of its outstanding stock is 
owned (directly or indirectly under the provisions of section 544) by or 
for not more than 5 individuals, the stock ownership requirement in 
section 542(a)(2) will be met and the trust would be a personal holding 
company. See Sec.  1.857-8, relating to record requirements for purposes 
of determining whether the trust is a personal holding company.
    (e) Other rules applicable. To the extent that other provisions of 
chapter 1 of the Code are not inconsistent with those under part II of 
subchapter M there of and the regulations thereunder, such provisions 
will apply with respect to both the real estate investment trust and its 
shareholders in the same manner that they would apply to any other 
organization which would be taxable as a domestic corporation. For 
example:
    (1) Taxable income of a real estate investment trust is computed in 
the same manner as that of a domestic corporation;
    (2) Section 301, relating to distributions of property, applies to 
distributions by a real estate investment trust in the same manner as it 
would apply to a domestic corporation;
    (3) Sections 302, 303, 304, and 331 are applicable in determining 
whether distributions by a real estate investment trust are to be 
treated as in exchange for stock;
    (4) Section 305 applies to distributions by a real estate investment 
trust of its own stock;
    (5) Section 311 applies to distributions by a real estate investment 
trust;
    (6) Except as provided in section 857(d), earnings and profits of a 
real estate investment trust are computed in the same manner as in the 
case of a domestic corporation;
    (7) Section 316, relating to the definition of a dividend, applies 
to distributions by a real estate investment trust; and
    (8) Section 341, relating to collapsible corporations, applies to 
gain on the sale or exchange of, or a distribution which is in exchange 
for, stock in a real estate investment trust in the same manner that it 
would apply to a domestic corporation.
    (f) Unincorporated status required for certain taxable years. In the 
case of a taxable year beginning before October 5, 1976, a real estate 
investment trust must be an unincorporated trust or unincorporated 
association. Accordingly, in applying the regulations under part II of 
subchapter M of the Code with respect to such a taxable year, the term 
``an unincorporated trust or unincorporated association'' is to be 
substituted for the term ``a corporation, trust, or association'' each 
place it appears, and the references to ``directors''

[[Page 54]]

and ``corporate charter or bylaws'' are to be disregarded.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. 856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917, 26 U.S.C. 7805), 
Internal Revenue Code of 1954)

[T.D. 6598, 27 FR 4082, Apr. 28, 1962, as amended by T.D. 6928, 32 FR 
13221, Sept. 19, 1967; T.D. 7767, 46 FR 11265, Feb. 6, 1981]



Sec.  1.856-2  Limitations.

    (a) Effective date. The provisions of part II, subchapter M, chapter 
1 of the Code, and the regulations thereunder apply only to taxable 
years of a real estate investment trust beginning after December 31, 
1960.
    (b) Election. Under the provisions of section 856(c)(1), a trust, 
even though it satisfies the other requirements of part II of subchapter 
M for the taxable year, will not be considered a ``real estate 
investment trust'' for such year, within the meaning of such part II, 
unless it elects to be a real estate investment trust for such taxable 
year, or has made such an election for a previous taxable year which has 
not been terminated or revoked under section 856(g)(1) or (2). The 
election shall be made by the trust by computing taxable income as a 
real estate investment trust in its return for the first taxable year 
for which it desires the election to apply, even though it may have 
otherwise qualified as a real estate investment trust for a prior year. 
No other method of making such election is permitted. An election cannot 
be revoked with respect to a taxable year beginning before October 5, 
1976. Thus, the failure of an organization to be a qualified real estate 
investment trust for a taxable year beginning before October 5, 1976, 
does not have the effect of revoking a prior election by the 
organization to be a real estate investment trust, even though the 
organization is not taxable under part II of subchapter M for such 
taxable year. See section 856(g) and Sec.  1.856-8 for rules under which 
an election may be revoked with respect to taxable years beginning after 
October 4, 1976.
    (c) Gross income requirements. Section 856(c) (2), (3), and (4), 
provides that a corporation, trust, or association is not a ``real 
estate investment trust'' for a taxable year unless it meets certain 
requirements with respect to the sources of its gross income for the 
taxable year. In determining whether the gross income of a real estate 
investment trust satisfies the percentage requirements of section 856(c) 
(2), (3), and (4), the following rules shall apply:
    (1) Gross income. For purposes of both the numerator and denominator 
in the computation of the specified percentages, the term ``gross 
income'' has the same meaning as that term has under section 61 and the 
regulations thereunder. Thus, in determining the gross income 
requirements under section 856(c) (2), (3), and (4), a loss from the 
sale or other disposition of stock, securities, real property, etc. does 
not enter into the computation.
    (2) Lapse of options. Under section 856(c)(6)(C), the term 
``interests in real property'' includes options to acquire land or 
improvements thereon, and options to acquire leaseholds of land and 
improvements thereon. However, where a corporation, trust, or 
association writes an option giving the holder the right to acquire land 
or improvements thereon, or writes an option giving the holder the right 
to acquire a leasehold of land or improvements thereon, any income that 
the corporation, trust, or association recognizes because the option 
expires unexercised is not considered to be gain from the sale or other 
disposition of real property (including interests in real property) for 
purposes of section 856(c) (2)(D) and (3)(C). The rule in the preceding 
sentence also applies for purposes of section 856(c)(4)(C) in 
determining gain from the sale or other disposition of real property for 
the 30-percent-of-gross-income limitation.
    (3) Commitment fees. For purposes of section 856(c) (2)(G) and 
(3)(G), if consideration is received or accrued for an agreement to make 
a loan secured by a mortgage covering both real property and other 
property, or for an agreement to purchase or lease both real

[[Page 55]]

property and other property, an apportionment of the consideration is 
required. The apportionment of consideration received or accrued for an 
agreement to make a loan secured by a mortgage covering both real 
property and other property shall be made under the principles of Sec.  
1.856-5(c), relating to the apportionment of interest income.
    (4) Holding period of property. For purposes of the 30-percent 
limitation of section 856(c)(4), the determination of the period for 
which property described in such section has been held is governed by 
the provisions of section 1223 and the regulations thereunder.
    (5) Rents from real property and interest. See Sec. Sec.  1.856-4 
and 1.856-5 for rules relating to rents from real property and interest.
    (d) Diversification of investment requirements--(1) 75-percent test. 
Section 856(c)(5)(A) requires that at the close of each quarter of the 
taxable year at least 75 percent of the value of the total assets of the 
trust be represented by one or more of the following:
    (i) Real estate assets;
    (ii) Government securities; and
    (iii) Cash and cash items (including receivables).


For purposes of this subparagraph the term ``receivables'' means only 
those receivables which arise in the ordinary course of the trust's 
operation and does not include receivables purchased from another 
person. Subject to the limitations in section 856(c)(5)(B) and 
subparagraph (2) of this paragraph, the character of the remaining 25 
percent (or less) of the value of the total assets is not restricted.
    (2) Limitations on certain securities. Under section 856(c)(5)(B), 
not more than 25 percent of the value of the total assets of the trust 
may be represented by securities other than those described in section 
856(c)(5)(A). The ownership of securities under the 25-percent 
limitation in section 856(c)(5)(B) is further limited in respect of any 
one issuer to an amount not greater in value than 5 percent of the value 
of the total assets of the trust and to not more than 10 percent of the 
outstanding voting securities of such issuer. Thus, if the real estate 
investment trust meets the 75-percent asset diversification requirement 
in section 856(c)(5)(A), it will also meet the first test under section 
856(c)(5)(B) since it will, of necessity, have not more than 25 percent 
of its total assets represented by securities other than those described 
in section 856(c)(5)(A). However, the trust must also meet two 
additional tests under section 856(c)(5)(B), i.e. it cannot own the 
securities of any one issuer in an amount (i) greater in value than 5 
percent of the value of the trust's total assets, or (ii) representing 
more than 10 percent of the outstanding voting securities of such 
issuer.
    (3) Determination of investment status. The term ``total assets'' 
means the gross assets of the trust determined in accordance with 
generally accepted accounting principles. In order to determine the 
effect, if any, which an acquisition of any security or other property 
may have with respect to the status of a trust as a real estate 
investment trust, section 856(c)(5) requires a revaluation of the 
trust's assets at the end of the quarter in which such acquisition was 
made. A revaluation of assets is not required at the end of any quarter 
during which there has been no acquisition of a security or other 
property since the mere change in market value of property held by the 
trust does not, of itself, affect the status of the trust as a real 
estate investment trust. A change in the nature of ``cash items'', for 
example, the prepayment of insurance or taxes, does not constitute the 
acquisition of ``other property'' for purposes of this subparagraph. A 
real estate investment trust shall keep sufficient records as to 
investments so as to be able to show that it has complied with the 
provisions of section 856(c)(5) during the taxable year. Such records 
shall be kept at all times available for inspection by any internal 
revenue officer or employee and shall be retained so long as the 
contents thereof may become material in the administration of any 
internal revenue law.
    (4) Illustrations. The application of section 856(c)(5) and this 
paragraph may be illustrated by the following examples:

    Example 1. Real Estate Investment Trust M, at the close of the first 
quarter of its taxable year, has its assets invested as follows:

[[Page 56]]



 
                                                                Percent
 
Cash.........................................................          6
Government securities........................................          7
Real estate assets...........................................         63
Securities of various corporations (not exceeding, with               24
 respect to any one issuer, 5 percent of the value of the
 total assets of the trust nor 10 percent of the outstanding
 voting securities of such issuer)...........................
                                                              ----------
 Total.......................................................        100
 


Trust M meets the requirements of section 856(c)(5) for that quarter of 
its taxable year.
    Example 2. Real Estate Investment Trust P, at the close of the first 
quarter of its taxable year, has its assets invested as follows:

 
                                                                Percent
 
Cash.........................................................          6
Government securities........................................          7
Real estate assets...........................................         63
Securities of Corporation Z..................................         20
Securities of Corporation X..................................          4
                                                              ----------
 Total.......................................................        100
 


Trust P meets the requirement of section 856(c)(5)(A) since at least 75 
percent of the value of the total assets is represented by cash, 
Government securities, and real estate assets. However, Trust P does not 
meet the diversification requirements of section 856(c)(5)(B) because 
its investment in the voting securities of Corporation Z exceeds 5 
percent of the value of the trust's total assets.
    Example 3. Real Estate Investment Trust G, at the close of the first 
quarter of its taxable year, has its assets invested as follows:

 
                                                                Percent
 
Cash.........................................................          4
Government securities........................................          9
Real estate assets...........................................         70
Securities of Corporation S..................................          5
Securities of Corporation L..................................          4
Securities of Corporation U..................................          4
Securities of Corporation M (which equals 25 percent of                4
 Corporation M's outstanding voting securities)..............
                                                              ----------
 Total.......................................................        100
 


Trust G meets the 75-percent requirement of section 856(c)(5)(A), but 
does not meet the requirements of section 856(c)(5)(B) because its 
investment in the voting securities of Corporation M exceeds 10 percent 
of Corporation M's outstanding voting securities.
    Example 4. Real Estate Investment Trust R, at the close of the first 
quarter of its taxable year (i.e. calendar year), is a qualified real 
estate investment trust and has its assets invested as follows:

Cash..........................................................    $5,000
Government securities.........................................     4,000
Receivables...................................................     4,000
Real estate assets............................................    68,000
Securities of Corporation P...................................     4,000
Securities of Corporation O...................................     5,000
Securities of Corporation U...................................     5,000
Securities of Corporation T...................................     5,000
                                                               ---------
 Total assets.................................................   100,000
 


During the second calendar quarter the stock in Corporation P increases 
in value to $50,000 while the value of the remaining assets has not 
changed. If Real Estate Investment Trust R has made no acquisition of 
stock or other property during such second quarter it will not lose its 
status as a real estate investment trust merely by reason of the 
appreciation in the value of P's stock. If, during the third quarter, 
Trust R acquires stock of Corporation S worth $2,000, such acquisition 
will necessitate a revaluation of all of the assets of Trust R as 
follows:

Cash..........................................................    $3,000
Government securities.........................................     4,000
Receivables...................................................     4,000
Real estate assets............................................    68,000
Securities in Corporation P...................................    50,000
Securities in Corporation O...................................     5,000
Securities in Corporation U...................................     5,000
Securities in Corporation T...................................     5,000
Securities in Corporation S...................................     2,000
                                                               ---------
 Total assets.................................................   146,000
 

Because of the discrepancy between the value of its various investments 
and the 25-percent limitation in section 856(c)(5), resulting in part 
from the acquisition of the stock of Corporation S, Trust R, at the end 
of the third quarter, loses its status as a real estate investment 
trust. However, if Trust R, within 30 days after the close of such 
quarter, eliminates the discrepancy so that it meets the 25-percent 
limitation, the trust will be considered to have met the requirements of 
section 856(c)(5) at the close of the third quarter, even though the 
discrepancy between the value of its investment in Corporation P and the 
5-percent limitation in section 856(c)(5) (resulting solely from 
appreciation) may still exist. If instead of acquiring stock of 
Corporation S, Trust R had acquired additional stock of Corporation P, 
then because of the discrepancy between the value of its investments and 
both the 5-percent and the 25-percent limitations in section 856(c)(5) 
resulting in part from this acquisition, trust R, at the end of the 
third quarter, would lose its status as a real estate investment trust, 
unless within 30 days after the close of such quarter both of the 
discrepancies are eliminated.
    Example 5. If, in the previous example, the stock of Corporation P 
appreciates only to $10,000 during the second quarter and, in the third 
quarter, Trust R acquires stock of Corporation S worth $1,000, the 
assets as of the end of the third quarter would be as follows:

Cash..........................................................    $4,000
Government securities.........................................     4,000
Receivables...................................................     4,000
Real estate assets............................................    68,000
Securities in Corporation P...................................    10,000

[[Page 57]]

 
Securities in Corporation O...................................     5,000
Securities in Corporation U...................................     5,000
Securities in Corporation T...................................     5,000
Securities in Corporation S...................................     1,000
                                                               ---------
 Total assets.................................................   106,000
 


Because the discrepancy between the value of its investment in 
Corporation P and the 6-percent limitation in section 856(c)(5) results 
solely from appreciation, and because there is no discrepancy between 
the value of its various investments and the 25-percent limitation, 
Trust R, at the end of the third quarter, does not lose its status as a 
real estate investment trust. If, instead of acquiring stock of 
Corporation S, Trust R had acquired additional stock of Corporation P 
worth $1,000, then, because of the discrepancy between the value of its 
investment in Corporation P and the 5-percent limitation resulting in 
part from this acquisition, Trust R, at the end of the third quarter, 
would lose its status as a real estate investment trust, unless within 
30 days after the close of such quarter this discrepancy is eliminated.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. 856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001); (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 
26 U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 
(68A Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 
7805), Internal Revenue Code of 1954)

[T.D. 6598, 27 FR 4083, Apr. 28, 1962, as amended by T.D. 7767, 46 FR 
11265, Feb. 6, 1981]



Sec.  1.856-3  Definitions.

    For purposes of the regulations under part II, subchapter M, chapter 
1 of the Code, the following definitions shall apply.
    (a) Value. The term ``value'' means, with respect to securities for 
which market quotations are readily available, the market value of such 
securities; and with respect to other securities and assets, fair value 
as determined in good faith by the trustees of the real estate 
investment trust. In the case of securities of other qualified real 
estate investment trusts, fair value shall not exceed market value or 
asset value, whichever is higher.
    (b) Real estate assets--(1) In general. The term ``real estate 
assets'' means real property, interests in mortgages on real property 
(including interests in mortgages on leaseholds of land or improvements 
thereon), and shares in other qualified real estate investment trusts. 
The term ``mortgages on real property'' includes deeds of trust on real 
property.
    (2) Treatment of REMIC interests as real estate assets--(i) In 
general. If, for any calendar quarter, at least 95 percent of a REMIC's 
assets (as determined in accordance with Sec.  1.860F-4(e)(1)(ii) or 
Sec.  1.6049-7(f)(3)) are real estate assets (as defined in paragraph 
(b)(1) of this section), then, for that calendar quarter, all the 
regular and residual interests in that REMIC are treated as real estate 
assets and, except as provided in paragraph (b)(2)(iii) of this section, 
any amount includible in gross income with respect to those interests is 
treated as interest on obligations secured by mortgages on real 
property. If less than 95 percent of a REMIC's assets are real estate 
assets, then the real estate investment trust is treated as holding 
directly its proportionate share of the assets and as receiving directly 
its proportionate share of the income of the REMIC. See Sec. Sec.  
1.860F-4(e)(1)(ii)(B) and 1.6049-7(f)(3) for information required to be 
provided to regular and residual interest holders if the 95-percent test 
is not met.
    (ii) Treatment of REMIC assets for section 856 purposes--(A) 
Manufactured housing treated as real estate asset. For purposes of 
paragraphs (b) (1) and (2) of this section, the term ``real estate 
asset'' includes manufactured housing treated as a single family 
residence under section 25(e)(10).
    (B) Status of cash flow investments. For purposes of this paragraph 
(b)(2), cash flow investments (as defined in section 860G(a)(6) and 
Sec.  1.860G-2(g)(1)) are real estate assets.
    (iii) Certain contingent interest payment obligations held by a 
REIT. If a REIT holds a residual interest in a REMIC for a principal 
purpose of avoiding the limitation set out in section 856(f) (concerning 
interest based on mortgagor net profits) or section 856(j) (concerning 
shared appreciation provisions), then, even if the REMIC satisfies the 
95-percent test of paragraph (b)(i) of this section, the REIT is treated 
as receiving directly the REMIC's items of income for purposes of 
section 856.

[[Page 58]]

    (c) Interests in real property. The term ``interests in real 
property'' includes fee ownership and co-ownership of land or 
improvements thereon, leaseholds of land or improvements thereon, 
options to acquire land or improvements thereon, and options to acquire 
leaseholds of land or improvements thereon. The term also includes 
timeshare interests that represent an undivided fractional fee interest, 
or undivided leasehold interest, in real property, and that entitle the 
holders of the interests to the use and enjoyment of the property for a 
specified period of time each year. The term also includes stock held by 
a person as a tenant-stockholder in a cooperative housing corporation 
(as those terms are defined in section 216). Such term does not, 
however, include mineral, oil, or gas royalty interests, such as a 
retained economic interest in coal or iron ore with respect to which the 
special provisions of section 631(c) apply.
    (d) Real property. See Sec.  1.856-10 for the definition of real 
property. A regulation that adopts the definition of real property in 
this paragraph is to be interpreted as if it had referred to Sec.  
1.856-10.
    (e) Securities. The term ``securities'' does not include ``interests 
in real property'' or ``real estate assets'' as those terms are defined 
in section 856 and this section.
    (f) Qualified real estate investment trusts. The term ``qualified 
real estate investment trust'' means a real estate investment trust 
within the meaning of part II of subchapter M which is taxable under 
such part as a real estate investment trust. For purposes of the 75-
percent requirement in section 856(c)(5)(A), the trust whose stock has 
been included by another trust as ``real estate assets'' must be a 
``qualified real estate investment trust'' for its full taxable year in 
which falls the close of each quarter of the trust's taxable year for 
which the computation is made. For example, Real Estate Investment Trust 
Z for its taxable year ending December 31, 1963, holds as ``real estate 
assets'' stock in Real Estate Investment Trust Y, which is also on a 
calendar year. If Trust Y is not a qualified real estate investment 
trust for its full taxable year ending December 31, 1963, Trust Z may 
not include the stock of Trust Y as ``real estate assets'' in computing 
the 75-percent requirement as of the close of any quarter of its taxable 
year ending December 31, 1963.
    (g) Partnership interest. In the case of a real estate investment 
trust which is a partner in a partnership, as defined in section 
7701(a)(2) and the regulations thereunder, the trust will be deemed to 
own its proportionate share of each of the assets of the partnership and 
will be deemed to be entitled to the income of the partnership 
attributable to such share. For purposes of section 856, the interest of 
a partner in the partnership's assets shall be determined in accordance 
with his capital interest in the partnership. The character of the 
various assets in the hands of the partnerhsip and items of gross income 
of the partnership shall retain the same character in the hands of the 
partners for all purposes of section 856. Thus, for example, if the 
trust owns a 30-percent capital interest in a partnership which owns a 
piece of rental property the trust will be treated as owning 30 percent 
of such property and as being entitled to 30 percent of the rent derived 
from the property by the partnership. Similarly, if the partnership 
holds any property primarily for sale to customers in the ordinary 
course of its trade or business, the trust will be treated as holding 
its proportionate share of such property primarily for such purpose. 
Also, for example, where a partnership sells real property or a trust 
sells its interest in a partnership which owns real property, any gross 
income realized from such sale, to the extent that it is attributable to 
the real property, shall be deemed gross income from the sale or 
disposition of real property held for either the period that the 
partnership has held the real property of the period that the trust was 
a member of the partnership, whichever is the shorter.
    (h) Net capital gain. The term ``net capital gain'' means the excess 
of the

[[Page 59]]

net long-term capital gain for the taxable year over the net short-term 
capital loss for the taxable year.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. 856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954)

[T.D. 6598, 27 FR 4084, Apr. 28, 1962, as amended by T.D. 6841, 30 FR 
9308, July 27, 1965; T.D. 7767, 46 FR 11266, Feb. 6, 1981; T.D. 8458, 57 
FR 61298, Dec. 24, 1992; T.D. 9784, 81 FR 59860, Aug. 31, 2016]



Sec.  1.856-4  Rents from real property.

    (a) In general. Subject to the exceptions of section 856(d) and 
paragraph (b) of this section, the term ``rents from real property'' 
means, generally, the gross amounts received for the use of, or the 
right to use, real property of the real estate investment trust.
    (b) Amounts specifically included or excluded--(1) Charges for 
customary services. For taxable years beginning after October 4, 1976, 
the term ``rents from real property'', for purposes of paragraphs (2) 
and (3) of section 856(c), includes charges for services customarily 
furnished or rendered in connection with the rental of real property, 
whether or not the charges are separately stated. Services furnished to 
the tenants of a particular building will be considered as customary if, 
in the geographic market in which the building is located, tenants in 
buildings which are of a similar class (such as luxury apartment 
buildings) are customarily provided with the service. The furnishing of 
water, heat, light, and air-conditioning, the cleaning of windows, 
public entrances, exits, and lobbies, the performance of general 
maintenance and of janitorial and cleaning services, the collection of 
trash, and the furnishing of elevator services, telephone answering 
services, incidental storage space, laundry equipment, watchman or guard 
services, parking facilities, and swimming pool facilities are examples 
of services which are customarily furnished to the tenants of a 
particular class of buildings in many geographic marketing areas. Where 
it is customary, in a particular geographic marketing area, to furnish 
electricity or other utilities to tenants in buildings of a particular 
class, the submetering of such utilities to tenants in such buildings 
will be considered a customary service. To qualify as a service 
customarily furnished, the service must be furnished or rendered to the 
tenants of the real estate investment trust or, primarily for the 
convenience or benefit of the tenant, to the guests, customers, or 
subtenants of the tenant. The service must be furnished through an 
independent contractor from whom the trust does not derive or receive 
any income. See paragraph (b)(5) of this section. For taxable years 
beginning before October 5, 1976, the rules in paragraph (b)(3) of 26 
CFR 1.856-4 (revised as of April 1, 1977), relating to the furnishing of 
services, shall continue to apply.
    (2) Amounts received with respect to certain personal property--(i) 
In general. In the case of taxable years beginning after October 4, 
1976, rent attributable to personal property that is leased under, or in 
connection with, the lease of real property is treated under section 
856(d)(1)(C) as ``rents from real property'' (and thus qualified for 
purposes of the income source requirements) if the rent attributable to 
the personal property is not more than 15 percent of the total rent 
received or accrued under the lease for the taxable year. If, however, 
the rent attributable to personal property is greater than 15 percent of 
the total rent received or accrued under the lease for the taxable year, 
then the portion of the rent from the lease that is attributable to 
personal property will not qualify as ``rents from real property''.
    (ii) Application. In general, the 15-percent test in section 
856(d)(1)(C) is applied separately to each lease of real property. 
However, where the real estate investment trust rents all (or a portion 
of all) the units in a multiple unit project under substantially similar 
leases (such as the leasing of apartments in an apartment building or 
complex to individual tenants), the 15-

[[Page 60]]

percent test may be applied with respect to the aggregate rent received 
or accrued for the taxable year under the similar leases of the 
property, by using the average of the trust's aggregate adjusted bases 
of all of the personal property subject to such leases, and the average 
of the trust's aggregate adjusted bases of all real and personal 
property subject to such leases. A lease of a furnished apartment is not 
considered to be substantially similar to a lease of an unfurnished 
apartment (including an apartment where the trust provides only personal 
property, such as major appliances, that is commonly provided by a 
landlord in connection with the rental of unfurnished living quarters).
    (iii) Taxable years beginning before October 5, 1976. In the case of 
taxable years beginning before October 5, 1976, any amount of rent that 
is attributable to personal property does not qualify as rent from real 
property.
    (3) Disqualification of rent which depends on income or profits of 
any person. Except as provided in paragraph (b)(6)(ii) of this section, 
no amount received or accrued, directly or indirectly, with respect to 
any real property (or personal property leased under, or in connection 
with, real property) qualifies as ``rents from real property'' where the 
determination of the amount depends in whole or in part on the income or 
profits derived by any person from the property. However, any amount so 
accured or received shall not be excluded from the term ``rents from 
real property'' solely by reason of being based on a fixed percentage or 
percentages of receipts or sales (whether or not receipts or sales are 
adjusted for returned merchandise, or Federal, State, or local sales 
taxes). Thus, for example, ``rents from real property'' would include 
rents where the lease provides for differing percentages or receipts or 
sales from different departments or from separate floors of a retail 
store so long as each percentage is fixed at the time of entering into 
the lease and a change in such percentage is not renegotiated during the 
term of the lease (including any renewal periods of the lease, in a 
manner which has the effect of basing the rent on income of profits. See 
paragraph (b)(6) of this section for rules relating to certain amounts 
received or accrued by a trust which are considered to be based on the 
income or profits of a sublessee of the prime tenant. The amount 
received or accrued as rent for the taxable year which is based on a 
fixed percentage or percentages of the lessee's receipts or sales 
reduced by escalation receipts (including those determined under a 
formula clause) will qualify as ``rents from real property''. Escalation 
receipts include amounts received by a prime tenant from subtenants by 
reason of an agreement that rent shall be increased to reflect all or a 
portion of an increase in real estate taxes, property insurance, 
operating costs of the prime tenant, or similar items customarily 
included in lease escalation clauses. Where in accordance with the terms 
of an agreement an amount received or accrued as rent for the taxable 
year includes both a fixed rental and a percentage of all or a portion 
of the lessee's income or profits, neither the fixed rental nor the 
additional amount will qualify as ``rents from real property''. However, 
where the amount received or accrued for the taxable year under such an 
agreement includes only the fixed rental, the determination of which 
does not depend in whole or in part on the income or profits derived by 
the lessee, such amount may qualify as ``rents from real property''. An 
amount received or accrued as rent for the taxable year which consists, 
in whole or in part, of one or more percentages of the lessee's receipts 
or sales in excess of determinable dollar amounts may qualify as ``rents 
from real property'', but only if two conditions exist. First, the 
determinable amounts must not depend in whole or in part on the income 
or profits of the lessee. Second, the percentages and, in the case of 
leases entered into after July 7, 1978, the determinable amounts, must 
be fixed at the time the lease is entered into and a change in 
percentages and determinable amounts is not renegotiated during the term 
of the lease (including any renewal periods of the lease) in a manner 
which has the effect of basing rent on income or profits. In any event, 
an amount will not qualify as ``rents from real property''

[[Page 61]]

if, considering the lease and all the surrounding circumstances, the 
arrangement does not conform with normal business practice but is in 
reality used as a means of basing the rent on income or profits. The 
provisions of this subparagraph may be illustrated by the following 
example:

    Example. A real estate investment trust owns land underlying an 
office building. On January 1, 1975, the trust leases the land for 50 
years to a prime tenant for an annual rental of $100x plus 20 percent of 
the prime tenant's annual gross receipts from the office building in 
excess of a fixed base amount of $5,000x and 10 percent of such gross 
receipts in excess of $10,000x. For this purpose the lease defines gross 
receipts as all amounts received by the prime tenant from occupancy 
tenants pursuant to leases of space in the office building reduced by 
the amount by which real estate taxes, property insurance, and operating 
costs related to the office building for a particular year exceed the 
amount of such items for 1974. The exclusion from gross receipts of 
increases since 1974 in real estate taxes, property insurance, and other 
expenses relating to the office building reflects the fact that the 
prime tenant passes on to occupancy tenants by way of a customary lease 
escalation provision the risk that such expenses might increase during 
the term of an occupancy lease. The exclusion from gross receipts of 
these expense escalation items will not cause the rental received by the 
real estate investment trust from the prime tenant to fail to qualify as 
``rents from real property'' for purposes of section 856(c).

    (4) Disqualification of amounts received from persons owned in whole 
or in part by the trust. ``Rents from real property'' does not include 
any amount received or accrued, directly or indirectly, from any person 
in which the real estate investment trust owns, at any time during the 
taxable year, the specified percentage or number of shares of stock (or 
interest in the assets or net profits) of that person. Any amount 
received from such person will not qualify as ``rents from real 
property'' if such person is a corporation and the trust owns 10 percent 
or more of the total combined voting power of all classes of its stock 
entitled to vote or 10 percent or more of the total number of shares of 
all classes of its outstanding stock, or if such person is not a 
corporation and the trust owns a 10-percent-or-more interest in its 
assets or net profits. For example, a trust leases an office building to 
a tenant for which it receives rent of $100,000 for the taxable year 
1962. The lessee of the building subleases space to various subtenants 
for which it receives gross rent of $500,000 for the year 1962. The 
trust owns 15 percent of the total assets of an unincorporated 
subtenant. The rent paid by this subtenant for the taxable year is 
$50,000. Therefore, $10,000 (50,000/500,000 x $100,000) of the rent paid 
to the trust does not qualify as ``rents from real property''. Where the 
real estate investment trust receives, directly or indirectly, any 
amount of rent from any person in which it owns any proprietary 
interest, the trust shall submit, at the time it files its return for 
the taxable year (or before June 1, 1962, whichever is later), a 
schedule setting forth--
    (i) The name and address of such person and the amount received as 
rent from such person; and
    (ii) If such person is a corporation, the highest percentage of the 
total combined voting power of all classes of its stock entitled to 
vote, and the highest percentage of the total number of shares of all 
classes of its outstanding stock, owned by the trust at any time during 
the trust's taxable year; or
    (iii) If such person is not a corporation, the highest percentage of 
the trust's interest in the assets or net profits of such person, owned 
by the trust at any time during its taxable year.
    (5) Furnishing of services or management of property must be through 
an independent contractor--(i) In general. No amount received or 
accrued, directly or indirectly, with respect to any real property (or 
any personal property leased under, or in connection with, the real 
property) qualifies as ``rents from real property'' if the real estate 
investment trust furnishes or renders services to the tenants of the 
property or manages or operates the property, other than through an 
independent contractor from whom the trust itself does not derive or 
receive any income. The prohibition against the trust deriving or 
receiving any income from the independent contractor applies regardless 
of the source from which the income was derived by the

[[Page 62]]

independent contractor. Thus, for example, the trust may not receive any 
dividends from the independent contractor. The requirement that the 
trust not receive any income from an independent contractor requires 
that the relationship between the two be an arm's-length relationship. 
The independent contractor must be adequately compensated for any 
services which are performed for the trust. Compensation to an 
independent contractor determined by reference to an unadjusted 
percentage of gross rents will generally be considered to be adequate 
where the percentage is reasonable taking into account the going rate of 
compensation for managing similar property in the same locality, the 
services rendered, and other relevant factors. The independent 
contractor must not be an employee of the trust (i.e., the manner in 
which he carries out his duties as independent contractor must not be 
subject to the control of the trust). Although the cost of services 
which are customarily rendered or furnished in connection with the 
rental of real property may be borne by the trust, the services must be 
furnished or rendered through an independent contractor. Furthermore, 
the facilities through which the services are furnished must be 
maintained and operated by an independent contractor. For example, if a 
heating plant is located in the building, it must be maintained and 
operated by an independent contractor. To the extent that services 
(other than those customarily furnished or rendered in connection with 
the rental of real property) are rendered to the tenants of the property 
by the independent contractor, the cost of the services must be borne by 
the independent contractor, a separate charge must be made for the 
services, the amount of the separate charge must be received and 
retained by the independent contractor, and the independent contractor 
must be adequately compensated for the services.
    (ii) Trustee or director functions. The trustees or directors of the 
real estate investment trust are not required to delegate or contract 
out their fiduciary duty to manage the trust itself, as distinguished 
from rendering or furnishing services to the tenants of its property or 
managing or operating the property. Thus, the trustees or directors may 
do all those things necessary, in their fiduciary capacities, to manage 
and conduct the affairs of the trust itself. For example, the trustees 
or directors may establish rental terms, choose tenants, enter into and 
renew leases, and deal with taxes, interest, and insurance, relating to 
the trust's property. The trustees or directors may also make capital 
expenditures with respect to the trust's property (as defined in section 
263) and may make decisions as to repairs of the trust's property (of 
the type which would be deductible under section 162), the cost of which 
may be borne by the trust.
    (iii) Independent contractor defined. The term ``independent 
contractor'' means--
    (a) A person who does not own, directly or indirectly, at any time 
during the trust's taxable year more than 35 percent of the shares in 
the real estate investment trust, or
    (b) A person--
    (1) If a corporation, not more than 35 percent of the total combined 
voting power of whose stock (or 35 percent of the total shares of all 
classes of whose stock), or
    (2) If not a corporation, not more than 35 percent of the interest 
in whose assets or net profits is owned, directly or indirectly, at any 
time during the trust's taxable year by one or more persons owning at 
any time during such taxable year 35 percent or more of the shares in 
the trust.
    (iv) Information required. The real estate investment trust shall 
submit with its return for the taxable year (or before June 1, 1962, 
whichever is later) a statement setting forth the name and address of 
each independent contractor; and
    (a) The highest percentage of the outstanding shares in the trust 
owned at any time during its taxable year by such independent contractor 
and by any person owning at any time during such taxable year any shares 
of stock or interest in the independent contractor.
    (b) If the independent contractor is a corporation such statement 
shall set forth the highest percentage of the total combined voting 
power of its stock and the highest percentage of the

[[Page 63]]

total number of shares of all classes of its stock owned at any time 
during its taxable year by any person owning shares in the trust at any 
time during such taxable year.
    (c) If the independent contractor is not a corporation such 
statement shall set forth the highest percentage of any interest in its 
assets or net profits owned at any time during its taxable year by any 
person owning shares in the trust at any time during such taxable year.
    (6) Amounts based on income or profits of subtenants. (i) Except as 
provided in paragraph (b)(6)(ii) of this section, if a trust leases real 
property to a tenant under terms other than solely on a fixed sum rental 
(for example, a percentage of the tenant's gross receipts), and the 
tenant subleases all or a part of such property under an agreement which 
provides for a rental based in whole or in part on the income or profits 
of the sublessee, the entire amount of the rent received by the trust 
from the prime tenant with respect to such property is disqualified as 
``rents from real property''.
    (ii) Exception. For taxable years beginning after October 4, 1976, 
section 856(d)(4) provides an exception to the general rule that amounts 
received or accrued, directly or indirectly, by a real estate investment 
trust do not qualify as rents from real property if the determination of 
the amount depends in whole or in part on the income or profits derived 
by any person from the property. This exception applies where the trust 
rents property to a tenant (the prime tenant) for a rental which is 
based, in whole or in part, on a fixed percentage or percentages of the 
receipts or sales of the prime tenant, and the rent which the trust 
receives or accrues from the prime tenant pursuant to the lease would 
not qualify as ``rents from real property'' solely because the prime 
tenant receives or accrues from subtenants (including concessionaires) 
rents or other amounts based on the income or profits derived by a 
person from the property. Under the exception, only a proportionate part 
of the rent received or accrued by the trust does not qualify as ``rents 
from real property''. The proportionate part of the rent received or 
accrued by the trust which is non-qualified is the lesser of the 
following two amounts:
    (A) The rent received or accrued by the trust from the prime tenant 
pursuant to the lease, that is based on a fixed percentage or 
percentages of receipts or sales, or
    (B) The product determined by multiplying the total rent which the 
trust receives or accrues from the prime tenant pursuant to the lease by 
a fraction, the numerator of which is the rent or other amount received 
by the prime tenant that is based, in whole or in part, on the income or 
profits derived by any person from the property, and the denominator of 
which is the total rent or other amount received by the prime tenant 
from the property. For example, assume that a real estate investment 
trust owns land underlying a shopping center. The trust rents the land 
to the owner of the shopping center for an annual rent of $10x plus 2 
percent of the gross receipts which the prime tenant receives from 
subtenants who lease space in the shopping center. Assume further that, 
for the year in question, the prime tenant derives total rent from the 
shopping center of $100x and, of that amount, $25x is received from 
subtenants whose rent is based, in whole or in part, on the income or 
profits derived from the property. Accordingly, the trust will receive a 
total rent of $12x, of which $2x is based on a percentage of the gross 
receipts of the prime tenant. The portion of the rent which is 
disqualified is the lesser of $2x (the rent received by the trust which 
is based on a percentage of gross receipts), or $3x, ($12x multiplied by 
$25x/$100x). Accordingly, $10x of the rent received by the trust 
qualifies as ``rents from real property'' and $2x does not qualify.
    (7) Attribution rules. Paragraphs (2) and (3) of section 856(d) 
relate to direct or indirect ownership of stock, assets, or net profits 
by the persons described therein. For purposes of determining such 
direct or indirect ownership, the rules prescribed by section 318(a) 
(for determining the ownership of stock) shall apply except that ``10 
percent''

[[Page 64]]

shall be substituted for ``50 percent'' in section 318(a) (2)(C) and 
(3)(C).

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4085, Apr. 28, 1962, as amended by T.D. 6969, 33 FR 
12000, Aug. 23, 1968; T.D. 7767, 46 FR 11266, Feb. 6, 1981]



Sec.  1.856-5  Interest.

    (a) In general. In computing the percentage requirements in section 
856(c) (2)(B) and (3)(B), the term ``interest'' includes only an amount 
which constitutes compensation for the use or forbearance of money. For 
example, a fee received or accrued by a lender which is in fact a charge 
for services performed for a borrower rather than a charge for the use 
of borrowed money is not includable as interest.
    (b) Where amount depends on income or profits of any person. Except 
as provided in paragraph (d) of this section, any amount received or 
accrued, directly or indirectly, with respect to an obligation is not 
includable as interest for purposes of section 856(c) (2)(B) and (3)(B) 
if, under the principles set forth in paragraphs (b)(3) and (6)(i) of 
Sec.  1.856-4, the determination of the amount depends in whole or in 
part on the income or profits of any person (whether or not derived from 
property secured by the obligation). Thus, for example, if in accordance 
with a loan agreement an amount is received or accrued by the trust with 
respect to an obligation which includes both a fixed amount of interest 
and a percentage of the borrower's income or profits, neither the fixed 
interest nor the amount based upon the percentage will qualify as 
interest for purposes of section 856(c) (2)(B) and (3)(B). This 
paragraph and paragraph (d) of this section apply only to amounts 
received or accrued in taxable years beginning after October 4, 1976, 
pursuant to loans made after May 27, 1976. For purposes of the preceding 
sentence, a loan is considered to be made before May 28, 1976, if it is 
made pursuant to a binding commitment entered into before May 28, 1976.
    (c) Apportionment of interest--(1) In general. Where a mortgage 
covers both real property and other property, an apportionment of the 
interest income must be made for purposes of the 75-percent requirement 
of section 856(c)(3). For purposes of the 75-percent requirement, the 
apportionment shall be made as follows:
    (i) If the loan value of the real property is equal to or exceeds 
the amount of the loan, then the entire interest income shall be 
apportioned to the real property.
    (ii) If the amount of the loan exceeds the loan value of the real 
property, then the interest income apportioned to the real property is 
an amount equal to the interest income multiplied by a fraction, the 
numerator of which is the loan value of the real property, and the 
denominator of which is the amount of the loan. The interest income 
apportioned to the other property is an amount equal to the excess of 
the total interest income over the interest income apportioned to the 
real property.
    (2) Loan value. For purposes of this paragraph, the loan value of 
the real property is the fair market value of the property, determined 
as of the date on which the commitment by the trust to make the loan 
becomes binding on the trust. In the case of a loan purchased by the 
trust, the loan value of the real property is the fair market value of 
the property, determined as of the date on which the commitment by the 
trust to purchase the loan becomes binding on the trust. However, in the 
case of a construction loan or other loan made for purposes of improving 
or developing real property, the loan value of the real property is the 
fair market value of the land plus the reasonably estimated cost of the 
improvements or developments (other than personal property) which will 
secure the loan and which are to be constructed from the proceeds of the 
loan. The fair market value of the land and the reasonably estimated 
cost of improvements or developments shall be determined as of the date 
on which a commitment to make the loan becomes binding on the trust. If 
the

[[Page 65]]

trust does not make the construction loan but commits itself to provide 
long-term financing following completion of construction, the loan value 
of the real property is determined by using the principles for 
determining the loan value for a construction loan. Moreover, if the 
mortgage on the real property is given as additional security (or as a 
substitute for other security) for the loan after the trust's commitment 
is binding, the real property loan value is its fair market value when 
it becomes security for the loan (or, if earlier, when the borrower 
makes a binding commitment to add or substitute the property as 
security).
    (3) Amount of loan. For purposes of this paragraph, the amount of 
the loan means the highest principal amount of the loan outstanding 
during the taxable year.
    (d) Exception. Section 856(f)(2) provides an exception to the 
general rule that amounts received, directly or indirectly, with respect 
to an obligation do not qualify as ``interest'' where the determination 
of the amounts depends in whole or in part on the income or profits of 
any person. The exception applies where the trust receives or accrues, 
with respect to the obligation of its debtor, an amount that is based in 
whole or in part on a fixed percentage or percentages of receipts or 
sales of the debtor, and the amount would not qualify as interest solely 
because the debtor has receipts or sale proceeds that are based on the 
income or profits of any person. Under this exception only a 
proportionate part of the amount received or accrued by the trust fails 
to qualify as interest for purposes of the percentage-of-income 
requirements of section 856(c) (2) and (3). The proportionate part of 
the amount received or accrued by the trust that is non-qualified is the 
lesser of the following two amounts:
    (1) The amount received or accrued by the trust from the debtor with 
respect to the obligation that is based on a fixed percentage or 
percentages of receipts or sales, or
    (2) The product determined by multiplying by a fraction the total 
amount received or accrued by the trust from the debtor with respect to 
the obligation. The numerator of the fraction is the amount of receipts 
or sales of the debtor that is based, in whole or in part, on the income 
or profits of any person and the denominator is the total amount of the 
receipts or sales of the debtor. For purposes of the preceding sentence, 
the only receipts or sales to be taken into account are those taken into 
account in determining the payment to the trust pursuant to the loan 
agreement.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954)

[T.D. 7767, 46 FR 11268, Feb. 6, 1981]



Sec.  1.856-6  Foreclosure property.

    (a) In general. Under section 856(e) a real estate investment trust 
may make an irrevocable election to treat as ``foreclosure property'' 
certain real property (including interests in real property), and any 
personal property incident to the real property, acquired by the trust 
after December 31, 1973. This section prescribes rules relating to the 
election, including rules relating to property eligible for the 
election. This section also prescribes rules relating to extensions of 
the general two-year period (hereinafter the ``grace period'') during 
which property retains its status as foreclosure property, as well as 
rules relating to early termination of the grace period under section 
856(e)(4). The election to treat property as foreclosure property does 
not alter the character of the income derived therefrom (other than for 
purposes of section 856(c)(2)(F) and (3)(F)). For example, if 
foreclosure property is sold, the determination of whether it is 
property described in section 1221(1) will not be affected by the fact 
that it is foreclosure property.
    (b) Property eligible for the election--(1) Rules relating to 
acquisitions. In general, the trust must acquire the property after 
December 31, 1973, as the result of

[[Page 66]]

having bid in the property at foreclosure, or having otherwise reduced 
the property to ownership or possession by agreement or process of law, 
after there was default (or default was imminent) on a lease of the 
property (where the trust was the lessor) or on an indebtedness owed to 
the trust which the property secured. Foreclosure property which secured 
an indebtedness owed to the trust is acquired for purposes of section 
856(e) on the date on which the trust acquires ownership of the property 
for Federal income tax purposes. Foreclosure property which a trust 
owned and leased to another is acquired for purposes of section 856(e) 
on the date on which the trust acquires possession of the property from 
its lessee. A trust will not be considered to have acquired ownership of 
property for purposes of section 856(e) where it takes control of the 
property as a mortgagee-in-possession and cannot receive any profit or 
sustain any loss with respect to the property except as a creditor of 
the mortgagor. A trust may be considered to have acquired ownership of 
property for purposes of section 856(e) even through legal title to the 
property is held by another person. For example, where, upon foreclosure 
of a mortgage held by the trust, legal title to the property is acquired 
in the name of a nominee for the exclusive benefit of the trust and the 
trust is the equitable owner of the property, the trust will be 
considered to have acquired ownership of the property for purposes of 
section 856(e). Generally, the fact that under local law the mortgagor 
has a right of redemption after foreclosure is not relevant in 
determining whether the trust has acquired ownership of the property for 
purposes of section 856(e). Property is not ineligible for the election 
solely because the property, in addition to securing an indebtedness 
owed to the trust, also secures debts owed to other creditors. Property 
eligible for the election includes a building or other improvement which 
has been constructed on land owned by the trust and which is acquired by 
the trust upon default of a lease of the land.
    (2) Personal property. Personal property (including personal 
property not subject to a mortgage or lease of the real property) will 
be considered incident to a particular item of real property if the 
personal property is used in a trade or business conducted on the 
property or the use of the personal property is otherwise an ordinary 
and necessary corollary of the use to which the real property is put. In 
the case of a hotel, such items as furniture, appliances, linens, china, 
food, etc. would be examples of incidental personal property. Personal 
property incident to the real property is eligible for the election even 
though it is acquired after the real property is acquired or is placed 
in the building or other improvement in the course of the completion of 
construction.
    (3) Property with respect to which default is anticipated. Property 
is not eligible for the election to be treated as foreclosure property 
if the loan or lease with respect to which the default occurs (or is 
imminent) was made or entered into (or the lease or indebtedness was 
acquired) by the trust with an intent to evict or foreclose, or when the 
trust knew or had reason to know that default would occur (``improper 
knowledge''). For purposes of the preceding sentence, a trust will not 
be considered to have improper knowledge with respect to a particular 
lease or loan, if the lease or loan was made pursuant to a binding 
commitment entered into by the trust at a time when it did not have 
improper knowledge. Moreover, if the trust, in an attempt to avoid 
default or foreclosure, advances additional amounts to the borrower in 
excess of amounts contemplated in the original loan commitment or 
modifies the lease or loan, such advance or modification will be 
considered not to have been made with an intent to evict or foreclose, 
or with improper knowledge, unless the original loan or lease was 
entered into with that intent or knowledge.
    (c) Election--(1) In general. (i) An election to treat property as 
foreclosure property applies to all of the eligible real property 
acquired in the same taxable year by the trust upon the default (or as a 
result of the imminence of default) on a particular lease (where the 
trust is the lessor) or on a particular

[[Page 67]]

indebtedness owed to the trust. For example, if a loan made by a trust 
is secured by two separate tracts of land located in different cities, 
and in the same taxable year the trust acquires both tracts on 
foreclosure upon the default (or imminence of default) of the loan, the 
trust must include both tracts in the election. For a further example, 
the trust may choose to make a separate election for only one of the 
tracts if they are acquired in different taxable years or were not 
security for the same loan. If real property subject to the same 
election is acquired at different times in the same taxable year, the 
grace period for a particular property begins when that property is 
acquired.
    (ii) If the trust acquires separate pieces of real property that 
secure the same indebtedness (or are under the same lease) in different 
taxable years because the trust delays acquiring one of them until a 
later taxable year, and the primary purpose for the delay is to include 
only one of them in an election, then if the trust makes an election for 
one piece it must also make an election for the other piece. A trust 
will not be considered to have delayed the acquisition of property for 
this purpose if there is a legitimate business reason for the delay 
(such as an attempt to avoid foreclosure by further negotiations with 
the debtor or lessee).
    (iii) All of the eligible personal property incident to the real 
property must also be included in the election.
    (2) Time for making election. The election to treat property as 
foreclosure property must be made on or before the due date (including 
extensions of time) for filing the trust's income tax return for the 
taxable year in which the trust acquires the property with respect to 
which the election is being made, or April 3, 1975, whichever is later.
    (3) Manner of making the election. An election made after February 
6, 1981, shall be made by a statement attached to the income tax return 
for the taxable year in which the trust acquired the property with 
respect to which the election is being made. The statement shall 
indicate that the election is made under section 856(e) and shall 
identify the property to which the election applies. The statement shall 
also set forth--
    (i) The name, address, and taxpayer identification number of the 
trust,
    (ii) The date the property was acquired by the trust, and
    (iii) A brief description of how the real property was acquired, 
including the name of the person or persons from whom the real property 
was acquired and a description of the lease or indebtedness with respect 
to which default occurred or was imminent.


An election made on or before February 6, 1981 shall be filed in the 
manner prescribed in 26 CFR 10.1(f) (revised as of April 1, 1977) 
(temporary regulations relating to the election to treat property as 
foreclosure property) as in effect when the election is made.
    (4) Status of taxpayer. In general, a taxpayer may make an election 
with respect to an acquisition of property only if the taxpayer is a 
qualified real estate investment trust for the taxable year in which the 
acquisition occurs. If, however, the taxpayer establishes, to the 
satisfaction of the district director for the internal revenue district 
in which the taxpayer maintains its principal place of business or 
principal office or agency, that its failure to be a qualified real 
estate investment trust for a taxable year was to due to reasonable 
cause and not due to willful neglect, the taxpayer may make the election 
with respect to property acquired in such taxable year. The principles 
of Sec. Sec.  1.856.7(c) and 1.856.8(d) (including the principles 
relating to expert advice) will apply in determining whether, for 
purposes of this subparagraph, the failure of the taxpayer to be a 
qualified real estate investment trust for the taxable year in which the 
property is acquired was due to reasonable cause and not due to willful 
neglect. If a taxpayer makes a valid election to treat property as 
foreclosure property, the property will not lose its status as 
foreclosure property solely because the taxpayer is not a qualified real 
estate investment trust for a subsequent taxable year (including a 
taxable year which encompasses an extension of the grace period). 
However, the rules relating to the termination of foreclosure property 
status in section 856(e)(4) (but not the tax on income from foreclosure

[[Page 68]]

property imposed by section 857(b)(4)) apply to the year in which the 
property is acquired and all subsequent years, even though the taxpayer 
is not a qualified real estate investment trust for such year.
    (d) Termination of 2-year grace period; subsequent leases--(1) In 
general. Under section 856(e)(4)(A), all real property (and any 
incidental personal property) for which a particular election has been 
made (see paragraph (c)(1) of this section) shall cease to be 
foreclosure property on the first day (occurring on or after the day on 
which the trust acquired the property) on which the trust either--
    (i) Enters into a lease with respect to any of the property which, 
by its terms, will give rise to income of the trust which is not 
described in section 856(c)(3) (other than section 856(c)(3)(F)), or
    (ii) Receives or accrues, directly or indirectly, any amount which 
is not described in section 856(c)(3) (other than section 856(c)(3)(F)) 
pursuant to a lease with respect to any of the real property entered 
into by the trust on or after the day the trust acquired the property.


For example, assume the trust acquires, in a particular taxable year, a 
shopping center upon the default of an indebtedness owed to the trust. 
Also assume that the trust subsequently enters into a lease with respect 
to one of several stores in the shopping center that requires the lessee 
to pay rent to the trust which is not income described in section 
856(c)(3) (other than section 856(c)(3)(F)). In such case, the entire 
shopping center will cease to be foreclosure property on the day the 
trust enters into the lease.
    (2) Extensions or renewals of leases. Generally, the extension or 
renewal of a lease of foreclosure property will be treated as the 
entering into of a new lease only if the trust has a right to 
renegotiate the terms of the lease. If, however, by operation of law or 
by contract, the acquisition of the foreclosure property by the trust 
terminates a preexisting lease of the property, or gives the trust a 
right to terminate the lease, then for purposes of section 856(e)(4)(A), 
a trust, in such circumstances, will not be considered to have entered 
into a lease with respect to the property solely because the terms of 
the preexisting lease are continued in effect after foreclosure without 
substantial modification. The letting of rooms in a hotel or motel does 
not constitute the entering into a lease for purposes of section 
856(e)(4)(A).
    (3) Rent attributable to personal property. Solely for the purposes 
of section 856(e)(4)(A), if a trust enters into a lease with respect to 
real property on or after the day upon which the trust acquires such 
real property by foreclosure, and a portion of the rent from such lease 
is attributable to personal property which is foreclosure property 
incident to such real property, such rent attributable to the incidental 
personal property will not be considered to terminate the status of such 
real property (or such incidental personal property) as foreclosure 
property.
    (e) Termination of 2-year grace period; completion of construction--
(1) In general. Under section 856(e)(4)(B), all real property (and any 
incidental personal property) for which a particular election has been 
made (see paragraph (c)(1) of this section) shall cease to be 
foreclosure property on the first day (occurring on or after the day on 
which the trust acquired the property) on which any construction takes 
place on the property, other than completion of a building (or 
completion of any other improvement) where more than 10 percent of the 
construction of the building (or other improvement) was completed before 
default became imminent. If more than one default occurred with respect 
to an indebtedness or lease in respect of which there is an acquisition, 
the more-than-10-percent test (including the rule prescribed in this 
paragraph relating to the test) will not be applied at the time a 
particular default became imminent if it is clear that the acquisition 
did not occur as the result of such default. For example, if the debtor 
fails to make four consecutive payments of principal and interest on the 
due dates, and the trust takes action to acquire the property securing 
the debt only after the fourth default becomes imminent, the 10-percent 
test is applied at the time the fourth default became imminent (even

[[Page 69]]

though the trust would not have foreclosed on the property had not all 
four defaults occurred).
    (2) Determination of percentage of completion. The determination of 
whether the construction of a building or other improvement was more 
than 10 percent complete when default became imminent shall be made by 
comparing the total direct costs of construction incurred with respect 
to the building or other improvement as of the date default became 
imminent with the estimated total direct costs of construction as of 
such date. If the building or other improvement qualifies as more than 
10 percent complete under this method, the building or other improvement 
shall be considered to be more than 10 percent complete. For purposes of 
this subparagraph, direct costs of construction include the cost of 
labor and materials which are directly connected with the construction 
of the building or improvement.


Thus, for example, direct costs of construction incurred as of the date 
default became imminent would include amounts paid, or for which 
liability has been incurred, for labor which has been performed as of 
such date that is directly connected with the construction of the 
building or other improvement and for building materials and supplies 
used or consumed in connection with the construction as of such date. 
For purposes of applying the 10-percent test the trust may also take 
into account the cost of building materials and supplies which have been 
delivered to the construction site as of the date default became 
imminent and which are to be used or consumed in connection with the 
construction. On the other hand, architect's fees, administrative costs 
of the developer or builder, lawyers' fees, and expenses incurred in 
connection with obtaining zoning approval or building permits are not 
considerd to be direct costs of construction. Any construction by the 
trust as mortgagee-in-possession is considered to have taken place after 
default resulting in acquisition of the property became imminent. 
Generally, the trust's estimate of the total direct costs of completing 
construction as of the date the default became imminent will be 
accepted, provided that the estimate is reasonable, in good faith, and 
is based on all of the data reasonably available to the trust when the 
trust undertakes completion of construction of the building or other 
improvement. Appropriate documentation which shows that construction was 
more than 10 percent complete when default became imminent must be 
available at the principal place of business of the trust for inspection 
in connection with an examination of the income tax return. Construction 
includes the renovation of a building, such as the remodeling of 
apartments, or the renovation of an apartment building to convert rental 
units to a condominium. The renovation must be more than 10 percent 
complete (determined by comparing the total direct cost of the physical 
renovation which has been incurred when default became imminent with the 
estimated total direct cost of renovation as of such date) when default 
became immiment in order for the property not to lose its status as 
foreclosure property if the trust undertakes the renovation.
    (3) Modification of a building or improvement. Generally, the terms 
``building'' and ``improvement'' in section 856(e)(4)(B) mean the 
building or improvement (including any intergral part thereof) as 
planned by the mortgagor or lessee (or other person in possession of the 
property, if appropriate) as of the date default became imminent. The 
trust, however, may estimate the total direct costs of construction and 
complete the construction of the building or other improvement by 
modifying the building or other improvement as planned as of the date 
default became imminent so as to reduce the estimated direct cost of 
construction of the building or improvement. If the trust does so modify 
the planned construction of the building or improvement, the 10-percent 
test is to be applied by comparing the direct costs of construction 
incurred as of the date default became imminent that are attributable to 
the building or improvement as modified, with the estimated total direct 
costs (as of such date) of construction of the building or other 
improvement as modified. The trust, in order to meet the 10-percent 
test, may not, however, modify the planned

[[Page 70]]

building or improvement by reducing the estimated direct cost of 
construction to such an extent that the building or improvement is not 
functional.


Also, the trust may make subsequent modifications which increase the 
direct cost of construction of the building or improvement if such 
modifications--
    (i) Are required by a Federal, State, or local agency, or
    (ii) Are alterations that are either required by a prospective 
lessee or purchaser as a condition of leasing or buying the property or 
are necessary for the property to be used for the purpose planned at the 
time default became imminent.


Subdivision (ii) of the preceding sentence applies, however, only if the 
building or improvement, as modified, was more than 10 percent complete 
when default became imminent. A building completed by the trust will not 
cease to be foreclosure property solely because the building is used in 
a manner other than that planed by the defaulting mortgagor or lessee. 
Thus, for example, assume a trust acquired on foreclosure a planned 
apartment building which was 20 percent complete when default became 
imminent and that the trust completes the building without modifications 
which increase the direct cost of construction. The property will not 
cease to be foreclosure property by reason of section 856(e)(4)(B) 
solely because the trust sells the dwelling units in the building as 
condominium units, rather than holding them for rent as planned by the 
defaulting mortgagor. (See, however, section 856(e)(4)(C) and paragraph 
(f)(2) of this section for rules relating to the requirement that where 
foreclosure property is used in a trade or business (including a trade 
or business of selling the foreclosure property), the trade or business 
must be conducted through an independent contractor after 90 days after 
the property is acquired.)
    (4) Application on building-by-building basis. Generally the more 
than 10 percent test is to be applied on a building-by-building basis. 
Thus, for example, if a trust has foreclosed on land held by a developer 
building a housing subdivision, the trust may complete construction of 
the houses which were more than 10 percent complete when default became 
imminent. The trust, however, may not complete construction of houses 
which were only 10 percent (or less) complete, nor may the trust begin 
construction of other houses planned for the subdivision on which 
construction has not begun. The trust, however, may construct an 
additional building or improvement (whether or not the construction 
thereof has begun) which is an integral part of another building or 
other improvement that was more than 10 percent complete when default 
became imminent if the additional building or improvement and the other 
building or improvement, taken together as a unit, meet the more than 10 
percent test. For purposes of this paragraph, an additional building or 
other improvement will be considered to be an integral part of another 
building or improvement if--
    (i) It is ancillary to the other building or improvement and its 
principal intended use is to furnish services or facilities which either 
supplement the use of such other building or improvement or are 
necessary for such other building or improvement to be utilized in the 
manner or for the purpose for which it is intended, or
    (ii) The buildings or improvements are intended to comprise 
constituent parts of an interdependent group of buildings or other 
improvements.


However, a building or other improvement will not be considered to be an 
integral part of another building or improvement unless the buildings or 
improvements were planned as part of the same overall construction plan 
or project before default became imminent. An additional building or 
other improvement (such as, for example, an outdoor swimming pool or a 
parking garage) may be considered to be an integral part of another 
building or improvement, even though the additional building or 
improvement was also intended to be used to provide facilities or 
services for use in connection with several other buildings or 
improvements which will not be completed. If the trust chooses not to 
undertake the construction of an additional building or other 
improvement which qualifies as an integral part of another building

[[Page 71]]

or improvement, so much of the costs of construction (including both the 
direct costs of construction incurred before the default became imminent 
and the estimated costs of completion) as are attributable to that 
``integral part'' shall not be taken into account in determining whether 
any other building or improvement was more than 10 percent complete when 
default became imminent. For example, assume the trust acquires on 
foreclosure a property on which the defaulting mortgagor has begun 
construction of a motel. The motel, as planned by the mortgagor, was to 
consist of a two-story building containing 30 units, and two detached 
one-story wings, each of which was to contain 20 units. At the time 
default became imminent, the defaulting mortgagor had completed more 
than 10 percent of the construction of the two-story structure but the 
two wings, an access road, a parking lot, and an outdoor swimming pool 
planned for the motel were each less than 10 percent complete. The trust 
may construct the two wings of the motel, the access road, the parking 
lot, and the swimming pool: Provided, That the motel and the other 
improvements which the trust undertakes to construct, taken together as 
a unit, were more than 10 percent complete when default became imminent. 
If, however, the trust chooses not to undertake construction of the 
swimming pool, the cost of construction attributable to the swimming 
pool, whether incurred before default became imminent or estimated as 
the cost of completion, shall not be taken into account in determining 
whether the trust can complete construction of the other buildings and 
improvements. For another example, assume that the trust acquires a 
planned shopping center on foreclosure. At the time default became 
imminent several large buildings intended to house shops and stores in 
the shopping center were more than 10 percent complete. Less than 10 
percent of the construction, however, had been completed on a separate 
structure intended to house a bank. The bank was planned as a component 
of the shopping center in order to provide, in conjunction with the 
other shops and stores, a specific range and variety of goods and 
services with which to attract customers to the shopping center. The 
trust may complete construction of the bank: Provided, That the bank and 
the other buildings and improvements which the trust undertakes to 
complete, taken together as a unit, were more than 10 percent complete 
when default became imminent. If the trust chooses not to construct the 
bank, no actual or estimated construction costs attributable to the bank 
are to be taken into account in applying the 10-percent test with 
respect to the other buildings and improvements in the shopping center. 
For a third example, assume that a defaulting mortgagor had planned to 
construct two identical apartment buildings, A and B, on the same tract 
of land, that neither building is to provide substantial facilities or 
services to be used in connection with the other, and that only building 
A was more than 10 percent complete when default became imminent. The 
trust, in this case, may not complete building B. On the other hand, if 
the facts are the same except that pursuant to the plans of the 
defaulting mortgagor, one of the buildings is to contain the furnace and 
central air conditioning machinery for both buildings A and B, the trust 
may complete both buildings A and B: Provided, That, taken together as a 
unit, the two buildings meet the more-than-10-percent test.
    (5) Repair and maintenance. Under this paragraph (e), 
``construction'' does not include--
    (i) The repair or maintenance of a building or other improvement 
(such as the replacement of worn or obsolete furniture and appliances) 
to offset normal wear and tear or obsolescence, and the restoration of 
property required because of damage from fire, storm, vandalism or other 
casualty,
    (ii) The preparation of leased space for a new tenant which does not 
substantially extend the useful life of the building or other 
improvement or significantly increase its value, even though, in the 
case of commercial space, this preparation includes adapting the 
property to the conduct of a different business, or
    (iii) The performing of repair or maintenance described in paragraph 
(e)(5)(i) of this section after property is

[[Page 72]]

acquired that was deferred by the defaulting party and that does not 
constitute renovation under paragraph (e)(2) of this section.
    (6) Independent contractor required. If any construction takes place 
on the foreclosure property more than 90 days after the day on which 
such property was acquired by the trust, such construction must be 
performed by an independent contractor (as defined in section 856(d)(3) 
and Sec.  1.856-4(b)(5)(iii)) from whom the trust does not derive or 
receive any income. Otherwise, the property will cease to be foreclosure 
property.
    (7) Failure to complete construction. Property will not cease to be 
foreclosure property solely because a trust which undertakes the 
completion of construction of a building or other improvement on the 
property that was more than 10 percent complete when default became 
imminent does not complete the construction. Thus, for example, if a 
trust continues construction of a building that was 20 percent complete 
when default became imminent, and the trust constructs an additional 40 
percent of the building and then sells the property, the property will 
not lose its status as foreclosure property solely because the trust 
fails to complete construction of the building.
    (f) Termination of 2-year grace period; use of foreclosure property 
in a trade or business--(1) In general. Under section 856(e)(4)(C), all 
real property (and any incidental personal property) for which a 
particular election has been made (see paragraph (c)(1) of this section) 
shall cease to be foreclosure property on the first day (occurring more 
than 90 days after the day on which the trust acquired the property) on 
which the property is used in a trade or business conducted by the 
trust, other than a trade or business conducted by the trust through an 
independent contractor from whom the trust itself does not derive or 
receive any income. (See section 856(d)(3) for the definition of 
independent contractor.)
    (2) Property held primarily for sale to customers. For the purposes 
of section 856(e)(4)(C), foreclosure property held by the trust 
primarily for sale to customers in the ordinary course of a trade or 
business is considered to be property used in a trade or business 
conducted by the trust. Thus, if a trust holds foreclosure property 
(whether real property or personal property incident to real property) 
for sale to customers in the ordinary course of a trade or business more 
than 90 days after the day on which the trust acquired the real 
property, the trade or business of selling the property must be 
conducted by the trust through an independent contractor from whom the 
trust does not derive or receive any income. Otherwise, after such 90th 
day the property will cease to be foreclosure property.
    (3) Change in use. Foreclosure property will not cease to be 
foreclosure property solely because the use of the property in a trade 
or business by the trust differs from the use to which the property was 
put by the person from whom it was acquired. Thus, for example, if a 
trust acquires a rental apartment building on foreclosure, the property 
will not cease to be foreclosure property solely because the trust 
converts the building to a condominium apartment building and, through 
an independent contractor from whom the trust derives no income, engages 
in the trade or business of selling the individual condominium units.
    (g) Extension of 2-year grace period--(1) In general. A real estate 
investment trust may apply to the district director of the internal 
revenue district in which is located the principal place of business (or 
principal office or agency) of the trust for an extension of the 2-year 
grace period. If the trust establishes to the satisfaction of the 
district director that an extension of the grace period is necessary for 
the orderly liquidation of the trust's interest in foreclosure property, 
or for an orderly renegotiation of a lease or leases of the property, 
the district director may extend the 2-year grace period. See section 
856(e)(3) (as in effect with respect to the particular extension) for 
rules relating to the maximum length of an extension, and the number of 
extensions which may be granted. An extension of the grace period may be 
granted by the district director either before or

[[Page 73]]

after the date on which the grace period, but for the extension, would 
expire. The extension shall be effective as of the date on which the 
grace period, but for the extension, would expire.
    (2) Showing required. Generally, in order to establish the necessity 
of an extension, the trust must demonstrate that it has made good faith 
efforts to renegotiate leases with respect to, or dispose of, the 
foreclosure property. In certain cases, however, the trust may establish 
the necessity of an extension even though it has not made such efforts. 
For example, if the trust demonstrates that, for valid business reasons, 
construction of the foreclosure property could not be completed before 
the expiration of the grace period, the necessity of the extension could 
be established even though the trust had made no effort to sell the 
property. For another example, if the trust demonstrates that due to a 
depressed real estate market, it could not sell the foreclosure property 
before the expiration of the grace period except at a distress price, 
the necessity of an extension could be established even though the trust 
had made no effort to sell the property. The fact that property was 
acquired as foreclosure property prior to January 3, 1975 (the date of 
enactment of section 856(e)), generally will be considered as a factor 
(but not a controlling factor) which tends to establish that an 
extension of the grace period is necessary.
    (3) Time for requesting an extension of the grace period. A request 
for an extension of the grace period must be filed with the appropriate 
district director more than 60 days before the day on which the grace 
period would otherwise expire. In the case of a grace period which would 
otherwise expire before August 6, 1976, a request for an extension will 
be considered to be timely filed if filed on or before June 7, 1976.
    (4) Information required. The request for an extension of the grace 
period shall identify the property with respect to which the request is 
being made and shall also include the following information:
    (i) The name, address, and taxpayer identification number of the 
trust,
    (ii) The date the property was acquired as foreclosure property by 
the trust,
    (iii) The taxable year of the trust in which the property was 
acquired,
    (iv) If the trust has been previously granted an extension of the 
grace period with respect to the property, a statement to that effect 
(which shall include the date on which the grace period, as extended, 
expires) and a copy of the information which accompanied the request for 
the previous extension,
    (v) A statement of the reasons why the grace period should be 
extended,
    (vi) A description of any efforts made by the trust after the 
acquisition of the property to dispose of the property or to renegotiate 
any lease with respect to the property, and
    (vii) A description of any other factors which tend to establish 
that an extension of the grace period is necessary for the orderly 
liquidation of the trust's interest in the property, or for an orderly 
renegotiation of a lease or leases of the property.


The trust shall also furnish any additional information requested by the 
district director after the request for extension is filed.
    (5) Automatic extension. If a real estate investment trust files a 
request for an extension with the district director more than 60 days 
before the expiration of the grace period, the grace period shall be 
considered to be extended until the end of the 30th day after the date 
on which the district director notifies the trust by certified mail sent 
to its last known address that the period of extension requested by the 
trust is not granted. For further guidance regarding the definition of 
last known address, see Sec.  301.6212-2 of this chapter. In no event, 
however, shall the rule in the preceding sentence extend the grace 
period beyond the expiration of (i) the period of extension requested by 
the trust, or (ii) the 1-year period following the date that the grace 
period (but for the automatic extension) would expire. The date of the 
postmark on the sender's receipt is considered to be the date of the 
certified mail for purposes of this subparagraph. This subparagraph does 
not apply, however,

[[Page 74]]

if the date of the notification by certified mail described in the first 
sentence is more than 30 days before the date that the grace period 
(determined without regard to this subparagraph) expires. Moreover, this 
subparagraph shall not operate to allow any period of extension that is 
prohibited by the last sentence of section 856(e)(3) (as in effect with 
respect to the particular extension).
    (6) Extension of time for filing. If a real estate investment trust 
fails to file the request for an extension of the grace period within 
the time provided in paragraph (g)(3) of this section, then the district 
director shall grant a reasonable extension of time for filing such 
request, provided (i) it is established to the satisfaction of the 
district director that there was reasonable cause for failure to file 
the request within the prescribed time and (ii) a request for such 
extension is filed within such time as the district director considers 
reasonable under the circumstances.
    (7) Status of taxpayer. The reference to ``real estate investment 
trust'' or ``trust'' in this paragraph (g) shall be considered to 
include a taxpayer that is not a qualified real estate investment trust, 
if the taxpayer establishes to the satisfaction of the district director 
that its failure to be a qualified real estate investment trust for the 
taxable year was due to reasonable cause and not due to willful neglect. 
The principles of Sec.  1.856-7(c) and Sec.  1.856-8(d) (including the 
principles relating to expert advice) shall apply for determining 
reasonable cause (and absence of willful neglect) for this purpose.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11269, Feb. 6, 1981; 46 FR 15263, Mar. 5, 1981, as 
amended by T.D. 8939, 66 FR 2819, Jan. 12, 2001]



Sec.  1.856-7  Certain corporations, etc., that are considered to meet 
the gross income requirements.

    (a) In general. A corporation, trust, or association which fails to 
meet the requirements of paragraph (2) or (3) of section 856(c), or of 
both such paragraphs, for any taxable year nevertheless is considered to 
have satisfied these requirements if the corporation, trust, or 
association meets the requirements of subparagraphs (A), (B), and (C) of 
section 856(c)(7) (relating to a schedule attached to the return, the 
absence of fraud, and reasonable cause).
    (b) Contents of the schedule. The schedule required by subparagraph 
(A) of section 856(c)(7) must contain a breakdown, or listing, of the 
total amount of gross income falling under each of the separate 
subparagraphs of section 856(c) (2) and (3). Thus, for example, the real 
estate investment trust, for purposes of listing its income from the 
sources described in section 856(c)(2), would list separately the total 
amount of dividends, the total amount of interest, the total amount of 
rents from real property, etc. The listing is not required to be on a 
lease-by-lease, loan-by-loan, or project-by-project basis, but the real 
estate investment trust must maintain adequate records on such a basis 
with which to substantiate each total amount listed in the schedule.
    (c) Reasonable cause--(1) In general. The failure to meet the 
requirements of paragraph (2) or (3) of section 856(c) (or of both 
paragraphs) will be considered due to reasonable cause and not due to 
willful neglect if the real estate investment trust exercised ordinary 
business care and prudence in attempting to satisfy the requirements. 
Such care and prudence must be exercised at the time each transaction is 
entered into by the trust. However, even if the trust exercised ordinary 
business care and prudence in entering into a transaction, if the trust 
later determines that the transaction results in the receipt or accrual 
of nonqualified income and that the amounts of such nonqualified income, 
in the context of the trust's overall portfolio, reasonably can be 
expected to cause a source-of-income requirement to be failed, the

[[Page 75]]

trust must use ordinary business care and prudence in an effort to 
renegotiate the terms of the transaction, dispose of property acquired 
or leased in the transaction, or alter other elements of its portfolio. 
In any case, failure to meet an income source requirement will be 
considered due to willful neglect and not due to reasonable cause if the 
failure is willful and the trust could have avoided such failure by 
taking actions not inconsistent with ordinary business care and 
prudence. For example, if the trust enters into a lease knowing that it 
will produce nonqualified income which reasonably can be expected to 
cause a source-of-income requirement to be failed, the failure is due to 
willful neglect even if the trust has a legitimate business purpose for 
entering into the lease.
    (2) Expert advice--(i) In general. The reasonable reliance on a 
reasoned, written opinion as to the characterization for purposes of 
section 856 of gross income to be derived (or being derived) from a 
transaction generally constitutes ``reasonable cause'' if income from 
that transaction causes the trust to fail to meet the requirements of 
paragraph (2) or (3) of section 856(c) (or of both paragraphs). The 
absence of such a reasoned, written opinion with respect to a 
transaction does not, by itself, give rise to any inference that the 
failure to meet a percentage of income requirement was without 
reasonable cause. An opinion as to the character of income from a 
transaction includes an opinion pertaining to the use of a standard form 
of transaction or standard operating procedure in a case where such 
standard form or procedure is in fact used or followed.
    (ii) If the opinion indicates that a portion of the income from a 
transaction will be nonqualifed income, the trust must still exercise 
ordinary business care and prudence with respect to the nonqualified 
income and determine that the amount of that income, in the context of 
its overall portfolio, reasonably cannot be expected to cause a source-
of-income requirement to be failed. Reliance on an opinion is not 
reasonable if the trust has reason to believe that the opinion is 
incorrect (for example, because the trust withholds facts from the 
person rendering the opinion).
    (iii) Reasoned written opinion. For purposes of this subparagraph 
(2), a written opinion means an opinion, in writing, rendered by a tax 
advisor (including house counsel) whose opinion would be relied on by a 
person exercising ordinary business care and prudence in the 
circumstances of the particular transaction. A written opinion is 
considered ``reasoned'' even if it reaches a conclusion which is 
subsequently determined to be incorrect, so long as the opinion is based 
on a full disclosure of the factual situation by the real estate 
investment trust and is addressed to the facts and law which the person 
rendering the opinion believes to be applicable. However, an opinion is 
not considered ``reasoned'' if it does nothing more than recite the 
facts and express a conclusion.
    (d) Application of section 856(c)(7) to taxable years beginning 
before October 5, 1976. Pursuant to section 1608(b) of the Tax Reform 
Act of 1976, paragraph (7) of section 856(c) and this section apply to a 
taxable year of a real estate investment trust which begins before 
October 5, 1976, only if as the result of a determination occurring 
after October 4, 1976, the trust does not meet the requirements of 
paragraph (2) or (3) of section 856(c), or both paragraphs, as in effect 
for the taxable year. The requirement that the schedule described in 
subparagraph (A) of section 856(c)(7) be attached to the income tax 
return of a real estate investment trust in order for section 856(c)(7) 
to apply is not applicable to taxable years beginning before October 5, 
1976. For purposes of section 1608(b) of the Tax Reform Act of 1976 and 
this paragraph, the rules relating to determinations prescribed in 
section 860(e) and Sec.  1.860-2(b)(1) (other than the second, third, 
and last sentences of Sec.  1.860-2(b)(1)(ii)) shall apply. However, a 
determination consisting of an agreement between the taxpayer and the 
district director (or other official to whom authority to sign the 
agreement is delegated) shall set forth the amount of gross income for 
the taxable year to which the determination applies, the amount of the 
90 percent and 75 percent source-of-income requirements for the taxable 
year to

[[Page 76]]

which the determination applies, and the amount by which the real estate 
investment trust failed to meet either or both of the requirements. The 
agreement shall also set forth the amount of tax for which the trust is 
liable pursuant to section 857(b)(5). The agreement shall also contain a 
finding as to whether the failure to meet the requirements of paragraph 
(2) or (3) of section 856(c) (or of both paragraphs) was due to 
reasonable cause and not due to willful neglect.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954); sec. 860(e) (92 Stat. 2849, 26 U.S.C. 
860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7767, 46 FR 11274, Feb. 6, 1981, as amended by T.D. 7936, 49 FR 
2106, Jan. 18, 1984]



Sec.  1.856-8  Revocation or termination of election.

    (a) Revocation of an election to be a real estate investment trust. 
A corporation, trust, or association that has made an election under 
section 856(c)(1) to be a real estate investment trust may revoke the 
election for any taxable year after the first taxable year for which the 
election is effective. The revocation must be made by filing a statement 
with the district director for the internal revenue district in which 
the taxpayer maintains its principal place of business or principal 
office or agency. The statement must be filed on or before the 90th day 
after the first day of the first taxable year for which the revocation 
is to be effective. The statement must be signed by an official 
authorized to sign the income tax return of the taxpayer and must--
    (1) Contain the name, address, and taxpayer identification number of 
the taxpayer,
    (2) Specify the taxable year for which the election was made, and
    (3) Include a statement that the taxpayer, pursuant to section 
856(g)(2), revokes its election under section 856(c)(1) to be a real 
estate investment trust.


The revocation may be made only with respect to a taxable year beginning 
after October 4, 1976, and is effective for the taxable year in which 
made and for all succeeding taxable years. A revocation with respect to 
a taxable year beginning after October 4, 1976, that is filed before 
February 6, 1981, in the time and manner prescribed in Sec.  7.856(g)-1 
of this chapter (as in effect when the revocation was filed) is 
considered to meet the requirements of this paragraph.
    (b) Termination of election to be a real estate investment trust. An 
election of a corporation, trust, or association under section 856(c)(1) 
to be a real estate investment trust shall terminate if the corporation, 
trust, or association is not a qualified real estate investment trust 
for any taxable year (including the taxable year with respect to which 
the election is made) beginning after October 4, 1976. (This election 
terminates whether the failure to be a qualified real estate investment 
trust is intentional or inadvertent.) The term ``taxable year'' includes 
a taxable year of less than 12 months for which a return is made under 
section 443. The termination of the election is effective for the first 
taxable year beginning after October 4, 1976, for which the corporation, 
trust, or association is not a qualified real estate investment trust 
and for all succeeding taxable years.
    (c) Restrictions on election after termination or revocation--(1) 
General rule. Except as provided in paragraph (d) of this section, if a 
corporation, trust, or association has made an election under section 
856(c)(1) to be a real estate investment trust and the election has been 
terminated or revoked under section 856(g)(1) or (2), the corporation, 
trust, or association (and any successor corporation, trust, or 
association) is not eligible to make a new election under section 
856(c)(1) for any taxable year prior to the fifth taxable year which 
begins after the first taxable year for which the termination or 
revocation is effective.
    (2) Successor corporation. The term ``successor corporation, trust, 
or association'', as used in section 856(g)(3),

[[Page 77]]

means a corporation, trust, or association which meets both a continuity 
of ownership requirement and a continuity of assets requirement with 
respect to the corporation, trust, or association whose election has 
been terminated under section 856(g)(1) or revoked under section 
856(g)(2). A corporation, trust, or association meets the continuity of 
ownership requirement only if at any time during the taxable year the 
persons who own, directly or indirectly, 50 percent or more in value of 
its outstanding shares owned, at any time during the first taxable year 
for which the termination or revocation was effective, 50 percent or 
more in value of the outstanding shares of the corporation, trust, or 
association whose election has been terminated or revoked. A 
corporation, trust, or association meets the continuity of assets 
requirement only if either (i) a substantial portion of its assets were 
assets of the corporation, trust, or association whose election has been 
revoked or terminated, or (ii) it acquires a substantial portion of the 
assets of the corporation, trust, or association whose election has been 
terminated or revoked.
    (3) Effective date. Section 856(g)(3) does not apply to the 
termination of an election that was made by a taxpayer pursuant to 
section 856(c)(1) on or before October 4, 1976, unless the taxpayer is a 
qualified real estate investment trust for a taxable year ending after 
October 4, 1976, for which the pre-October 5, 1976, election is in 
effect. For example, assume that Trust X, a calendar year taxpayer, 
files a timely election under section 856(c)(1) with respect to its 
taxable year 1974, and is a qualified real estate investment trust for 
calendar years 1974 and 1975. Assume further that Trust X is not a 
qualified real estate investment trust for 1976 and 1977 because it 
willfully fails to meet the asset diversification requirements of 
section 856(c)(5) for both years. The failure (whether or not willful) 
to meet these requirements in 1977 terminates the election to be a real 
estate investment trust made with respect to 1974. (See paragraph (b) of 
this section.) The termination is effective for 1977 and all succeeding 
taxable years. However, under section 1608(d)(3) of the Tax Reform Act 
of 1976, Trust X is not prohibited by section 856(g)(3) from making a 
new election under section 856(c)(1) with respect to 1978.
    (d) Exceptions. Section 856(g)(4) provides an exception to the 
general rule of section 856(g)(3) that the termination of an election to 
be a real estate investment trust disqualifies the corporation, trust, 
or association from making a new election for the 4 taxable years 
following the first taxable year for which the termination is effective. 
This exception applies where the corporation, trust, or association 
meets the requirements of section 856(g)(4)(A), (B) and (C) (relating to 
the timely filing of a return, the absence of fraud, and reasonable 
cause, respectively) for the taxable year with respect to which the 
termination of election occurs. In order to meet the requirements of 
section 856(g)(4)(C), the corporation, trust, or association must 
establish, to the satisfaction of the district director for the internal 
revenue district in which the corporation, trust, or association 
maintains its principal place of business or principal office or agency, 
that its failure to be a qualified real estate investment trust for the 
taxable year in question was due to reasonable cause and not due to 
willful neglect. The principles of Sec.  1.856-7(c) (including the 
principles relating to expert advice) will apply in determining whether, 
for purposes of section 856(g)(4), the failure of a corporation, trust, 
or association to be a qualified real estate investment trust for a 
taxable year was due to reasonable cause and not due to willful neglect. 
Thus, for example, the corporation, trust, or association must exercise 
ordinary business care and prudence in attempting to meet the status 
conditions of section 856(a) and the distribution and recordkeeping 
requirements of section 857(a), as well as the gross income requirements 
of section 856(c). The provisions of section 856(g)(4) do not apply to a 
taxable year in which the corporation, trust, or association makes a 
valid revocation,

[[Page 78]]

under section 856(g)(2), of an election to be a real estate investment 
trust.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11275, Feb. 6, 1981; 46 FR 15263, Mar. 5, 1981]



Sec.  1.856-9  Treatment of certain qualified REIT subsidiaries.

    (a) In general. A qualified REIT subsidiary, even though it is 
otherwise not treated as a corporation separate from the REIT, is 
treated as a separate corporation for purposes of:
    (1) Federal tax liabilities of the qualified REIT subsidiary with 
respect to any taxable period for which the qualified REIT subsidiary 
was treated as a separate corporation.
    (2) Federal tax liabilities of any other entity for which the 
qualified REIT subsidiary is liable.
    (3) Refunds or credits of Federal tax.
    (b) Examples. The following examples illustrate the application of 
paragraph (a) of this section:

    Example 1. X, a calendar year taxpayer, is a domestic corporation 
100 percent of the stock of which is acquired by Y, a real estate 
investment trust, in 2002. X was not a member of a consolidated group at 
any time during its taxable year ending in December 2001. Consequently, 
X is treated as a qualified REIT subsidiary under the provisions of 
section 856(i) for 2002 and later periods. In 2004, the Internal Revenue 
Service (IRS) seeks to extend the period of limitations on assessment 
for X's 2001 taxable year. Because X was treated as a separate 
corporation for its 2001 taxable year, X is the proper party to sign the 
consent to extend the period of limitations.
    Example 2. The facts are the same as in Example 1, except that upon 
Y's acquisition of X, Y and X jointly elect under section 856(l) to 
treat X as a taxable REIT subsidiary of Y. In 2003, Y and X jointly 
revoke that election. Consequently, X is treated as a qualified REIT 
subsidiary under the provisions of section 856(i) for 2003 and later 
periods. In 2004, the IRS determines that X miscalculated and 
underreported its income tax liability for 2001. Because X was treated 
as a separate corporation for its 2001 taxable year, the deficiency may 
be assessed against X and, in the event that X fails to pay the 
liability after notice and demand, a general tax lien will arise against 
all of X's property and rights to property.
    Example 3. X is a qualified REIT subsidiary of Y under the 
provisions of section 856(i). In 2001, Z, a domestic corporation that 
reports its taxes on a calendar year basis, merges into X in a state law 
merger. Z was not a member of a consolidated group at any time during 
its taxable year ending in December 2000. Under the applicable state 
law, X is the successor to Z and is liable for all of Z's debts. In 
2004, the IRS seeks to extend the period of limitations on assessment 
for Z's 2000 taxable year. Because X is the successor to Z and is liable 
for Z's 2000 taxes that remain unpaid, X is the proper party to sign the 
consent to extend the period of limitations.

    (c) Effective date. This section applies on or after April 1, 2004.

[T.D. 9183, 70 FR 9221, Feb. 25, 2005]



Sec.  1.856-10  Definition of real property.

    (a) In general. This section provides definitions for purposes of 
part II, subchapter M, chapter 1 of the Internal Revenue Code. Paragraph 
(b) of this section defines real property, which includes land as 
defined under paragraph (c) of this section and improvements to land as 
defined under paragraph (d) of this section. Improvements to land 
include inherently permanent structures as defined under paragraph 
(d)(2) of this section and structural components of inherently permanent 
structures as defined under paragraph (d)(3) of this section. Paragraph 
(e) of this section provides rules for determining whether an item is a 
distinct asset for purposes of applying the definitions in paragraphs 
(b), (c), and (d) of this section. Paragraph (f) of this section 
identifies intangible assets that are real property or interests in real 
property. Paragraph (g) of this section provides examples illustrating 
the rules of paragraphs (b) through (f) of this section. Paragraph (h) 
of this section provides the effective/applicability date for this 
section.
    (b) Real property. The term real property means land and 
improvements to

[[Page 79]]

land. Local law definitions are not controlling for purposes of 
determining the meaning of the term real property.
    (c) Land. Land includes water and air space superjacent to land and 
natural products and deposits that are unsevered from the land. Natural 
products and deposits, such as crops, water, ores, and minerals, cease 
to be real property when they are severed, extracted, or removed from 
the land. The storage of severed or extracted natural products or 
deposits, such as crops, water, ores, and minerals, in or upon real 
property does not cause the stored property to be recharacterized as 
real property.
    (d) Improvements to land--(1) In general. The term improvements to 
land means inherently permanent structures and their structural 
components.
    (2) Inherently permanent structure--(i) In general. The term 
inherently permanent structure means any permanently affixed building or 
other permanently affixed structure. Affixation may be to land or to 
another inherently permanent structure and may be by weight alone. If 
the affixation is reasonably expected to last indefinitely based on all 
the facts and circumstances, the affixation is considered permanent. A 
distinct asset that serves an active function, such as an item of 
machinery or equipment, is not a building or other inherently permanent 
structure.
    (ii) Building--(A) In general. A building encloses a space within 
its walls and is covered by a roof.
    (B) Types of buildings. Buildings include the following distinct 
assets if permanently affixed: Houses; apartments; hotels; motels; 
enclosed stadiums and arenas; enclosed shopping malls; factory and 
office buildings; warehouses; barns; enclosed garages; enclosed 
transportation stations and terminals; and stores.
    (iii) Other inherently permanent structures--(A) In general. Other 
inherently permanent structures serve a passive function, such as to 
contain, support, shelter, cover, protect, or provide a conduit or a 
route, and do not serve an active function, such as to manufacture, 
create, produce, convert, or transport.
    (B) Types of other inherently permanent structures. Other inherently 
permanent structures include the following distinct assets if 
permanently affixed: Microwave transmission, cell, broadcast, and 
electrical transmission towers; telephone poles; parking facilities; 
bridges; tunnels; roadbeds; railroad tracks; transmission lines; 
pipelines; fences; in-ground swimming pools; offshore drilling 
platforms; storage structures such as silos and oil and gas storage 
tanks; and stationary wharves and docks. Other inherently permanent 
structures also include outdoor advertising displays for which an 
election has been properly made under section 1033(g)(3).
    (iv) Facts and circumstances determination. If a distinct asset 
(within the meaning of paragraph (e) of this section) does not serve an 
active function as described in paragraph (d)(2)(iii)(A) of this section 
and is not otherwise listed in paragraph (d)(2)(ii)(B) or (d)(2)(iii)(B) 
of this section or in guidance published in the Internal Revenue 
Bulletin (see Sec.  601.601(d)(2)(ii) of this chapter), the 
determination of whether that asset is an inherently permanent structure 
is based on all the facts and circumstances. In particular, the 
following factors must be taken into account:
    (A) The manner in which the distinct asset is affixed to real 
property;
    (B) Whether the distinct asset is designed to be removed or to 
remain in place indefinitely;
    (C) The damage that removal of the distinct asset would cause to the 
item itself or to the real property to which it is affixed;
    (D) Any circumstances that suggest the expected period of affixation 
is not indefinite (for example, a lease that requires or permits removal 
of the distinct asset upon the expiration of the lease); and
    (E) The time and expense required to move the distinct asset.
    (3) Structural components--(i) In general. The term structural 
component means any distinct asset (within the meaning of paragraph (e) 
of this section) that is a constituent part of and integrated into an 
inherently permanent structure, serves the inherently permanent 
structure in its passive

[[Page 80]]

function, and, even if capable of producing income other than 
consideration for the use or occupancy of space, does not produce or 
contribute to the production of such income. If interconnected assets 
work together to serve an inherently permanent structure with a utility-
like function (for example, systems that provide a building with 
electricity, heat, or water), the assets are analyzed together as one 
distinct asset that may be a structural component. A structural 
component may qualify as real property only if the real estate 
investment trust (REIT) holds its interest in the structural component 
together with a real property interest in the space in the inherently 
permanent structure served by the structural component. A mortgage 
secured by a structural component is a real estate asset only if the 
mortgage is also secured by a real property interest in the inherently 
permanent structure served by the structural component. If a distinct 
asset is customized in connection with the rental of space in or on an 
inherently permanent structure to which the asset relates, the 
customization does not affect whether the distinct asset is a structural 
component.
    (ii) Types of structural components. Structural components include 
the following distinct assets and systems if integrated into the 
inherently permanent structure and held together with a real property 
interest in the space in the inherently permanent structure served by 
that distinct asset or system: Wiring; plumbing systems; central heating 
and air-conditioning systems; elevators or escalators; walls; floors; 
ceilings; permanent coverings of walls, floors, and ceilings; windows; 
doors; insulation; chimneys; fire suppression systems, such as sprinkler 
systems and fire alarms; fire escapes; central refrigeration systems; 
security systems; and humidity control systems.
    (iii) Facts and circumstances determination. If an interest in a 
distinct asset (within the meaning of paragraph (e) of this section) is 
held together with a real property interest in the space in the 
inherently permanent structure served by that distinct asset and that 
asset is not otherwise listed in paragraph (d)(3)(ii) of this section or 
in guidance published in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii) of this chapter), the determination of whether that 
asset is a structural component is based on all the facts and 
circumstances. In particular, the following factors must be taken into 
account:
    (A) The manner, time, and expense of installing and removing the 
distinct asset;
    (B) Whether the distinct asset is designed to be moved;
    (C) The damage that removal of the distinct asset would cause to the 
item itself or to the inherently permanent structure to which it is 
affixed;
    (D) Whether the distinct asset serves a utility-like function with 
respect to the inherently permanent structure;
    (E) Whether the distinct asset serves the inherently permanent 
structure in its passive function;
    (F) Whether the distinct asset produces income from consideration 
for the use or occupancy of space in or upon the inherently permanent 
structure;
    (G) Whether the distinct asset is installed during construction of 
the inherently permanent structure; and
    (H) Whether the distinct asset will remain if the tenant vacates the 
premises.
    (e) Distinct asset--(1) In general. A distinct asset is analyzed 
separately from any other assets to which the asset relates to determine 
if the asset is real property, whether as land, an inherently permanent 
structure, or a structural component of an inherently permanent 
structure.
    (2) Facts and circumstances. The determination of whether a 
particular separately identifiable item of property is a distinct asset 
is based on all the facts and circumstances. In particular, the 
following factors must be taken into account:
    (i) Whether the item is customarily sold or acquired as a single 
unit rather than as a component part of a larger asset;
    (ii) Whether the item can be separated from a larger asset, and if 
so, the cost of separating the item from the larger asset;
    (iii) Whether the item is commonly viewed as serving a useful 
function

[[Page 81]]

independent of a larger asset of which it is a part; and
    (iv) Whether separating the item from a larger asset of which it is 
a part impairs the functionality of the larger asset.
    (f) Intangible assets--(1) In general. To the extent that an 
intangible asset, including an intangible asset established under 
generally accepted accounting principles (GAAP) as a result of an 
acquisition of real property or an interest in real property, derives 
its value from real property or an interest in real property, is 
inseparable from that real property or interest in real property, and 
does not produce or contribute to the production of income other than 
consideration for the use or occupancy of space, the intangible asset is 
real property or an interest in real property.
    (2) Licenses and permits. A license, permit, or other similar right 
that is solely for the use, enjoyment, or occupation of land or an 
inherently permanent structure and that is in the nature of a leasehold 
or easement generally is an interest in real property. A license or 
permit to engage in or operate a business is not real property or an 
interest in real property if the license or permit produces or 
contributes to the production of income other than consideration for the 
use or occupancy of space.
    (g) Examples. The following examples demonstrate the rules of this 
section. Examples 1 and 2 illustrate the definition of land as provided 
in paragraph (c) of this section. Examples 3 through 10 illustrate the 
definition of improvements to land as provided in paragraph (d) of this 
section. Finally, Examples 11 through 13 illustrate whether certain 
intangible assets are real property or interests in real property as 
provided in paragraph (f) of this section.

    Example 1. Natural products of land. A is a REIT. REIT A owns land 
with perennial fruit-bearing plants. REIT A leases the fruit-bearing 
plants to a tenant and grants the tenant an easement to enter the land 
to cultivate the plants and to harvest the fruit. The lease and easement 
are long-term and REIT A provides no services to the tenant. The 
unsevered plants are natural products of the land and are land within 
the meaning of paragraph (c) of this section. The tenant annually 
harvests fruit from the plants. Upon severance from the land, the 
harvested fruit ceases to qualify as land. Storage of the harvested 
fruit upon or within real property does not cause the harvested fruit to 
be real property.
    Example 2. Water space superjacent to land. REIT B leases a marina 
from a governmental entity. The marina is comprised of U-shaped boat 
slips and end ties. The U-shaped boat slips are spaces on the water that 
are surrounded by a dock on three sides. The end ties are spaces on the 
water at the end of a slip or on a long, straight dock. REIT B rents the 
boat slips and end ties to boat owners. The boat slips and end ties are 
water space superjacent to land that is land within the meaning of 
paragraph (c) of this section and, therefore, are real property.
    Example 3. Indoor sculpture. (i) REIT C owns an office building and 
a large sculpture in the atrium of the building. The sculpture measures 
30 feet tall by 18 feet wide and weighs five tons. The building was 
specifically designed to support the sculpture, which is permanently 
affixed to the building by supports embedded in the building's 
foundation. The sculpture was constructed within the building. Removal 
would be costly and time consuming and would destroy the sculpture. The 
sculpture is reasonably expected to remain in the building indefinitely. 
The sculpture does not manufacture, create, produce, convert, transport, 
or serve any similar active function.
    (ii) The sculpture is not an asset listed in paragraph 
(d)(2)(iii)(B) of this section, and, therefore, the sculpture is an 
asset that must be analyzed to determine whether it is an inherently 
permanent structure using the factors provided in paragraph (d)(2)(iv) 
of this section. The sculpture--
    (A) Is permanently affixed to the building by supports embedded in 
the building's foundation;
    (B) Is not designed to be removed and is designed to remain in place 
indefinitely;
    (C) Would be damaged if removed and would damage the building to 
which it is affixed;
    (D) Will remain affixed to the building after any tenant vacates the 
premises and will remain affixed to the building indefinitely; and
    (E) Would require significant time and expense to move.
    (iii) The factors described in this paragraph (g) Example 3 (ii)(A) 
through (E) all support the conclusion that the sculpture is an 
inherently permanent structure within the meaning of paragraph (d)(2) of 
this section and, therefore, is real property.
    Example 4. Bus shelters. (i) REIT D owns 400 bus shelters, each of 
which consists of four posts, a roof, and panels enclosing two or three 
sides. REIT D enters into a long-term lease with a local transit 
authority for use of

[[Page 82]]

the bus shelters. Each bus shelter is prefabricated from steel and is 
bolted to the sidewalk. Bus shelters are disassembled and moved when bus 
routes change. Moving a bus shelter takes less than a day and does not 
significantly damage either the bus shelter or the real property to 
which it was affixed.
    (ii) The bus shelters are not permanently affixed enclosed 
transportation stations or terminals and do not otherwise meet the 
definition of a building in paragraph (d)(2)(ii) of this section nor are 
they listed as types of other inherently permanent structures in 
paragraph (d)(2)(iii)(B) of this section. Therefore, the bus shelters 
must be analyzed to determine whether they are inherently permanent 
structures using the factors provided in paragraph (d)(2)(iv) of this 
section. The bus shelters--
    (A) Are not permanently affixed to the land or an inherently 
permanent structure;
    (B) Are designed to be removed and are not designed to remain in 
place indefinitely;
    (C) Would not be damaged if removed and would not damage the 
sidewalks to which they are affixed;
    (D) Will not remain affixed after the local transit authority 
vacates the site and will not remain affixed indefinitely; and
    (E) Would not require significant time and expense to move.
    (iii) The factors described in this paragraph (g) Example 4 (ii)(A) 
through (E) all support the conclusion that the bus shelters are not 
inherently permanent structures within the meaning of paragraph (d)(2) 
of this section. Although the bus shelters serve a passive function of 
sheltering, the bus shelters are not permanently affixed, which means 
the bus shelters are not inherently permanent structures within the 
meaning of paragraph (d)(2) of this section and, therefore, are not real 
property.
    Example 5. Cold storage warehouse. (i) REIT E owns a refrigerated 
warehouse (Cold Storage Warehouse). REIT E enters into a long-term lease 
with a tenant. REIT E neither operates the Cold Storage Warehouse nor 
provides services to its tenant. The tenant uses the Cold Storage 
Warehouse to store perishable products. Certain components and utility 
systems that are integrated into the Cold Storage Warehouse have been 
customized to accommodate the tenant's need for refrigerated storage 
space. For example, the Cold Storage Warehouse has customized freezer 
walls and a central refrigeration system. Freezer walls within the Cold 
Storage Warehouse are specifically designed to maintain the desired 
temperature within the Cold Storage Warehouse. The freezer walls and 
central refrigeration system comprise a series of interconnected assets 
that work together to serve a utility-like function within the Cold 
Storage Warehouse, were installed during construction of the building, 
and will remain in place when the tenant vacates the premises. The 
freezer walls and central refrigeration system were designed to remain 
permanently in place.
    (ii) Walls and central refrigeration systems are listed as 
structural components in paragraph (d)(3)(ii) of this section and, 
therefore, are real property. The customization of the freezer walls 
does not affect their qualification as structural components of REIT E's 
Cold Storage Warehouse within the meaning of paragraph (d)(3) of this 
section. Therefore, the freezer walls and central refrigeration system 
are structural components of REIT E's Cold Storage Warehouse.
    Example 6. Data center. (i) REIT F owns a building that it leases to 
a tenant under a long-term lease. REIT F neither operates the building 
nor provides services to its tenant. To accommodate the particular 
requirements for housing computer servers, certain interior components 
and utility systems within the building have been customized to provide 
a higher level of functionality than a conventional office building. 
These customized systems are owned by REIT F and include an electrical 
distribution and redundancy system (Electrical System), a central 
heating and air-conditioning system, a telecommunication infrastructure 
system, an integrated security system, a fire suppression system, and a 
humidity control system (each, a System). In addition, the space for 
computer servers in REIT F's building has been constructed with raised 
flooring that is integrated into the building to accommodate the 
Systems. Each System is comprised of a series of interconnected assets 
that work together to serve a utility-like function within the building. 
The Systems are integrated into the office building, were installed 
during construction of the building, and will remain in place when the 
tenant vacates the premises. Each of the Systems was customized to 
enhance the capacity of the System in connection with the rental of 
space within the building.
    (ii) The central heating and air-conditioning system, integrated 
security system, fire suppression system, and humidity control system 
are listed as structural components in paragraph (d)(3)(ii) of this 
section and, therefore, are real property. The customization of these 
Systems does not affect the qualification of these Systems as structural 
components of REIT F's building within the meaning of paragraph (d)(3) 
of this section. Therefore, these Systems are structural components of 
REIT F's building.
    (iii) In addition to wiring and flooring, which are listed as 
structural components in paragraph (d)(3)(ii) of this section and, 
therefore, are real property, the Electrical System and 
telecommunication infrastructure system include equipment used to ensure 
that the tenant is provided with uninterruptable,

[[Page 83]]

stable power and telecommunication services. The Electrical System and 
telecommunication infrastructure system are not listed in paragraph 
(d)(3)(ii) of this section, and, therefore, they must be analyzed to 
determine whether they are structural components of the building using 
the factors provided in paragraph (d)(3)(iii) of this section. The 
Electrical System and telecommunication infrastructure system--
    (A) Are embedded within the walls and floors of the building and 
would be costly to remove;
    (B) Are not designed to be moved and are designed specifically for 
the particular building of which they are a part;
    (C) Would not be significantly damaged upon removal and, although 
removing them would damage the walls and floors in which they are 
embedded, their removal would not significantly damage the building;
    (D) Serve a utility-like function with respect to the building;
    (E) Serve the building in its passive functions of containing, 
sheltering, and protecting computer servers;
    (F) Produce income as consideration for the use or occupancy of 
space within the building;
    (G) Were installed during construction of the building; and
    (H) Will remain in place when the tenant vacates the premises.
    (iv) The factors described in this paragraph (g) Example 6 (iii)(A), 
(B), and (D) through (H) all support the conclusion that the Electrical 
System and telecommunication infrastructure system are structural 
components of REIT F's building within the meaning of paragraph (d)(3) 
of this section and, therefore, are real property. The factor described 
in this paragraph (g) Example 6 (iii)(C) would support a conclusion that 
the Electrical System and telecommunication infrastructure system are 
not structural components. However this factor does not outweigh the 
factors supporting the conclusion that the Electric System and 
telecommunication infrastructure system are structural components.
    Example 7. Partitions. (i) REIT G owns an office building that it 
leases to tenants under long-term leases. REIT G neither operates the 
office building nor provides services to its tenants. Partitions are 
owned by REIT G and are used to delineate space between tenants and 
within each tenant's space. The office building has two types of 
interior, non-load-bearing drywall partition systems: a conventional 
drywall partition system (Conventional Partition System) and a modular 
drywall partition system (Modular Partition System). Neither the 
Conventional Partition System nor the Modular Partition System was 
installed during construction of the office building. Conventional 
Partition Systems are comprised of fully integrated gypsum board 
partitions, studs, joint tape, and covering joint compound. Modular 
Partition Systems are comprised of assembled panels, studs, tracks, and 
exposed joints. Both the Conventional Partition System and the Modular 
Partition System reach from the floor to the ceiling.
    (ii) Depending on the needs of a new tenant, the Conventional 
Partition System may remain in place when a tenant vacates the premises. 
The Conventional Partition System is integrated into the office building 
and is designed and constructed to remain in areas not subject to 
reconfiguration or expansion. The Conventional Partition System can be 
removed only by demolition, and, once removed, neither the Conventional 
Partition System nor its components can be reused. Removal of the 
Conventional Partition System causes substantial damage to the 
Conventional Partition System itself but does not cause substantial 
damage to the building.
    (iii) Modular Partition Systems are typically removed when a tenant 
vacates the premises. Modular Partition Systems are not designed or 
constructed to remain permanently in place. Modular Partition Systems 
are designed and constructed to be movable. Each Modular Partition 
System can be readily removed, remains in substantially the same 
condition as before, and can be reused. Removal of a Modular Partition 
System does not cause any substantial damage to the Modular Partition 
System itself or to the building. The Modular Partition System may be 
moved to accommodate the reconfigurations of the interior space within 
the office building for various tenants that occupy the building.
    (iv) The Conventional Partition System is comprised of walls that 
are integrated into an inherently permanent structure, and thus are 
listed as structural components in paragraph (d)(3)(ii) of this section. 
The Conventional Partition System, therefore, is real property.
    (v) The Modular Partition System is not integrated into the building 
and, therefore, is not listed in paragraph (d)(3)(ii) of this section. 
Thus, the Modular Partition System must be analyzed to determine whether 
it is a structural component using the factors provided in paragraph 
(d)(3)(iii) of this section. The Modular Partition System--
    (A) Is installed and removed quickly and with little expense;
    (B) Is designed to be moved and is not designed specifically for the 
particular building of which it is a part;
    (C) Is not damaged, and the building is not damaged, upon its 
removal;
    (D) Does not serve a utility-like function with respect to the 
building;
    (E) Serves the building in its passive functions of containing and 
protecting the tenants' assets;

[[Page 84]]

    (F) Produces income only as consideration for the use or occupancy 
of space within the building;
    (G) Was not installed during construction of the building; and
    (H) Will not remain in place when a tenant vacates the premises.
    (vi) The factors described in this paragraph (g) Example 7 (v)(A) 
through (D), (G) and (H) all support the conclusion that the Modular 
Partition System is not a structural component of REIT G's building 
within the meaning of paragraph (d)(3) of this section and, therefore, 
is not real property. The factors described in this paragraph (g) 
Example 7 (v)(E) and (F) would support a conclusion that the Modular 
Partition System is a structural component. These factors, however, do 
not outweigh the factors supporting the conclusion that the Modular 
Partition System is not a structural component.
    Example 8. Solar energy site. (i) REIT H owns a solar energy site, 
among the components of which are land, photovoltaic modules (PV 
Modules), mounts and an exit wire. REIT H enters into a long-term lease 
with a tenant for the solar energy site. REIT H neither operates the 
solar energy site nor provides services to its tenant. The mounts 
support the PV Modules. The racks are affixed to the land through 
foundations made from poured concrete. The mounts will remain in place 
when the tenant vacates the solar energy site. The PV Modules convert 
solar photons into electric energy (electricity). The exit wire is 
buried underground, is connected to equipment that is in turn connected 
to the PV Modules, and transmits the electricity produced by the PV 
Modules to an electrical power grid, through which the electricity is 
distributed for sale to third parties.
    (ii) REIT H's PV Modules, mounts, and exit wire are each separately 
identifiable items. Separation from a mount does not affect the ability 
of a PV Module to convert photons to electricity. Separation from the 
equipment to which it is attached does not affect the ability of the 
exit wire to transmit electricity to the electrical power grid. The 
types of PV Modules and exit wire that REIT H owns are each customarily 
sold or acquired as single units. Removal of the PV Modules from the 
mounts that support them does not damage the function of the mounts as 
support structures and removal is not costly. The PV Modules serve the 
active function of converting photons to electricity. Disconnecting the 
exit wire from the equipment to which it is attached does not damage the 
function of that equipment, and the disconnection is not costly. The PV 
Modules, mounts, and exit wire are each distinct assets within the 
meaning of paragraph (e) of this section.
    (iii) The land is real property as defined in paragraph (c) of this 
section.
    (iv) The mounts are designed and constructed to remain in place 
indefinitely, and they have a passive function of supporting the PV 
Modules. The mounts are not listed in paragraph (d)(2)(iii)(B) of this 
section, and, therefore, the mounts are assets that must be analyzed to 
determine whether they are inherently permanent structures using the 
factors provided in paragraph (d)(2)(iv) of this section. The mounts--
    (A) Are permanently affixed to the land through the concrete 
foundations or molded concrete anchors (which are part of the mounts);
    (B) Are not designed to be removed and are designed to remain in 
place indefinitely;
    (C) Would be damaged if removed;
    (D) Will remain affixed to the land after the tenant vacates the 
premises and will remain affixed to the land indefinitely; and
    (E) Would require significant time and expense to move.
    (v) The factors described in this paragraph (g) Example 8 (iv)(A) 
through (E) all support the conclusion that the mounts are inherently 
permanent structures within the meaning of paragraph (d)(2) of this 
section and, therefore, are real property.
    (vi) The PV Modules convert solar photons into electricity that is 
transmitted through an electrical power grid for sale to third parties. 
The conversion is an active function. Thus, the PV Modules are items of 
machinery or equipment and therefore are not inherently permanent 
structures within the meaning of paragraph (d)(2) of this section and, 
so, are not real property. The PV Modules do not serve the mounts in 
their passive function of providing support; instead, the PV Modules 
produce electricity for sale to third parties, which is income other 
than consideration for the use or occupancy of space. Thus, the PV 
Modules are not structural components of REIT H's mounts within the 
meaning of paragraph (d)(3) of this section and, therefore, are not real 
property.
    (vii) The exit wire is buried under the ground and transmits the 
electricity produced by the PV Modules to the electrical power grid. The 
exit wire was installed during construction of the solar energy site and 
is designed to remain permanently in place. The exit wire is permanently 
affixed and is a transmission line, which is listed as an inherently 
permanent structure in paragraph (d)(2)(iii)(B) of this section. 
Therefore, the exit wire is real property.
    Example 9. Solar-powered building. (i) REIT I owns a solar energy 
site similar to that described in Example 8, except that REIT I's solar 
energy site assets (Solar Energy Site Assets) are mounted on land 
adjacent to an office building owned by REIT I. REIT I leases the office 
building and the solar energy site to a single tenant. REIT I does not 
operate the office building or the solar energy site and does not 
provide services to its

[[Page 85]]

tenant. Although the tenant occasionally transfers excess electricity 
produced by the Solar Energy Site Assets to a utility company, the Solar 
Energy Site Assets are designed and intended to produce electricity only 
to serve the office building. The size and specifications of the Solar 
Energy Site Assets were designed to be appropriate to serve only the 
electricity needs of the office building. Although the Solar Energy Site 
Assets were not installed during construction of the office building, no 
facts indicate either that the Solar Energy Site Assets will not remain 
in place indefinitely or that they may be removed if the tenant vacates 
the premises.
    (ii) With the exception of the occasional transfers of excess 
electricity to a utility company, the Solar Energy Site Assets serve the 
office building to which they are adjacent, and, therefore, the Solar 
Energy Site Assets are analyzed to determine whether they are a 
structural component using the factors provided in paragraph (d)(3)(iii) 
of this section. The Solar Energy Site Assets--
    (A) Are expensive and time consuming to install and remove;
    (B) Were designed with the size and specifications needed to serve 
only the office building;
    (C) Will be damaged, but will not cause damage to the office 
building, upon removal;
    (D) Serve a utility-like function with respect to the office 
building;
    (E) Serve the office building in its passive functions of 
containing, sheltering, and protecting the tenant and the tenant's 
assets;
    (F) Produce income from consideration for the use or occupancy of 
space within the office building;
    (G) Were not installed during construction of the office building; 
and
    (H) Will remain in place when the tenant vacates the premises.
    (iii) The factors described in this paragraph (g) Example 9 (ii)(A) 
through (C) (in part), (ii)(D) through (F), and (ii)(H) all support the 
conclusion that the Solar Energy Site Assets are a structural component 
of REIT I's office building within the meaning of paragraph (d)(3) of 
this section and, therefore, are real property. The factors described in 
this paragraph (g) Example 9 (ii)(C) (in part) and (ii)(G) would support 
a conclusion that the Solar Energy Site Assets are not a structural 
component, but these factors do not outweigh the factors supporting the 
conclusion that the Solar Energy Site Assets are a structural component.
    (iv) The result in this Example 9 would not change if, instead of 
the Solar Energy Site Assets, solar shingles were used as the roof of 
REIT I's office building. Solar shingles are roofing shingles like those 
commonly used for residential housing, except that they contain built-in 
PV modules. The solar shingle installation was specifically designed and 
constructed to serve only the needs of REIT I's office building, and the 
solar shingles were installed as a structural component to provide solar 
energy to REIT I's office building (although REIT I's tenant 
occasionally transfers excess electricity produced by the solar shingles 
to a utility company). The analysis of the application of the factors 
provided in paragraph (d)(3)(ii) of this section would be similar to the 
analysis of the application of the factors to the Solar Energy Site 
Assets in this paragraph (g) Example 9 (ii) and (iii).
    Example 10. Pipeline transmission system. (i) REIT J owns a natural 
gas pipeline transmission system that provides a conduit to transport 
natural gas from unrelated third-party producers and gathering 
facilities to unrelated third-party distributors and end users. REIT J 
enters into a long-term lease with a tenant for the pipeline 
transmission system. REIT J neither operates the pipeline transmission 
system nor provides services to its tenant. The pipeline transmission 
system is comprised of underground pipelines, isolation valves and 
vents, pressure control and relief valves, meters, and compressors. 
Although the pipeline transmission system as a whole serves an active 
function (transporting natural gas), one or more distinct assets within 
the system may nevertheless be inherently permanent structures that do 
not themselves perform active functions. Each of these distinct assets 
was installed during construction of the pipeline transmission system 
and will remain in place when the tenant vacates the pipeline 
transmission system. Each of these assets was designed to remain 
permanently in place.
    (ii) The pipelines are permanently affixed and are listed as other 
inherently permanent structures in paragraph (d)(2)(iii)(B) of this 
section. Therefore, the pipelines are real property.
    (iii) Isolation valves and vents are placed at regular intervals 
along the pipelines to isolate and evacuate sections of the pipelines in 
case there is need for a shut-down or maintenance of the pipelines. 
Pressure control and relief valves are installed at regular intervals 
along the pipelines to provide overpressure protection. The isolation 
valves and vents and pressure control and relief valves are not listed 
in paragraph (d)(3)(ii) and, therefore, must be analyzed to determine 
whether they are structural components using the factors provided in 
paragraph (d)(3)(iii) of this section. The isolation valves and vents 
and pressure control and relief valves--
    (A) Are time consuming and expensive to install and remove from the 
pipelines;
    (B) Are designed specifically for the particular pipelines for which 
they are a part;
    (C) Will sustain damage and will damage the pipelines if removed;

[[Page 86]]

    (D) Do not serve a utility-like function with respect to the 
pipelines;
    (E) Serve the pipelines in their passive function of providing a 
conduit for natural gas;
    (F) Produce income only from consideration for the use or occupancy 
of space within the pipelines;
    (G) Were installed during construction of the pipelines; and
    (H) Will remain in place when the tenant vacates the premises.
    (iv) The factors described in this paragraph (g) Example 10 (iii)(A) 
through (C) and (iii)(E) through (H) support the conclusion that the 
isolation valves and vents and pressure control and relief valves are 
structural components of REIT J's pipelines within the meaning of 
paragraph (d)(3) of this section and, therefore, are real property. The 
factor described in this paragraph (g) Example 10 (iii)(D) would support 
a conclusion that the isolation valves and vents and pressure control 
and relief valves are not structural components, but this factor does 
not outweigh the factors that support the conclusion that the isolation 
valves and vents and pressure control and relief valves are structural 
components.
    (v) Meters are used to measure the natural gas passing into or out 
of the pipeline transmission system for purposes of determining the end 
users' consumption. Over long distances, pressure is lost due to 
friction in the pipeline transmission system. Compressors are required 
to add pressure to transport natural gas through the entirety of the 
pipeline transmission system. The meters and compressors do not serve 
the pipelines in their passive function of providing a conduit for the 
natural gas, and are used in connection with the production of income 
from the sale and transportation of natural gas, rather than as 
consideration for the use or occupancy of space within the pipelines. 
The meters and compressors are not structural components within the 
meaning of paragraph (d)(3) of this section and, therefore, are not real 
property.
    Example 11. Above-market lease. REIT K acquires an office building 
from an unrelated third party subject to a long-term lease with a single 
tenant under which the tenant pays above-market rents. The above-market 
lease is an intangible asset under GAAP. Seventy percent of the value of 
the above-market lease asset is attributable to income from the long-
term lease that qualifies as rents from real property, as defined in 
section 856(d)(1). The remaining thirty percent of the value of the 
above-market lease asset is attributable to income from the long-term 
lease that does not qualify as rents from real property. The portion of 
the value of the above-market lease asset that is attributable to rents 
from real property (here, seventy percent) derives its value from real 
property, is inseparable from that real property, does not produce or 
contribute to the production of income other than consideration for the 
use or occupancy of space, and, therefore, is an interest in real 
property under section 856(c)(5)(C) and a real estate asset under 
section 856(c)(5)(B). The remaining portion of the above-market lease 
asset does not derive its value from real property and, therefore, is 
not a real estate asset.
    Example 12. Land use permit. REIT L receives a special use permit 
from the government to place a cell tower on Federal Government land 
that abuts a federal highway. Government regulations provide that the 
permit is not a lease of the land, but is a permit to use the land for a 
cell tower. Under the permit, the government reserves the right to 
cancel the permit and compensate REIT L if the site is needed for a 
higher public purpose. REIT L leases space on the tower to various cell 
service providers. Each cell service provider installs its equipment on 
a designated space on REIT L's cell tower. The permit does not produce, 
or contribute to the production of, any income other than REIT L's 
receipt of payments from the cell service providers in consideration for 
their being allowed to use space on the tower. The permit is in the 
nature of a leasehold that allows REIT L to place a cell tower in a 
specific location on government land. Therefore, the permit is an 
interest in real property.
    Example 13. License to operate a business. REIT M owns a building 
and receives a license from State to operate a casino in the building. 
The license applies only to REIT M's building and cannot be transferred 
to another location. REIT M's building is an inherently permanent 
structure under paragraph (d)(2)(i) of this section and, therefore, is 
real property. However, REIT M's license to operate a casino is not a 
right for the use, enjoyment, or occupation of REIT M's building but is 
rather a license to engage in the business of operating a casino in the 
building. Therefore, the casino license is not real property.

    (h) Effective/applicability date. The rules of this section apply 
for taxable years beginning after August 31, 2016. For purposes of 
applying the first sentence of the flush language of section 856(c)(4) 
to a quarter in a taxable year that begins after August 31, 2016, the 
rules of this section apply in determining whether the taxpayer met the 
requirements of section 856(c)(4) at the close of prior quarters. 
Taxpayers may rely on this section for quarters that end before the 
applicability date.

[T.D. 9784, 81 FR 59860, Aug. 31, 2016, as amended by 81 FR 68934, Oct. 
5, 2016]

[[Page 87]]



Sec.  1.857-1  Taxation of real estate investment trusts.

    (a) Requirements applicable thereto. Section 857(a) denies the 
application of the provisions of part II, subchapter M, chapter 1 of the 
Code (other than sections 856(g), relating to the revocation or 
termination of an election, and 857(d), relating to earnings and 
profits) to a real estate investment trust for a taxable year unless--
    (1) The deduction for dividends paid for the taxable year as defined 
in section 561 (computed without regard to capital gain dividends) 
equals or exceeds the amount specified in section 857(a)(1), as in 
effect for the taxable year; and
    (2) The trust complies for such taxable year with the provisions of 
Sec.  1.857-8 (relating to records required to be maintained by a real 
estate investment trust).


See section 858 and Sec.  1.858-1, relating to dividends paid after the 
close of the taxable year.
    (b) Failure to qualify. If a real estate investment trust does not 
meet the requirements of section 857(a) and paragraph (a) of this 
section for the taxable year, it will, even though it may otherwise be 
classified as a real estate investment trust, be taxed in such year as 
an ordinary corporation and not as a real estate investment trust. In 
such case, none of the provisions of part II of subchapter M (other than 
sections 856(g) and 857(d)) will be applicable to it. For the rules 
relating to the applicability of sections 856(g) and 857(d), see Sec.  
1.857-7.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4087, Apr. 28, 1962, as amended by T.D. 7767, 46 FR 
11277, Feb. 6, 1981]



Sec.  1.857-2  Real estate investment trust taxable income 
and net capital gain.

    (a) Real estate investment trust taxable income. Section 857(b)(1) 
imposes a nominal tax and surtax, computed at the rates and in the 
manner prescribed in section 11, on the ``real estate investment trust 
taxable income'', as defined in section 857(b)(2). Section 857(b)(2) 
requires certain adjustments to be made to convert taxable income of the 
real estate investment trust to ``real estate investment trust taxable 
income''. The adjustments are as follows:
    (1) Net capital gain. In the case of taxable years ending before 
October 5, 1976, the net capital gain, if any, is excluded.
    (2) Special deductions disallowed. The special deductions provided 
in part VIII, subchapter B, chapter 1 of the Code (except the deduction 
under section 248) are not allowed.
    (3) Deduction for dividends paid--(i) General rule. The deduction 
for dividends paid (as defined in section 561) is allowed. In the case 
of taxable years ending before October 5, 1976, the deduction for 
dividends paid is computed without regard to capital gains dividends.
    (ii) Deduction for dividends paid if there is net income from 
foreclosure property. If for any taxable year the trust has net income 
from foreclosure property (as defined in section 857(b)(4)(B) and Sec.  
1.857-3), the deduction for dividends paid is an amount equal to the 
amount which bears the same proportion to the total dividends paid or 
considered as paid during the taxable year that otherwise meet the 
requirements for the deduction for dividends paid (as defined in section 
561) as the real estate investment trust taxable income (determined 
without regard to the deduction for dividends paid) bears to the sum 
of--
    (A) The real estate investment trust taxable income (determined 
without regard to the deduction for dividends paid), and
    (B) The amount by which the net income from foreclosure property 
exceeds the tax imposed on such income by section 857(b)(4)(A).


[[Page 88]]



For purposes of the preceding sentence, the term ``total dividends paid 
or considered as paid during the taxable year'' includes deficiency 
dividends paid with respect to the taxable year that are not otherwise 
excluded under this subdivision or section 857(b)(3)(A). The term, 
however, does not include either deficiency dividends paid during the 
taxable year with respect to a preceding taxable year ending before 
October 5, 1976, capital gains dividends.
    (iii) Deduction for dividends paid for purposes of the alternative 
tax. The rules in section 857(b)(3)(A) apply in determining the amount 
of the deduction for dividends paid that is taken into account in 
computing the alternative tax. Thus, for example, if a real estate 
investment trust has net income from foreclosure property for a taxable 
year ending after October 4, 1976, then for purposes of determining the 
partial tax described in section 857(b)(3)(A)(i), the amount of the 
deduction for dividends paid is computed pursuant to paragraph 
(a)(3)(ii) of this section, except that capital gains dividends are 
excluded from the dividends paid or considered as paid during the 
taxable year, and the net capital gain is excluded in computing real 
estate investment trust taxable income.
    (4) Section 443(b) disregarded. The taxable income is computed 
without regard to section 443(b). Thus, the taxable income for a period 
of less than 12 months is not placed on an annual basis even though the 
short taxable year results from a change of accounting period.
    (5) Net operating loss deduction. In the case of a taxable year 
ending before October 5, 1976, the net operating loss deduction provided 
in section 172 is not allowed.
    (6) Net income from foreclosure property. An amount equal to the net 
income from foreclosure property (as defined in section 857(b)(4)(B) and 
paragraph (a) of Sec.  1.857-3), if any, is excluded.
    (7) Tax imposed by section 857(b)(5). An amount equal to the tax (if 
any) imposed on the trust by section 857(b)(5) for the taxble year is 
excluded.
    (8) Net income or loss from prohibited transactions. An amount equal 
to the amount of any net income derived from prohibited transactions (as 
defined in section 857(b)(6)(B)(i)) is excluded. On the other hand, an 
amount equal to amount of any net loss derived from prohibited 
transactions (as defined in section 857(b)(6)(B)(ii)) is included. 
Because the amount of the net loss derived from prohibited transactions 
is taken into account in computing taxable income before the adjustments 
required by section 857(b)(2) and this section are made, the effect of 
including an amount equal to the amount of the loss is to disallow a 
deduction for the loss.
    (b) Net capital gain in taxable years ending October 5, 1976. The 
rules relating to the taxation of capital gains in 26 CFR 1.857-2(b) 
(revised as of April 1, 1977) apply to taxable years ending before 
October 5, 1976.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11277, Feb. 6, 1981]



Sec.  1.857-3  Net income from foreclosure property.

    (a) In general. For purposes of section 857(b)(40(B), net income 
from foreclosure property means the aggregate of--
    (1) All gains and losses from sales or other dispositions of 
foreclosure property described in section 1221(1), and,
    (2) The difference (hereinafter called ``net gain or loss from 
operations'') between (i) the gross income derived from foreclosure 
property (as defined in section 856(e)) to the extent such gross income 
is not described in subparagraph (A), (B), (C), (D), (E), or (G) of 
section 856(c)(3), and (ii) the deductions allowed by chapter 1 of the 
Code which are directly connected with the production of such gross 
income.


Thus, the sum of the gains and losses from sales or other dispositions 
of foreclosure property described in section

[[Page 89]]

1221(1) is aggregated with the net gain or loss from operations in 
arriving at net income from foreclosure property. For example, if for a 
taxable year a real estate investment trust has gain of $100 from the 
sale of an item of foreclosure property described in section 1221(1), a 
loss of $50 from the sale of an item of foreclosure property described 
in section 1221(1), gross income of $25 from the rental of foreclosure 
property that is not gross income described in subparagraph (A), (B), 
(C), (D), or (G) of section 856(c)(3), and deductions of $35 allowed by 
chapter 1 of the Code which are directly connected with the production 
of the rental income, the net income from foreclosure property for the 
taxable years is $40 (($100-$50) + ($25-$35)).
    (b) Directly connected deductions. A deduction which is otherwise 
allowed by chapter 1 of the Code is ``directly connected'' with the 
production of gross income from the foreclosure property if it has a 
proximate and primary relationship to the earning of the income. Thus, 
in the case of gross income from real property that is foreclosure 
property, ``directly connected'' deductions would include depreciation 
on the property, interest paid or accrued on the indebtedness of the 
trust (whether or not secured by the property) to the extent 
attributable to the carrying of the property, real estate taxes, and 
fees paid to an independent contractor hired to manage the property. On 
the other hand, general overhead and administrative expenses of the 
trust are not ``directly connected'' deductions. Thus, salaries of 
officers and other administrative employees of the trust are not 
``directly connected'' deductions. The net operating loss deduction 
provided by section 172 is not allowed in computing net income from 
foreclosure property.
    (c) Net loss from foreclosure property. The tax imposed by section 
857(b)(4) applies only if there is net income from foreclosure property. 
If there is a net loss from foreclosure property (that is, if the 
aggregate computed under paragraph (a) of this section results in a 
negative amount) the loss is taken into account in computing real estate 
investment trust taxable income under section 857(b)(2).
    (d) Gross income not subject to tax on foreclosure property. If the 
gross income derived from foreclosure property consists of two classes, 
a deduction directly connected with the production of both classes 
(including interest attributable to the carrying of the property) must 
be apportioned between them. The two classes are:
    (1) Gross income which is taken into account in computing net income 
from foreclosure property and
    (2) Other income (such as income described in subparagraph (A), (B), 
(C), (D), or (G) of section 856(c)(3)).


The apportionment may be made on any reasonable basis.
    (e) Allocation and apportionment of interest. For purposes of 
determining the amount of interest attributable to the carrying of 
foreclosure property under paragraph (b) of this section, the following 
rules apply:
    (1) Deductible interest. Interest is taken into account under this 
paragraph (e) only if it is otherwise deductible under chapter 1 of the 
Code.
    (2) Interest specifically allocated to property. Interest that is 
specifically allocated to an item of property is attributable only to 
the carrying of that property. Interest is specifically allocated to an 
item of property if (i) the indebtedness on which the interest is paid 
or accrued is secured only by that property, (ii) such indebtedness was 
specifically incurred for the purpose of purchasing, constructing, 
maintaining, or improving that property, and (iii) the proceeds of the 
borrowing were applied for that purpose.
    (3) Other interest. Interest which is not specifically allocated to 
property is apportioned between foreclosure property and other property 
under the principles of Sec.  1.861-8(e)(2)(v).
    (4) Effective date. The rules in this paragraph (e) are mandatory 
for all

[[Page 90]]

taxable years ending after February 6, 1981.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11277, Feb. 6, 1981]



Sec.  1.857-4  Tax imposed by reason of the failure to meet certain 
source-of-income requirements.

    Section 857(b)(5) imposes a tax on a real estate investment trust 
that is considered, by reason of section 856(c)(7), as meeting the 
source-of-income requirements of paragraph (2) or (3) of section 856(c) 
(or both such paragraphs). The amount of the tax is determined in the 
manner prescribed in section 857(b)(5).

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11278, Feb. 2, 1981]



Sec.  1.857-5  Net income and loss from prohibited transactions.

    (a) In general. Section 857(b)(6) imposes, for each taxable year, a 
tax equal to 100 percent of the net income derived from prohibited 
transactions. A prohibited transaction is a sale or other disposition of 
property described in section 1221(1) that is not foreclosure property. 
The 100-percent tax is imposed to preclude a real estate investment 
trust from retaining any profit from ordinary retailing activities such 
as sales to customers of condominium units or subdivided lots in a 
development tract. In order to prevent a trust from receiving any tax 
benefit from such activities, a net loss from prohibited transactions 
effectively is disallowed in compting real estate investment trust 
taxable income. See Sec.  1.857-2(a)(8). Such loss, however, does reduce 
the amount which a trust is required to distribute as dividends. For 
purposes of applying the provisions of the Code, other than those 
provisions of part II of subchapter M which relate to prohibited 
transactions, no inference is to be drawn from the fact that a type of 
transaction does not constitute a prohibited transaction.
    (b) Special rules. In determining whether a particular transaction 
constitutes a prohibited transaction, the activities of a real estate 
investment trust with respect to foreclosure property and its sales of 
such property are disregarded. Also, if a real estate investment trust 
enters into a purchase and leaseback of real property with an option in 
the seller-lessee to repurchase the property at the end of the lease 
period, and the seller exercises the option pursuant to its terms, 
income from the sale generally will not be considered to be income from 
a prohibited transaction solely because the purchase and leaseback was 
entered into with an option in the seller to repurchase and because the 
option was exercised pursuant to its terms. Other facts and 
circumstances, however, may require a conclusion that the property is 
held primarily for sale to customers in the ordinary course of a trade 
or business. Gain from the sale or other disposition of property 
described in section 1221(1) (other than foreclosure property) that is 
included in gross income for a taxable year of a qualified real estate 
investment trust constitutes income from a prohibited transaction, even 
though the sale or other disposition from which the gain is derived 
occurred in a prior taxable year. For example, if a corporation that is 
a qualified real estate investment trust for the current taxable year 
elected to report the income from the sale of an item of section 1221(1) 
property (other than foreclosure property) on the installment method of 
reporting income, the gain from the sale that is taken into income by 
the real estate

[[Page 91]]

investment trust for the current taxable year is income from a 
prohibited transaction. This result follows even though the sale 
occurred in a prior taxable year for which the corporation did not 
qualify as a real estate investment trust. On the other hand, if the 
gain is taken into income in a taxable year for which the taxpayer is 
not a qualifed real estate investment trust, the 100-percent tax does 
not apply.
    (c) Net income or loss from prohibited transactions. Net income or 
net loss from prohibited transactions is determined by aggregating all 
gains from the sale or other disposition of property (other than 
foreclosure property) described in section 1221(1) with all losses from 
the sale or other disposition of such property. Thus, for example, if a 
real estate investment trust sells two items of property described in 
section 1221(1) (other than foreclosure property) and recognizes a gain 
of $100 on the sale of one item and a loss of $40 on the sale of the 
second item, the net income from prohibited transactions will be $60.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 7767, 46 FR 11278, Feb. 6, 1981]



Sec.  1.857-6  Method of taxation of shareholders of real estate 
investment trusts.

    (a) Ordinary income. Except as otherwise provided in paragraph (b) 
of this section (relating to capital gains), a shareholder receiving 
dividends from a real estate investment trust shall include such 
dividends in gross income for the taxable year in which they are 
received. See section 858(b) and paragraph (c) of Sec.  1.858-1 for 
treatment by shareholders of dividends paid by a real estate investment 
trust after the close of its taxable year in the case of an election 
under section 858(a).
    (b) Capital gains. Under section 857(b)(3)(B), shareholders of a 
real estate investment trust who receive capital gain dividends (as 
defined in paragraph (e) of this section), in respect of the capital 
gains of a corporation, trust, or association for a taxable year for 
which it is taxable under part II of subchapter M as a real estate 
investment trust, shall treat such capital gain dividends as gains from 
the sale or exchange of capital assets held for more than 1 year (6 
months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) and realized in the taxable year of the 
shareholder in which the dividend was received. In the case of dividends 
with respect to any taxable year of a real estate investment trust 
ending after December 31, 1969, and beginning before January 1, 1975, 
the portion of a shareholder's capital gain dividend which in his hands 
is gain to which section 1201(d) (1) or (2) applies is the portion so 
designated by the real estate investment trust pursuant to paragraph 
(e)(2) of this section.
    (c) Special treatment of loss on the sale or exchange of real estate 
investment trust stock held less than 31 days--(1) In general. Under 
section 857(b)(7), if any person with respect to a share of real estate 
investment trust stock held for a period of less than 31 days, is 
required by section 857(b)(3)(B) to include in gross income as a gain 
from the sale or exchange of a capital asset held for more than 1 year 
(6 months for taxable years beginning before 1977; 9 months for taxable 
years beginning in 1977) the amount of a capital gains dividend, then 
such person shall, to the extent of such amount, treat any loss on the 
sale or exchange of such share as a loss from the sale or exchange of a 
capital asset held for more than 1 year (6 months for taxable years 
beginning before 1977; 9 months for taxable years beginning in 1977).
    (2) Determination of holding period. The rules contained in section 
246(c)(3) (relating to the determination of holding periods for purposes 
of the deduction for dividends received) shall be applied in determining 
whether, for purposes of section 857(b)(7)(B) and this paragraph, a 
share of real estate investment trust stock has been held for

[[Page 92]]

a period of less than 31 days. In applying those rules, however, ``30 
days'' shall be substituted for the number of days specified in 
subparagraph (B) of such section.
    (3) Illustration. The application of section 857(b)(7) and this 
paragraph may be illustrated by the following example:

    Example. On December 15, 1961, A purchased a share of stock in the S 
Real Estate Investment Trust for $20. The S trust declared a capital 
gains dividend of $2 per share to shareholders of record on December 31, 
1961. A, therefore, received a capital gain dividend of $2 which, 
pursuant to section 857(b)(3)(B), he must treat as a gain from the sale 
or exchange of a capital asset held for more than six months. On January 
5, 1962, A sold his share of stock in the S trust for $17.50, which sale 
resulted in a loss of $2.50. Under section 857(b)(4) and this paragraph, 
A must treat $2 of such loss (an amount equal to the capital gain 
dividend received with respect to such share of stock) as a loss from 
the sale or exchange of a capital asset held for more than six months.

    (d) Dividend received credit, exclusion, and deduction not allowed. 
Any dividend received from a real estate investment trust which, for the 
taxable year to which the dividend relates, is a qualified real estate 
investment trust, shall not be eligible for the dividend received credit 
(for dividends received on or before December 31, 1964) under section 
34(a), the dividend received exclusion under section 116, or the 
dividend received deduction under section 243.
    (e) Definition of capital gain dividend. (1)(i) A capital gain 
dividend, as defined in section 857(b)(3)(C), is any dividend or part 
thereof which is designated by a real estate investment trust as a 
capital gain dividend in a written notice mailed to its shareholders 
within the period specified in section 857(b)(3)(C) and paragraph (f) of 
this section. If the aggregate amount so designated with respect to the 
taxable year (including capital gain dividends paid after the close of 
the taxable year pursuant to an election under section 858) is greater 
than the net capital gain of the taxable year, the portion of each 
distribution which shall be a capital gain dividend shall be only that 
proportion of the amount so designated which such excess of the net 
long-term capital gain over the net short-term capital loss bears to the 
aggregate of the amount so designated. For example, a real estate 
investment trust making its return on the calendar year basis advised 
its shareholders by written notice mailed December 30, 1961, that 
$200,000 of a distribution of $500,000 made December 15, 1961, 
constituted a capital gain dividend, amounting to $2 per share. It was 
later discovered that an error had been made in determining the net 
capital gain of the taxable year and the net capital gain was $100,000 
instead of $200,000. In such case, each shareholder would have received 
a capital gain dividend of $1 per share instead of $2 per share.
    (ii) For purposes of section 857(b)(3)(C) and this paragraph, the 
net capital gain for a taxable year ending after October 4, 1976, is 
deemed not to exceed the real estate investment trust taxable income 
determined by taking into account the net operating loss deduction for 
the taxable year but not the deduction for dividends paid. See example 2 
in Sec.  1.172-5(a)(4).
    (2) In the case of capital gain dividends designated with respect to 
any taxable year of a real estate investment trust ending after December 
31, 1969, and beginning before January 1, 1975 (including capital gain 
dividends paid after the close of the taxable year pursuant to an 
election under section 858), the real estate investment trust must 
include in its written notice designating the capital gain dividend a 
statement showing the shareholder's proportionate share of such dividend 
which is gain described in section 1201(d)(1) and his proportionate 
share of such dividend which is gain described in section 1201(d)(2). In 
determining the portion of the capital gain dividend which, in the hands 
of a shareholder, is gain described in section 1201(d) (1) or (2), the 
real estate investment trust shall consider that capital gain dividends 
for a taxable year are first made from its long-term capital gains which 
are not described in section 1201(d) (1) or (2), to the extent thereof, 
and then from its long-term capital gains for such year which are 
described in section 1201(d) (1) or (2). A shareholder's proportionate 
share of gains which are described in section 1201(d)(1) is the

[[Page 93]]

amount which bears the same ratio to the amount paid to him as a capital 
gain dividend in respect of such year as (i) the aggregate amount of the 
trust's gains which are described in section 1201(d)(1) and paid to all 
shareholders bears to (ii) the aggregate amount of the capital gain 
dividend paid to all shareholders in respect of such year. A 
shareholder's proportionate share of gains which are described in 
section 1201(d)(2) shall be determined in a similar manner. Every real 
estate investment trust shall keep a record of the proportion of each 
capital gain divided (to which this subparagraph applies) which is gain 
described in section 1201(d) (1) or (2).
    (f) Mailing of written notice to shareholders--(1) General rule. 
Except as provided in paragraph (f)(2) of this section, the written 
notice designating a dividend or part thereof as a capital gain dividend 
must be mailed to the shareholders not later than 30 days after the 
close of the taxable year of the real estate investment trust.
    (2) Net capital gain resulting from a determination. If, as a result 
of a determination (as defined in section 860(e)), occurring after 
October 4, 1976, there is an increase in the amount by which the net 
capital gain exceeds the deduction for dividends paid (determined with 
reference to capital gains dividends only) for the taxable year, then a 
real estate investment trust may designate a dividend (or part thereof) 
as a capital gain dividend in a written notice mailed to its 
shareholders at any time during the 120-day period immediately following 
the date of the determination. The designation may be made with respect 
to a dividend (or part thereof) paid during the taxable year to which 
the determination applies (including a dividend considered as paid 
during the taxable year pursuant to section 858). A deficiency dividend 
(as defined in section 860(f)), or a part thereof, that is paid with 
respect to the taxable year also may be designated as a capital gain 
dividend by the real estate investment trust (or by the acquiring 
corporation to which section 381(c)(25) applies) before the expiration 
of the 120-day period immediately following the determination. However, 
the aggregate amount of the dividends (or parts thereof) that may be 
designated as capital gain dividends after the date of the determination 
shall not exceed the amount of the increase in the excess of the net 
capital gain over the deduction for dividends paid (determined with 
reference to capital gains dividends only) that results from the 
determination. The date of a determination shall be established in 
accordance with Sec.  1.860-2(b)(1).

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954); sec. 860(e) (92 Stat. 2849, 26 U.S.C. 
860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 6598, 27 FR 4088, Apr. 28, 1962, as amended by T.D. 6777, 29 FR 
17809, Dec. 16, 1964; T.D. 7337, 39 FR 44974, Dec. 30, 1974; T.D. 7728, 
45 FR 72650, Nov. 3, 1980. Redesignated and amended by T.D. 7767, 46 FR 
11277, 11279, 11283, Feb. 6, 1981; T.D. 7936, 49 FR 2107, Jan. 18, 1984; 
T.D. 8107, 51 FR 43347, Dec. 2, 1986]



Sec.  1.857-7  Earnings and profits of a real estate investment trust.

    (a) Any real estate investment trust whether or not such trust meets 
the requirements of section 857(a) and paragraph (a) of Sec.  1.857-1 
for any taxable year beginning after December 31, 1960 shall apply 
paragraph (b) of this section in computing its earnings and profits for 
such taxable year.
    (b) In the determination of the earnings and profits of a real 
estate investment trust, section 857(d) provides that such earnings and 
profits for any taxable year (but not the accumulated earnings and 
profits) shall not be reduced by any amount which is not allowable as a 
deduction in computing its taxable income for the taxable year. Thus, if 
a trust would have had earnings and profits of $500,000 for the taxable 
year except for the fact that it had a net capital loss of $100,000, 
which amount was not deductible in determining its taxable income, its 
earnings and profits for that year if it is a real estate investment 
trust would be

[[Page 94]]

$500,000. If the real estate investment trust had no accumulated 
earnings and profits at the beginning of the taxable year, in 
determining its accumulated earnings and profits as of the beginning of 
the following taxable year, the earnings and profits for the taxable 
year to be considered in such computation would amount to $400,000 
assuming that there had been no distribution from such earnings and 
profits. If distributions had been made in the taxable year in the 
amount of the earnings and profits then available for distribution, 
$500,000, the trust would have as of the beginning of the following 
taxable year neither accumulated earnings and profits nor a deficit in 
accumulated earnings and profits, and would begin such year with its 
paid-in capital reduced by $100,000, an amount equal to the excess of 
the $500,000 distributed over the $400,000 accumulated earnings and 
profits which would otherwise have been carried into the following 
taxable year. For purposes of section 857(d) and this section, if an 
amount equal to any net loss derived from prohibited transactions is 
included in real estate investment trust taxable income pursuant to 
section 857(b)(2)(F), that amount shall be considered to be an amount 
which is not allowable as a deduction in computing taxable income for 
the taxable year. The earnings and profits for the taxable year (but not 
the accumulated earnings and profits) shall not be considered to be less 
than (i) in the case of a taxable year ending before October 5, 1976, 
the amount (if any) of the net capital gain for the taxable year, or 
(ii) in the case of a taxable year ending after December 31, 1973, the 
amount (if any), of the excess of the net income from foreclosure 
property for the taxable year over the tax imposed thereon by section 
857(b)(4)(A).

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4088, Apr. 28, 1962. Redesignated and amended by T.D. 
7767, 46 FR 11277, 11279, Feb. 6, 1981]



Sec.  1.857-8  Records to be kept by a real estate investment trust.

    (a) In general. Under section 857(a)(2) a real estate investment 
trust is required to keep such records as will disclose the actual 
ownership of its outstanding stock. Thus, every real estate investment 
trust shall maintain in the internal revenue district in which it is 
required to file its income tax return permanent records showing the 
information relative to the actual owners of its stock contained in the 
written statements required by this section to be demanded from its 
shareholders. Such records shall be kept at all times available for 
inspection by any internal revenue officer or employee, and shall be 
retained so long as the contents thereof may become material in the 
administration of any internal revenue law.
    (b) Actual owner of stock. The actual owner of stock of a real 
estate investment trust is the person who is required to include in 
gross income in his return the dividends received on the stock. 
Generally, such person is the shareholder of record of the real estate 
investment trust. However, where the shareholder of record is not the 
actual owner of the stock, the stockholding record of the real estate 
investment trust may not disclose the actual ownership of such stock. 
Accordingly, the real estate investment trust shall demand written 
statements from shareholders of record disclosing the actual owners of 
stock as required in paragraph (d) of this section.

[[Page 95]]

    (c) Stock ownership for personal holding company determination. For 
the purpose of determining under section 856(a)(6) whether a trust, 
claiming to be a real estate investment trust, is a personal holding 
company, the permanent records of the trust shall show the maximum 
number of shares of the trust (including the number and face value of 
securities convertible into stock of the trust) to be considered as 
actually or constructively owned by each of the actual owners of any of 
its stock at any time during the last half of the trust's taxable year, 
as provided in section 544.
    (d) Statements to be demanded from shareholders. The information 
required by paragraphs (b) and (c) of this section shall be set forth in 
written statements which shall be demanded from shareholders of record 
as follows:
    (1) In the case of a trust having 2,000 or more shareholders of 
record of its stock on any dividend record date, from each record holder 
of 5 percent or more of its stock; or
    (2) In the case of a trust having less than 2,000 and more than 200 
shareholders of record of its stock on any dividend record date, from 
each record holder of 1 percent or more of its stock; or
    (3) In the case of a trust having 200 or less shareholders of record 
of its stock on any dividend record date, from each record holder of 
one-half of 1 percent or more of its stock.
    (e) Demands for statements. The written statements from shareholders 
of record shall be demanded by the real estate investment trust in 
accordance with paragraph (d) of this section within 30 days after the 
close of the real estate investment trust's taxable year (or before June 
1, 1962, whichever is later). When making demand for such written 
statements, the trust shall inform each such shareholder of his duty to 
submit at the time he files his income tax return (or before July 1, 
1962, whichever is later) the statements which are required by Sec.  
1.857-9 if he fails or refuses to comply with such demand. A list of the 
persons failing or refusing to comply in whole or in part with the 
trust's demand for statements under this section shall be maintained as 
a part of the trust's records required by this section. A trust which 
fails to keep such records to show, to the extent required by this 
section, the actual ownership of its outstanding stock shall be taxable 
as an ordinary corporation and not as a real estate investment trust.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4088, Apr. 28, 1962. Redesignated and amended by T.D. 
7767, 46 FR 11277, 11279, Feb. 6, 1981]



Sec.  1.857-9  Information required in returns of shareholders.

    (a) In general. Any person who fails or refuses to submit to a real 
estate investment trust the written statements required under Sec.  
1.857-8 to be demanded by such trust from its shareholders of record 
shall submit at the time he files his income tax return for his taxable 
year which ends with, or includes, the last day of the trust's taxable 
year (or before July 1, 1962, whichever is later) a statement setting 
forth the information required by this section.
    (b) Information required--(1) Shareholder of record not actual 
owner. In the case of any person holding shares of stock in any trust 
claiming to be a real estate investment trust who is not the actual 
owner of such stock, the name and address of each actual owner, the 
number of shares owned by each actual owner at any time during such 
person's taxable year, and the amount of dividends belonging to each 
actual owner.
    (2) Actual owner of shares. In the case of an actual owner of shares 
of stock in any trust claiming to be a real estate investment trust--
    (i) The name and address of each such trust, the number of shares 
actually owned by him at any and all times during his taxable year, and 
the amount of dividends from each such trust received during his taxable 
year;

[[Page 96]]

    (ii) If shares of any such trust were acquired or disposed of during 
such person's taxable year, the name and address of the trust, the 
number of shares acquired or disposed of, the dates of acquisition or 
disposition, and the names and addresses of the persons from whom such 
shares were acquired or to whom they were transferred;
    (iii) If any shares of stock (including securities convertible into 
stock) of any such trust are also owned by any member of such person's 
family (as defined in section 544(a)(2)), or by any of his partners, the 
name and address of the trust, the names and addresses of such members 
of his family and his partners, and the number of shares owned by each 
such member of his family or partner at any and all times during such 
person's taxable year; and
    (iv) The names and addresses of any corporation, partnership, 
association, or trust, in which such person had a beneficial interest of 
10 percent or more at any time during his taxable year.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4089, Apr. 28, 1962, as amended by T.D. 6628, 27 FR 
12794, Dec. 28, 1962. Redesignated and amended by T.D. 7767, 46 FR 
11277, 11279, Feb. 6, 1981]



Sec.  1.857-10  Information returns.

    Nothing in Sec. Sec.  1.857-8 and 1.857-9 shall be construed to 
relieve a real estate investment trust or its shareholders from the duty 
of filing information returns required by regulations prescribed under 
the provisions of subchapter A, chapter 61 of the Code.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4089, Apr. 28, 1962. Redesignated and amended by T.D. 
7767, 46 FR 11277, 11279, Feb. 6, 1981]



Sec.  1.857-11  Non-REIT earnings and profits.

    (a) Applicability of section 857(a)(3)(A). A real estate investment 
trust does not satisfy section 857(a)(3)(A) unless--
    (1) Part II of subchapter M applied to the trust for all its taxable 
years beginning after February 28, 1986; and
    (2) For each corporation to whose earnings and profits the trust 
succeeded by the operation of section 381, part II of subchapter M 
applied for all the corporation's taxable years beginning after February 
28, 1986.
    (b) Applicability of section 857(a)(3)(B); in general. A real estate 
investment trust does not satisfy section 857(a)(3)(B) unless, as of the 
close of the taxable year, it has no earnings and profits other than 
earnings and profits that--
    (1) Were earned by a corporation in a year for which part II of 
subchapter M applied to the corporation and, at all times thereafter, 
were the earnings and profits of a corporation to which part II of 
subchapter M applied; or
    (2) By the operation of section 381 pursuant to a transaction that 
occurred before December 22, 1992, became the earnings and profits of a 
corporation to which part II of subchapter M applied and, at all times 
thereafter, were the earnings and profits of a corporation to which part 
II of subchapter M applied.
    (c) Distribution procedures similar to those for regulated 
investment companies to apply. Distribution procedures similar to those 
in section 852(e) for regulated investment companies apply to

[[Page 97]]

non-REIT earnings and profits of real estate investment trusts.
    (d) Effective date. This regulation is effective for taxable years 
ending on or after December 22, 1992.
    (e) For treatment of net built-in gain assets of a C corporation 
that become assets of a REIT, see Sec.  1.337(d)-5T.

[T.D. 8483, 58 FR 43798, Aug. 18, 1993, as amended by T.D. 8872, 65 FR 
5777, Feb. 7, 2000]



Sec.  1.858-1  Dividends paid by a real estate investment trust 
after close of taxable year.

    (a) General rule. Under section 858, a real estate investment trust 
may elect to treat certain dividends that are distributed within a 
specified period after the close of a taxable year as having been paid 
during the taxable year. The dividend is taken into account in 
determining the deduction for dividends paid for the taxable year in 
which it is treated as paid. The dividend may be an ordinary dividend 
or, subject to the requirements of sections 857(b)(3)(C) and 858(c), a 
capital gain dividend. The trust may make the dividend declaration 
required by section 858(a)(1) either before or after the close of the 
taxable year as long as the declaration is made before the time 
prescribed by law for filing its return for the taxable year (including 
the period of any extension of time granted for filing the return).
    (b) Election--(1) Method of making election. The election must be 
made in the return filed by the trust for the taxable year. The election 
shall be made by treating the dividend (or portion thereof) to which the 
election applies as a dividend paid during the taxable year of the trust 
in computing its real estate investment trust taxable income and, if 
applicable, the alternative tax imposed by section 857(b)(3)(A). (In the 
case of an election with respect to a taxable year ending before October 
5, 1976, if the dividend (or portion thereof) to which the election is 
to apply is a capital gain dividend, the trust shall treat the dividend 
as paid during such taxable year in computing the amount of capital 
gains dividends paid during the taxable year.) In the case of an 
election with respect to a taxable year beginning after October 4, 1976, 
the trust must also specify in its return (or in a statement attached to 
its return) the exact dollar amount that is to be treated as having been 
paid during the taxable year.
    (2) Limitation based on earnings and profits. The election provided 
in section 858(a) may be made only to the extent that the earnings and 
profits of the taxable year (computed with the application of sections 
857(d) and Sec.  1.857-7) exceed the total amount of distributions out 
of such earnings and profits actually made during the taxable year. For 
purposes of the preceding sentence, deficiency dividends and 
distributions with respect to which an election has been made for a 
prior year under section 858(a) are disregarded in determining the total 
amount of distributions out of earnings and profits actually made during 
the taxable year. The dividend or portion thereof, with respect to which 
the real estate investment trust has made a valid election under section 
858(a), shall be considered as paid out of the earnings and profits of 
the taxable year for which such election is made, and not out of the 
earnings and profits of the taxable year in which the distribution is 
actually made.
    (3) Additional limitation based on amount specified. The amount 
treated under section 858(a) as having been paid in a taxable year 
beginning after October 4, 1976, cannot exceed the lesser of (i) the 
dollar amount specified by the trust in its return (or a statement 
attached thereto) in making the election or (ii) the amount allowable 
under the limitation prescribed in paragraph (b)(2) of this section.
    (4) Irrevocability of the election. After the expiration of the time 
for filing the return for the taxable year for which an election is made 
under section 858(a), such election shall be irrevocable with respect to 
the dividend or portion thereof to which it applies.
    (c) Receipt by shareholders. Under section 858(b), the dividend or 
portion thereof, with respect to which a valid election has been made, 
will be includable in the gross income of the shareholders of the real 
estate investment trust for the taxable year in which the dividend is 
received by them.

[[Page 98]]

    (d) Illustrations. The application of paragraphs (a), (b), and (c) 
of this section may be illustrated by the following examples:

    Example 1. The X Trust, a real estate investment trust, had taxable 
income (and earnings and profits) for the calendar year 1961 of 
$100,000. During that year the trust distributed to shareholders taxable 
dividends aggregating $88,000. On March 10, 1962, the trust declared a 
dividend of $37,000 payable to shareholders on March 20, 1962. Such 
dividend consisted of the first regular quarterly dividend for 1962 of 
$25,000 plus an additional $12,000 representing that part of the taxable 
income for 1961 which was not distributed in 1961. On March 15, 1962, 
the X Trust filed its Federal income tax return and elected therein to 
treat $12,000 of the total dividend of $37,000 to be paid to 
shareholders on March 20, 1962, as having been paid during the taxable 
year 1961. Assuming that the X Trust actually distributed the entire 
amount of the dividend of $37,000 on March 20, 1962, an amount equal to 
$12,000 thereof will be treated for the purposes of section 857(a) as 
having been paid during the taxable year 1961. Upon distribution of such 
dividend the trust becomes a qualified real estate investment trust for 
the taxable year 1961. Such amount ($12,000) will be considered by the X 
Trust as a distribution out of the earnings and profits for the taxable 
year 1961, and will be treated by the shareholders as a taxable dividend 
for the taxable year in which such distribution is received by them. 
However, assuming that the X Trust is not a qualified real estate 
investment trust for the calendar year 1962, nevertheless, the $12,000 
portion of the dividend (paid on March 20, 1962) which the trust elected 
to relate to the calendar year 1961, will not qualify as a dividend for 
purposes of section 34, 116, or 243.
    Example 2. The Y Trust, a real estate investment trust, had taxable 
income (and earnings and profits) for the calendar year 1964 of 
$100,000, and for 1965 taxable income (and earnings and profits) of 
$125,000. On January 1, 1964, the trust had a deficit in its earnings 
and profits accumulated since February 28, 1913, of $115,000. During the 
year 1964 the trust distributed to shareholders taxable dividends 
aggregating $85,000. On March 5, 1965, the trust declared a dividend of 
$65,000 payable to shareholders on March 31, 1965. On March 15, 1965, 
the Y Trust filed its Federal income tax return in which it included 
$40,000 of the total dividend of $65,000 payable to shareholders on 
March 31, 1965, as a dividend paid by it during the taxable year 1964. 
On March 31, 1965, the Y Trust distributed the entire amount of the 
dividend of $65,000 declared on March 5, 1965. The election under 
section 858(a) is valid only to the extent of $15,000, the amount of the 
undistributed earnings and profits for 1964 ($100,000 earnings and 
profits less $85,000 distributed during 1964). The remainder ($50,000) 
of the $65,000 dividend paid on March 31, 1965, could not be the subject 
of an election, and such amount will be regarded as a distribution by 
the Y Trust out of earnings and profits for the taxable year 1965. 
Assuming that the only other distribution by the Y Trust during 1965 was 
a distribution of $75,000 paid as a dividend on October 31, 1965, the 
total amount of the distribution of $65,000 paid on March 31, 1965, is 
to be treated by the shareholders as taxable dividends for the taxable 
year in which such dividend is received. The Y Trust will treat the 
amount of $15,000 as a distribution of the earnings or profits of the 
trust for the taxable year 1964, and the remaining $50,000 as a 
distribution of the earnings or profits for the year 1965. The 
distribution of $75,000 on October 31, 1966, is, of course, a taxable 
dividend out of the earnings and profits for the year 1965.
    Example 3. Assume the facts are the same as in example 2, except 
that the taxable years involved are calendar years 1977 and 1978, and Y 
Trust specified in its Federal income tax return for 1977 that the 
dollar amount of $40,000 of the $65,000 distribution payable to 
shareholders on March 31, 1978, is to be treated as having been paid in 
1977. The result will be the same as in example 2, since the amount of 
the undistributed earnings and profits for 1977 is less than the $40,000 
amount specified by Y Trust in making its election. Accordingly, the 
election is valid only to the extent of $15,000. Y Trust will treat the 
amount of $15,000 as a distribution, in 1977, of earnings and profits of 
the trust for the taxable year 1977 and the remaining $50,000 as a 
distribution, in 1978, of the earnings and profits for 1978.

    (e) Notice to shareholders. Section 858(c) provides that, in the 
case of dividends with respect to which a real estate investment trust 
has made an election under section 858(a), any notice to shareholders 
required under part II, subchapter M, chapter 1 of the Code, with 
respect to such amounts, shall be made not later than 30 days after the 
close of the taxable year in which the distribution is made. Thus, the 
notice requirement of section 857(b)(3)(C) and paragraph (f) of Sec.  
1.857-6 with respect to capital gains dividends may be satisfied with 
respect to amounts to which section 858(a) and this section apply if the 
notice relating to such amounts is mailed to the shareholders not later 
than 30 days after the close of the taxable year in which the 
distribution is made. If the notice

[[Page 99]]

under section 858(c) reltes to an election with respect to any capital 
gains dividends, such capital gains dividends shall be aggregated by the 
real estate investment trust with the designated capital gains dividends 
actually paid during the taxable year to which the election applies (not 
including deficiency dividends or dividends with respect to which an 
election has been made for a prior taxable year under section 858) to 
determine whether the aggregate of the designated capital gains 
dividends with respect to such taxable year exceeds the net capital gain 
of the trust. See section 857(b)(3)(C) and paragraph (f) of Sec.  1.857-
6.

(Sec. 856(d)(4) (90 Stat. 1750; 26 U.S.C. 856(d)(4)); sec. 856(e)(5) (88 
Stat. 2113; 26 U.S.C. 856(e)(5)); sec. 856(f)(2) (90 Stat. 1751; 26 
U.S.C. (856(f)(2)); sec. 856(g)(2) (90 Stat. 1753; 26 U.S.C. 856(g)(2)); 
sec. 858(a) (74 Stat. 1008; 26 U.S.C. 858(a)); sec. 859(c) (90 Stat. 
1743; 26 U.S.C. 859(c)); sec. 859(e) (90 Stat. 1744; 26 U.S.C. 859(e)); 
sec. 6001 (68A Stat. 731; 26 U.S.C. 6001); sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011); sec. 6071 (68A Stat. 749, 26 U.S.C. 6071); sec. 6091 (68A 
Stat. 752; 26 U.S.C. 6091); sec. 7805 (68A Stat. 917; 26 U.S.C. 7805), 
Internal Revenue Code of 1954))

[T.D. 6598, 27 FR 4089, Apr. 28, 1962, as amended by T.D. 7767, 46 FR 
11279, Feb. 6, 1981]



Sec.  1.860-1  Deficiency dividends.

    Section 860 allows a qualified investment entity to be relieved from 
the payment of a deficiency in (or to be allowed a credit or refund of) 
certain taxes. ``Qualified investment entity'' is defined in section 
860(b). The taxes referred to are those imposed by sections 852(b) (1) 
and (3), 857(b) (1) or (3), the minimum tax on tax preferences imposed 
by section 56 and, if the entity fails the distribution requirements of 
section 852(a)(1)(A) or 857(a)(1) (as applicable), the corporate income 
tax imposed by section 11(a) or 1201(a). The method provided by section 
860 is to allow an additional deduction for a dividend distribution 
(that meets the requirements of section 860 and Sec.  1.860-2) in 
computing the deduction for dividends paid for the taxable year for 
which the deficiency is determined. A deficiency divided may be an 
ordinary dividend or, subject to the limitations of sections 
852(b)(3)(C), 857(b)(3)(C), and 860(f)(2)(B), may be a capital gain 
dividend.

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; sec. 860(e) (92 Stat. 2849, 
26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7936, 49 FR 2107, Jan. 18, 1984]



Sec.  1.860-2  Requirements for deficiency dividends.

    (a) In general--(1) Determination, etc. A qualified investment 
entity is allowed a deduction for a deficiency dividend only if there is 
a determination (as defined in section 860(e) and paragraph (b)(1) of 
this section) that results in an adjustment (as defined in section 
860(d) (1) or (2)) for the taxable year for which the deficiency 
dividend is paid. An adjustment does not include an increase in the 
excess of (i) the taxpayer's interest income excludable from gross 
income under section 103(a) over (ii) its deductions disallowed under 
sections 265 and 171(a)(2).
    (2) Payment date and claim. The deficiency dividend must be paid on, 
or within 90 days after, the date of the determination and before the 
filing of a claim under section 860(g) and paragraph (b)(2) of this 
section. This claim must be filed within 120 days after the date of the 
determination.
    (3) Nature and amount of distribution. (i) The deficiency dividend 
must be a distribution of property (including money) that would have 
been properly taken into account in computing the dividends paid 
deduction under section 561 for the taxable year for which tax liability 
resulting from the determination exists if the property had been 
distributed during that year. Thus, if the distribution would have been 
a dividend under section 316(a) if it had been made during the taxable 
year for which the determination applies, and the distribution may 
qualify under sections 316(b)(3), 562(a), and 860(f)(1), even though the 
distributing corporation, trust, or association has no current or 
accumulated earnings and profits for the taxable year in which the 
distribution is actually made. The amount of the distribution is 
determined under section 301 as of the date of the distribution.


[[Page 100]]



The amount of the deduction is subject to the applicable limitations 
under sections 562 and 860(f)(2). Thus, if the entity distributes to an 
individual shareholder property (other than money) which on the date of 
the distribution has a fair market value in excess of its adjusted basis 
in the hands of the entity, the amount of the deficiency dividend in the 
individual's hands for purposes of section 316(b)(3) is determined by 
using the property's fair market value on that date. Nevertheless, the 
amount of the deficiency dividend the entity may deduct is limited, 
under Sec.  1.562-1(a), to the adjusted basis of the property and the 
amount taxable to the individual as a dividend is determined by 
reference to the current and accumulated earnings and profits for the 
year to which the determination applies.
    (ii) The qualified investment entity does not have to distribute the 
full amount of the adjustment in order to pay a deficiency dividend. For 
example, assume that in 1983 a determination with respect to a calendar 
year regulated investment company results in an increase of $100 in 
investment company taxable income (computed without the dividends paid 
deduction) for 1981 and no other change. The regulated investment 
company may choose to pay a deficiency dividend of $100 or of any lesser 
amount and be allowed a dividends paid deduction for 1981 for the amount 
of that deficiency dividend.
    (4) Status of distributor. The corporation, trust, or association 
that pays the deficiency dividend does not have to be a qualified 
investment entity at the time of payment.
    (5) Certain definitions to apply. For purposes of sections 860(d) 
(defining adjustment) and (f)(2) (limitations) the definitions of the 
terms ``investment company taxable income,'' ``real estate investment 
trust taxable income,'' and ``capital gains dividends'' in sections 
852(b)(2), 857(b)(2), 852(b)(3)(C), and 857(b)(3)(C) apply, as 
appropriate to the particular entity.
    (b) Determination and claim for deduction--(1) Determination. For 
purposes of applying section 860(e), the following rules apply:
    (i) The date of determination by a decision of the United States Tax 
Court, the date upon which a judgment of a court becomes final, and the 
date of determination by a closing agreement shall be determined under 
the rules in Sec.  1.547-2(b)(1) (ii), (iii), and (iv).
    (ii) A determination under section 860(e)(3) may be made by an 
agreement signed by the district director or another official to whom 
authority to sign the agreement is delegated, and by or on behalf of the 
taxpayer. The agreement shall set forth the amount, if any, of each 
adjustment described in subparagraphs (A), (B), and (C) of section 
860(d) (1) or (2) (as appropriate) for the taxable year and the amount 
of the liability for any tax imposed by section 11(a), 56(a), 852(b)(1), 
852(b)(3)(A), 857(b)(1), 857(b)(3)(A), or 1201(a) for the taxable year. 
The agreement shall also set forth the amount of the limitation 
(determined under section 860(f)(2)) on the amount of deficiency 
dividends that can qualify as capital gain dividends and ordinary 
dividends, respectively, for the taxable year. An agreement under this 
subdivision (ii) which is signed by the district director (or other 
delegate) shall be sent to the taxpayer at its 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, the date of registration is the date of 
determination. If certified mail is used, the date of the postmark on 
the sender's receipt is the date of determination. However, if a 
dividend is paid by the taxpayer before the registration or postmark 
date, but on or after the date the agreement is signed by the district 
director (or other delegate), the date of determination is the date of 
signing.
    (2) Claim for deduction. A claim for deduction for a deficiency 
dividend shall be made, with the requisite declaration, on Form 976 and 
shall contain the following information and have the following 
attachments:
    (i) The name, address, and taxpayer identification number of the 
corporation, trust, or association;
    (ii) The amount of the deficiency and the taxable year or years 
involved;
    (iii) The amount of the unpaid deficiency or, if the deficiency has 
been

[[Page 101]]

paid in whole or in part, the date of payment and the amount thereof;
    (iv) A statement as to how the deficiency was established (i.e., by 
an agreement under section 860(e)(3), by a closing agreement under 
section 7121, or by a decision of the Tax Court or court judgment);
    (v) Any date or other information with respect to the determination 
that is required by Form 976;
    (vi) The amount and date of payment of the dividend with respect to 
which the claim for the deduction for deficiency dividends is filed;
    (vii) The amount claimed as a deduction for deficiency dividends;
    (viii) If the amount claimed as a deduction for deficiency dividends 
includes any amount designated (or to be designated) as capital gain 
dividends, the amount of capital gain dividends for which a deficiency 
dividend deduction is claimed;
    (ix) Any other information required by the claim form;
    (x) A certified copy of the resolution of the trustees, directors, 
or other authority authorizing the payment of the dividend with respect 
to which the claim is filed; and
    (xi) A copy of any court decision, judgment, agreement, or other 
document required by Form 976.
    (3) Filing claim. The claim, together with the accompanying 
documents, shall be filed with the district director, or director of the 
internal revenue service center, with whom the income tax return for the 
taxable year for which the determination applies was filed. In the event 
that the determination is an agreement with the district director (or 
other delegate) described in section 860(e)(3) and paragraph (b)(1)(ii) 
of this section, the claim may be filed with the district director with 
whom (or pursuant to whose delegation) the agreement was made.

(The reporting requirements of this section were approved by the Office 
of Management and Budget under control number 1545-0045)

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; sec. 860(e) (92 Stat. 2849, 
26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7936, 49 FR 2107, Jan. 18, 1984; 49 FR 3177, Jan. 26, 1984, as 
amended by T.D. 8939, 66 FR 2819, Jan. 12, 2001]



Sec.  1.860-3  Interest and additions to tax.

    (a) In general. If a qualified investment entity is allowed a 
deduction for deficiency dividends with respect to a taxable year, under 
section 860(c)(1) the tax imposed on the entity by chapter 1 of the Code 
(computed by taking into account the deduction) for that year is deemed 
to be increased by the amount of the deduction. This deemed increase in 
tax, however, applies solely for purposes of determining the liability 
of the entity for interest under subchapter A of chapter 67 of the Code 
and for additions to tax and additional amounts under chapter 68 of the 
Code. For purposes of applying subchapter A of chapter 67 and 68, the 
last date prescribed for payment of the deemed increase in tax is 
considered to be the last date prescribed for the payment of tax 
(determined in the manner provided in section 6601(b)) for the taxable 
year for which the deduction for deficiency dividends is allowed. The 
deemed increase in tax is considered to be paid as of the date that the 
claim for the deficiency dividend deduction described in section 860(g) 
is filed.
    (b) Overpayments of tax. If a qualified investment entity is 
entitled to a credit or refund of an overpayment of the tax imposed by 
chapter 1 of the Code for the taxable year for which the deficiency 
dividend deduction is allowed, then, for purposes of computing interest, 
additions to tax, and additional amounts, the payment (or payments) that 
result in the overpayment and that precede the filing of the claim 
described in section 860(g) will be applied against and reduce the 
increase in tax that is deemed to occur under section 860(c)(1).
    (c) Examples. This section is illustrated by the following examples:

    Example 1. Corporation X is a real estate investment trust that 
files its income tax return on a calendar year basis. X receives an 
extension of time until June 15, 1978, to file its 1977 income tax 
return and files the return on May 15, 1978. X does not elect to pay any 
tax due in installments. For 1977, X reports real estate investment 
trust taxable income (computed without the dividends paid deduction) of 
$100, a dividends paid deduction of $100, and no tax liability. 
Following an examination of X's 1977 return, the district director and X 
enter into an agreement which is a determination under section

[[Page 102]]

860(e)(3). The determination is dated November 1, 1979, and increases 
X's real estate investment trust taxable income (computed without the 
dividends paid deduction) by $20 to $120. Thus, taking into account the 
$100 of dividends paid in 1977, X has undistributed real estate 
investment trust taxable income of $20 as a result of the determination. 
X pays a dividend of $20 on November 10, 1979, files a claim for a 
deficiency dividend deduction of this $20 pursuant to section 860(g) on 
November 15, 1979, and is allowed a deficiency dividend deduction of $20 
for 1977. After taking into account this deduction, X has no real estate 
investment trust taxable income and meets the distribution requirements 
of section 857(a)(1). However, for purposes of section 6601 (relating to 
interest on underpayment of tax), the tax imposed by chapter 1 of the 
Code on X for 1977 is deemed increased by this $20, and the last date 
prescribed for payment of the tax is March 15, 1978 (the due date of the 
1977 return determined without any extension of time). The tax of $20 is 
deemed paid on November 15, 1979, the date the claim for the deficiency 
dividend deduction is filed. Thus, X is liable for interest on $20, at 
the rate established under section 6621, for the period from March 15, 
1978, to November 15, 1979. Also, for purposes of determining whether X 
is liable for any addition to tax or additional amount imposed by 
chapter 68 of the Code (including the penalty prescribed by section 
6697), the amount of tax imposed on X by chapter 1 of the Code is deemed 
to be increased by $20 (the amount of the deficiency dividend deduction 
allowed), the last date prescribed for payment of such tax is March 15, 
1978, and the tax of $20 is deemed to be paid on November 15, 1979. X, 
however, is not subject to interest and penalties for the amount of any 
tax for which it would have been liable under section 11(a), 56(a), 
1201(a), or 857(b) had it not been allowed the $20 deduction for 
deficiency dividends.
    Example 2. Assume the facts are the same as in example (1) except 
that the district director, upon examining X's income tax return, 
asserts an income tax deficiency of $4, based on an asserted increase of 
$10 in real estate investment trust taxable income, and no agreement is 
entered into between the parties. X pays the $4 on June 1, 1979, and 
files suit for refund in the United States District Court. The District 
Court, in a decision which becomes final on November 1, 1980, holds that 
X did fail to report $10 of real estate investment trust taxable income 
and is not entitled to any refund. (No other item of income or deduction 
is in issue.) X pays a dividend of $10 on November 10, 1980, files a 
claim for a deficiency dividend deduction of this $10 on November 15, 
1980, and is allowed a deficiency dividend deduction of $10 for 1977. 
Assume further that $4 is refunded to X on December 31, 1980, as the 
result of the $10 deficiency dividend deduction being allowed. Also 
assume that any assessable penalties, additional amounts, and additions 
to tax (including the penalty imposed by section 6697) for which X is 
liable are paid within 10 days of notice and demand, so that no interest 
is imposed on such penalties, etc. X's liability for interest for the 
period March 15, 1978, to June 1, 1979, is determined with respect to 
$10 (the amount of the deficiency dividend deduction allowed). X's 
liability for interest for the period June 1, 1979, to November 15, 
1980, is determined with respect to $6, i.e., $10 minus the $4 payment. 
X is entitled to interest on the $4 overpayment for the period described 
in section 6611(b)(2), beginning on November 15, 1980.

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; sec. 860(e) (92 Stat. 2849, 
26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7936, 49 FR 2108, Jan. 18, 1984]



Sec.  1.860-4  Claim for credit or refund.

    If the allowance of a deduction for a deficiency dividend results in 
an overpayment of tax, the taxpayer, in order to secure credit or refund 
of the overpayment, must file a claim on Form 1120X in addition to the 
claim for the deficiency dividend deduction required under section 
860(g). The credit or refund will be allowed as if on the date of the 
determination (as defined in section 860(e)) two years remained before 
the expiration of the period of limitations on the filing of claim for 
refund for the taxable year to which the overpayment relates.

(The reporting requirements of this section were approved by the Office 
of Management and Budget under control number 1545-0045)

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; sec. 860(e) (92 Stat. 2849, 
26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7936, 49 FR 2109, Jan. 18, 1984]



Sec.  1.860-5  Effective date.

    (a) In general. Section 860 and Sec. Sec.  1.860-1 through 1.860-4 
apply with respect to determinations after November 6, 1978.
    (b) Prior determination of real estate investments trusts. Section 
859 (as in effect before the enactment of the Revenue Act of 1978) 
applies to determinations with respect to real estate investment trusts 
occurring after October 4, 1976, and before November 7, 1978. In the 
case of such a determination, the rules in Sec. Sec.  1.860-1 through 
1.860-4 apply, a reference in this chapter 1 to section 860

[[Page 103]]

(or to a particular provision of section 860) shall be considered to be 
a reference to section 859 (or to the corresponding substantive 
provision of section 859), as in effect before enactment of the Revenue 
Act of 1978, and ``qualified investment entity'' in Sec. Sec.  
1.381(c)25-1(a) and 1.860-1 through 1.860-3 means a real estate 
investment trust.

(Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805; sec. 860(e) (92 Stat. 2849, 
26 U.S.C. 860(e)); sec. 860(g) (92 Stat. 2850, 26 U.S.C. 860(g)))

[T.D. 7936, 49 FR 2109, Jan. 18, 1984]



Sec.  1.860A-0  Outline of REMIC provisions.

    This section lists the paragraphs contained in Sec. Sec.  1.860A-1 
through 1.860G-3.

         Section 1.860A-1 Effective dates and transition rules.

    (a) In general.
    (b) Exceptions.
    (1) Reporting regulations.
    (2) Tax avoidance rules.
    (i) Transfers of certain residual interests.
    (ii) Transfers to foreign holders.
    (iii) Residual interests that lack significant value.
    (3) Excise taxes.
    (4) Rate based on current interest rate.
    (i) In general.
    (ii) Rate based on index.
    (iii) Transition obligations.
    (5) Accounting for REMIC net income of foreign persons.

    Sec.  1.860C-2 Determination of REMIC taxable income or net loss.

    (a) Treatment of gain or loss.
    (b) Deductions allowable to a REMIC.
    (1) In general.
    (2) Deduction allowable under section 163.
    (3) Deduction allowable under section 166.
    (4) Deduction allowable under section 212.
    (5) Expenses and interest relating to tax-exempt income.

                  Sec.  1.860D-1 Definition of a REMIC.

    (a) In general.
    (b) Specific requirements.
    (1) Interests in a REMIC.
    (i) In general.
    (ii) De minimis interests.
    (2) Certain rights not treated as interests.
    (i) Payments for services.
    (ii) Stripped interests.
    (iii) Reimbursement rights under credit enhancement contracts.
    (iv) Rights to acquire mortgages.
    (3) Asset test.
    (i) In general.
    (ii) Safe harbor.
    (4) Arrangements test.
    (5) Reasonable arrangements.
    (i) Arrangements to prevent disqualified organizations from holding 
residual interests.
    (ii) Arrangements to ensure that information will be provided.
    (6) Calendar year requirement.
    (c) Segregated pool of assets.
    (1) Formation of REMIC.
    (2) Identification of assets.
    (3) Qualified entity defined.
    (d) Election to be treated as a real estate mortgage investment 
conduit.
    (1) In general.
    (2) Information required to be reported in the REMIC's first taxable 
year.
    (3) Requirement to keep sufficient records.

Sec.  1.860E-1 Treatment of taxable income of a residual interest holder 
                      in excess of daily accruals.

    (a) Excess inclusion cannot be offset by otherwise allowable 
deductions.
    (1) In general.
    (2) Affiliated groups.
    (3) Special rule for certain financial institutions.
    (i) In general.
    (ii) Ordering rule.
    (A) In general.
    (B) Example.
    (iii) Significant value.
    (iv) Determining anticipated weighted average life.
    (A) Anticipated weighted average life of the REMIC.
    (B) Regular interests that have a specified principal amount.
    (C) Regular interests that have no specified principal amount or 
that have only a nominal principal amount, and all residual interests.
    (D) Anticipated payments.
    (b) Treatment of a residual interest held by REITs, RICs, common 
trust funds, and subchapter T cooperatives. [Reserved]
    (c) Transfers of noneconomic residual interests.
    (1) In general.
    (2) Noneconomic residual interest.
    (3) Computations.
    (4) Safe harbor for establishing lack of improper knowledge.
    (5) Asset test.
    (6) Definitions for asset test.
    (7) Formula test.
    (8) Conditions and limitations on formula test.
    (9) Examples.
    (10) Effective dates.
    (d) Transfers to foreign persons.

    Sec.  1.860E-2 Tax on transfers of residual interest to certain 
                             organizations.

    (a) Transfers to disqualified organizations.

[[Page 104]]

    (1) Payment of tax.
    (2) Transitory ownership.
    (3) Anticipated excess inclusions.
    (4) Present value computation.
    (5) Obligation of REMIC to furnish information.
    (6) Agent.
    (7) Relief from liability.
    (i) Transferee furnishes information under penalties of perjury.
    (ii) Amount required to be paid.
    (b) Tax on pass-thru entities.
    (1) Tax on excess inclusions.
    (2) Record holder furnishes information under penalties of perjury.
    (3) Deductibility of tax.
    (4) Allocation of tax.

                 Sec.  1.860F-1 Qualified liquidations.

                  Sec.  1.860F-2 Transfers to a REMIC.

    (a) Formation of a REMIC.
    (1) In general.
    (2) Tiered arrangements.
    (i) Two or more REMICs formed pursuant to a single set of 
organizational documents.
    (ii) A REMIC and one or more investment trusts formed pursuant to a 
single set of documents.
    (b) Treatment of sponsor.
    (1) Sponsor defined.
    (2) Nonrecognition of gain or loss.
    (3) Basis of contributed assets allocated among interests.
    (i) In general.
    (ii) Organizational expenses.
    (A) Organizational expense defined.
    (B) Syndication expenses.
    (iii) Pricing date.
    (4) Treatment of unrecognized gain or loss.
    (i) Unrecognized gain on regular interests.
    (ii) Unrecognized loss on regular interests.
    (iii) Unrecognized gain on residual interests.
    (iv) Unrecognized loss on residual interests.
    (5) Additions to or reductions of the sponsor's basis.
    (6) Transferred basis property.
    (c) REMIC's basis in contributed assets.

  Sec.  1.860F-4 REMIC reporting requirements and other administrative 
                                 rules.

    (a) In general.
    (b) REMIC tax return.
    (1) In general.
    (2) Income tax return.
    (c) Signing of REMIC return.
    (1) In general.
    (2) REMIC whose startup day is before November 10, 1988.
    (i) In general.
    (ii) Startup day.
    (iii) Exception.
    (d) Designation of tax matters person.
    (e) Notice to holders of residual interests.
    (1) Information required.
    (i) In general.
    (ii) Information with respect to REMIC assets.
    (A) 95 percent asset test.
    (B) Additional information required if the 95 percent test not met.
    (C) For calendar quarters in 1987.
    (D) For calendar quarters in 1988 and 1989.
    (iii) Special provisions.
    (2) Quarterly notice required.
    (i) In general.
    (ii) Special rule for 1987.
    (3) Nominee reporting.
    (i) In general.
    (ii) Time for furnishing statement.
    (4) Reports to the Internal Revenue Service.
    (f) Information returns for persons engaged in a trade or business.

      Sec.  1.860G-1 Definition of regular and residual interests.

    (a) Regular interest.
    (1) Designation as a regular interest.
    (2) Specified portion of the interest payments on qualified 
mortgages.
    (i) In general.
    (ii) Specified portion cannot vary.
    (iii) Defaulted or delinquent mortgages.
    (iv) No minimum specified principal amount is required.
    (v) Specified portion includes portion of interest payable on 
regular interest.
    (vi) Examples.
    (3) Variable rate.
    (i) Rate based on current interest rate.
    (ii) Weighted average rate.
    (A) In general.
    (B) Reduction in underlying rate.
    (iii) Additions, subtractions, and multiplications.
    (iv) Caps and floors.
    (v) Funds-available caps.
    (A) In general.
    (B) Facts and circumstances test.
    (C) Examples.
    (vi) Combination of rates.
    (4) Fixed terms on the startup day.
    (5) Contingencies prohibited.
    (b) Special rules for regular interests.
    (1) Call premium.
    (2) Customary prepayment penalties received with respect to 
qualified mortgages.
    (3) Certain contingencies disregarded.
    (i) Prepayments, income, and expenses.
    (ii) Credit losses.
    (iii) Subordinated interests.
    (iv) Deferral of interest.
    (v) Prepayment interest shortfalls.
    (vi) Remote and incidental contingencies.
    (4) Form of regular interest.
    (5) Interest disproportionate to principal.
    (i) In general.
    (ii) Exception.
    (6) Regular interest treated as a debt instrument for all Federal 
income tax purposes.

[[Page 105]]

    (c) Residual interest.
    (d) Issue price of regular and residual interests.
    (1) In general.
    (2) The public.

                       Sec.  1.860G-2 Other rules.

    (a) Obligations principally secured by an interest in real property.
    (1) Tests for determining whether an obligation is principally 
secured.
    (i) The 80-percent test.
    (ii) Alternative test.
    (2) Treatment of liens.
    (3) Safe harbor.
    (i) Reasonable belief that an obligation is principally secured.
    (ii) Basis for reasonable belief.
    (iii) Later discovery that an obligation is not principally secured.
    (4) Interests in real property; real property.
    (5) Obligations secured by an interest in real property.
    (6) Obligations secured by other obligations; residual interests.
    (7) Certain instruments that call for contingent payments are 
obligations.
    (8) Release of a lien on an interest in real property securing a 
qualified mortgage; defeasance.
    (9) Stripped bonds and coupons.
    (b) Assumptions and modifications.
    (1) Significant modifications are treated as exchanges of 
obligations.
    (2) Significant modification defined.
    (3) Exceptions.
    (4) Modifications that are not significant modifications.
    (5) Assumption defined.
    (6) Pass-thru certificates.
    (7) Test for determining whether an obligation continues to be 
principally secured following certain types of modifications.
    (c) Treatment of certain credit enhancement contracts.
    (1) In general.
    (2) Credit enhancement contracts.
    (3) Arrangements to make certain advances.
    (i) Advances of delinquent principal and interest.
    (ii) Advances of taxes, insurance payments, and expenses.
    (iii) Advances to ease REMIC administration.
    (4) Deferred payment under a guarantee arrangement.
    (d) Treatment of certain purchase agreements with respect to 
convertible mortgages.
    (1) In general.
    (2) Treatment of amounts received under purchase agreements.
    (3) Purchase agreement.
    (4) Default by the person obligated to purchase a convertible 
mortgage.
    (5) Convertible mortgage.
    (e) Prepayment interest shortfalls.
    (f) Defective obligations.
    (1) Defective obligation defined.
    (2) Effect of discovery of defect.
    (g) Permitted investments.
    (1) Cash flow investment.
    (i) In general.
    (ii) Payments received on qualified mortgages.
    (iii) Temporary period.
    (2) Qualified reserve funds.
    (3) Qualified reserve asset.
    (i) In general.
    (ii) Reasonably required reserve.
    (A) In general.
    (B) Presumption that a reserve is reasonably required.
    (C) Presumption may be rebutted.
    (h) Outside reserve funds.
    (i) Contractual rights coupled with regular interests in tiered 
arrangements.
    (1) In general.
    (2) Example.
    (j) Clean-up call.
    (1) In general.
    (2) Interest rate changes.
    (3) Safe harbor.
    (k) Startup day.

              Sec.  1.860G-3 Treatment of foreign persons.

    (a) Transfer of a residual interest with tax avoidance potential.
    (1) In general.
    (2) Tax avoidance potential.
    (i) Defined.
    (ii) Safe harbor.
    (3) Effectively connected income.
    (4) Transfer by a foreign holder.
    (b) Accounting for REMIC net income
    (1) Allocation of partnership income to a foreign partner.
    (2) Excess inclusion income allocated by certain pass-through 
entities to a foreign person.

[T.D. 8458, 57 FR 61299, Dec. 24, 1992; 58 FR 15089, Mar. 19, 1993, as 
amended by T.D. 8614, 60 FR 42787, Aug. 17, 1995; T.D. 9004, 67 FR 
47453, July 19, 2002; T.D. 9128, 69 FR 26041, May 11, 2004; T.D. 9272, 
71 FR 43365, Aug. 1, 2006; T.D. 9415, 73 FR 40172, July 14, 2008; T.D. 
9463, 74 FR 47438, Sept. 16, 2009]



Sec.  1.860A-1  Effective dates and transition rules.

    (a) In general. Except as otherwise provided in paragraph (b) of 
this section, the regulations under sections 860A through 860G are 
effective only for a qualified entity (as defined in Sec.  1.860D-
1(c)(3)) whose startup day (as defined in section 860G(a)(9) and Sec.  
1.860G-2(k)) is on or after November 12, 1991.

[[Page 106]]

    (b) Exceptions--(1) Reporting regulations. (i) Sections 1.860D-1(c) 
(1) and (3), and Sec.  1.860D-1(d) (1) through (3) are effective after 
December 31, 1986.
    (ii) Sections 1.860F-4 (a) through (e) are effective after December 
31, 1986 and are applicable after that date except as follows:
    (A) Section 1.860F-4(c)(1) is effective for REMICs with a startup 
day on or after November 10, 1988.
    (B) Sections 1.860F-4(e)(1)(ii) (A) and (B) are effective for 
calendar quarters and calendar years beginning after December 31, 1988.
    (C) Section 1.860F-4(e)(1)(ii)(C) is effective for calendar quarters 
and calendar years beginning after December 31, 1986 and ending before 
January 1, 1988.
    (D) Section 1.860F-4(e)(1)(ii)(D) is effective for calendar quarters 
and calendar years beginning after December 31, 1987 and ending before 
January 1, 1990.
    (2) Tax avoidance rules--(i) Transfers of certain residual 
interests. Section 1.860E-1(c) (concerning transfers of noneconomic 
residual interests) and Sec.  1.860G-3(a)(4) (concerning transfers by a 
foreign holder to a United States person) are effective for transfers of 
residual interests on or after September 27, 1991.
    (ii) Transfers to foreign holders. Generally, Sec.  1.860G-3(a) 
(concerning transfers of residual interests to foreign holders) is 
effective for transfers of residual interests after April 20, 1992. 
However, Sec.  1.860G-3(a) does not apply to a transfer of a residual 
interest in a REMIC by the REMIC's sponsor (or by another transferor 
contemporaneously with formation of the REMIC) on or before June 30, 
1992, if--
    (A) The terms of the regular interests and the prices at which 
regular interests were offered had been fixed on or before April 20, 
1992;
    (B) On or before June 30, 1992, a substantial portion of the regular 
interests in the REMIC were transferred, with the terms and at the 
prices that were fixed on or before April 20, 1992, to investors who 
were unrelated to the REMIC's sponsor at the time of the transfer; and
    (C) At the time of the transfer of the residual interest, the 
expected future distributions on the residual interest were equal to at 
least 30 percent of the anticipated excess inclusions (as defined in 
Sec.  1.860E-2(a)(3)), and the transferor reasonably expected that the 
transferee would receive sufficient distributions from the REMIC at or 
after the time at which the excess inclusions accrue in an amount 
sufficient to satisfy the taxes on the excess inclusions.
    (iii) Residual interests that lack significant value. The 
significant value requirement in Sec.  1.860E-1(a) (1) and (3) 
(concerning excess inclusions accruing to organizations to which section 
593 applies) generally is effective for residual interests acquired on 
or after September 27, 1991. The significant value requirement in Sec.  
1.860E-1(a) (1) and (3) does not apply, however, to residual interests 
acquired by an organization to which section 593 applies as a sponsor at 
formation of a REMIC in a transaction described in Sec.  1.860F-2(a)(1) 
if more than 50 percent of the interests in the REMIC (determined by 
reference to issue price) were sold to unrelated investors before 
November 12, 1991. The exception from the significant value requirement 
provided by the preceding sentence applies only so long as the sponsor 
owns the residual interests.
    (3) Excise taxes. Section 1.860E-2(a)(1) is effective for transfers 
of residual interests to disqualified organizations after March 31, 
1988. Section 1.860E-2(b)(1) is effective for excess inclusions accruing 
to pass-thru entities after March 31, 1988.
    (4) Rate based on current interest rate--(i) In general. Section 
1.860G-1(a)(3)(i) applies to obligations (other than transition 
obligations described in paragraph (b)(4)(iii) of this section) intended 
to qualify as regular interests that are issued on or after April 4, 
1994.
    (ii) Rate based on index. Section 1.860G-1(a)(3)(i) (as contained in 
26 CFR part 1 revised as of April 1, 1994) applies to obligations 
intended to qualify as regular interests that--
    (A) Are issued by a qualified entity (as defined in Sec.  1.860D-
1(c)(3)) whose startup date (as defined in section 860G(a)(9) and Sec.  
1.860G-2(k)) is on or after November 12, 1991; and
    (B) Are either--
    (1) Issued before April 4, 1994; or

[[Page 107]]

    (2) Transition obligations described in paragraph (b)(4)(iii) of 
this section.
    (iii) Transition obligations. Obligations are described in this 
paragraph (b)(4)(iii) if--
    (A) The terms of the obligations and the prices at which the 
obligations are offered are fixed before April 4, 1994; and
    (B) On or before June 1, 1994, a substantial portion of the 
obligations are transferred, with the terms and at the prices that are 
fixed before April 4, 1994, to investors who are unrelated to the 
REMIC's sponsor at the time of the transfer.
    (5) Accounting for REMIC net income of foreign persons. Section 
1.860G-3(b) is applicable to REMIC net income (including excess 
inclusions) of a foreign person with respect to a REMIC residual 
interest if the first net income allocation under section 860C(a)(1) to 
the foreign person with respect to that interest occurs on or after 
August 1, 2006.
    (6) Exceptions for certain modified obligations. Paragraphs 
(a)(8)(i), (b)(3)(v), (b)(3)(vi), and (b)(7) of Sec.  1.860G-2 apply to 
modifications made to the terms of an obligation on or after September 
16, 2009.

[T.D. 8458, 57 FR 61300, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993; 58 FR 
15089, Mar. 19, 1993; T.D. 8614, 60 FR 42787, Aug. 17, 1995; T.D. 9272, 
71 FR 43365, Aug. 1, 2006; T.D. 9415, 73 FR 40172, July 14, 2008; T.D. 
9463, 74 FR 47438, Sept. 16, 2009]



Sec.  1.860C-1  Taxation of holders of residual interests.

    (a) Pass-thru of income or loss. Any holder of a residual interest 
in a REMIC must take into account the holder's daily portion of the 
taxable income or net loss of the REMIC for each day during the taxable 
year on which the holder owned the residual interest.
    (b) Adjustments to basis of residual interests--(1) Increase in 
basis. A holder's basis in a residual interest is increased by--
    (i) The daily portions of taxable income taken into account by that 
holder under section 860C(a) with respect to that interest; and
    (ii) The amount of any contribution described in section 860G(d)(2) 
made by that holder.
    (2) Decrease in basis. A holder's basis in a residual interest is 
reduced (but not below zero) by--
    (i) First, the amount of any cash or the fair market value of any 
property distributed to that holder with respect to that interest; and
    (ii) Second, the daily portions of net loss of the REMIC taken into 
account under section 860C(a) by that holder with respect to that 
interest.
    (3) Adjustments made before disposition. If any person disposes of a 
residual interest, the adjustments to basis prescribed in paragraph (b) 
(1) and (2) of this section are deemed to occur immediately before the 
disposition.
    (c) Counting conventions. For purposes of determining the daily 
portion of REMIC taxable income or net loss under section 860C(a)(2), 
any reasonable convention may be used. An example of a reasonable 
convention is ``30 days per month/90 days per quarter/360 days per 
year.''
    (d) For rules on the proper accounting for income from inducement 
fees, see Sec.  1.446-6.

[T.D. 8458, 57 FR 61301, Dec. 24, 1992, as amended by T.D. 9128, 69 FR 
26041, May 11, 2004]



Sec.  1.860C-2  Determination of REMIC taxable income or net loss.

    (a) Treatment of gain or loss. For purposes of determining the 
taxable income or net loss of a REMIC under section 860C(b), any gain or 
loss from the disposition of any asset, including a qualified mortgage 
(as defined in section 860G(a)(3)) or a permitted investment (as defined 
in section 860G(a)(5) and Sec.  1.860G-2(g)), is treated as gain or loss 
from the sale or exchange of property that is not a capital asset.
    (b) Deductions allowable to a REMIC--(1) In general. Except as 
otherwise provided in section 860C(b) and in paragraph (b) (2) through 
(5) of this section, the deductions allowable to a REMIC for purposes of 
determining its taxable income or net loss are those deductions that 
would be allowable to an individual, determined by taking into account 
the same limitations that apply to an individual.
    (2) Deduction allowable under section 163. A REMIC is allowed a 
deduction, determined without regard to section

[[Page 108]]

163(d), for any interest expense accrued during the taxable year.
    (3) Deduction allowable under section 166. For purposes of 
determining a REMIC's bad debt deduction under section 166, debt owed to 
the REMIC is not treated as nonbusiness debt under section 166(d).
    (4) Deduction allowable under section 212. A REMIC is not treated as 
carrying on a trade or business for purposes of section 162. Ordinary 
and necessary operating expenses paid or incurred by the REMIC during 
the taxable year are deductible under section 212, without regard to 
section 67. Any expenses that are incurred in connection with the 
formation of the REMIC and that relate to the organization of the REMIC 
and the issuance of regular and residual interests are not treated as 
expenses of the REMIC for which a deduction is allowable under section 
212. See Sec.  1.860F-2(b)(3)(ii) for treatment of those expenses.
    (5) Expenses and interest relating to tax-exempt income. Pursuant to 
section 265(a), a REMIC is not allowed a deduction for expenses and 
interest allocable to tax-exempt income. The portion of a REMIC's 
interest expense that is allocable to tax-exempt interest is determined 
in the manner prescribed in section 265(b)(2), without regard to section 
265(b)(3).

[T.D. 8458, 57 FR 61301, Dec. 24, 1992]



Sec.  1.860D-1  Definition of a REMIC.

    (a) In general. A real estate mortgage investment conduit (or REMIC) 
is a qualified entity, as defined in paragraph (c)(3) of this section, 
that satisfies the requirements of section 860D(a). See paragraph (d)(1) 
of this section for the manner of electing REMIC status.
    (b) Specific requirements--(1) Interests in a REMIC--(i) In general. 
A REMIC must have one class, and only one class, of residual interests. 
Except as provided in paragraph (b)(1)(ii) of this section, every 
interest in a REMIC must be either a regular interest (as defined in 
section 860G(a)(1) and Sec.  1.860G-1(a)) or a residual interest (as 
defined in section 860G(a)(2) and Sec.  1.860G-1(c)).
    (ii) De minimis interests. If, to facilitate the creation of an 
entity that elects REMIC status, an interest in the entity is created 
and, as of the startup day (as defined in section 860G(a)(9) and Sec.  
1.860G-2(k)), the fair market value of that interest is less than the 
lesser of $1,000 or 1/1,000 of one percent of the aggregate fair market 
value of all the regular and residual interests in the REMIC, then, 
unless that interest is specifically designated as an interest in the 
REMIC, the interest is not treated as an interest in the REMIC for 
purposes of section 860D(a) (2) and (3) and paragraph (B)(1)(i) of this 
section.
    (2) Certain rights not treated as interests. Certain rights are not 
treated as interests in a REMIC. Although not an exclusive list, the 
following rights are not interests in a REMIC.
    (i) Payments for services. The right to receive from the REMIC 
payments that represent reasonable compensation for services provided to 
the REMIC in the ordinary course of its operation is not an interest in 
the REMIC. Payments made by the REMIC in exchange for services may be 
expressed as a specified percentage of interest payments due on 
qualified mortgages or as a specified percentage of earnings from 
permitted investments. For example, a mortgage servicer's right to 
receive reasonable compensation for servicing the mortgages owned by the 
REMIC is not an interest in the REMIC.
    (ii) Stripped interests. Stripped bonds or stripped coupons not held 
by the REMIC are not interests in the REMIC even if, in a transaction 
preceding or contemporaneous with the formation of the REMIC, they and 
the REMIC's qualified mortgages were created from the same mortgage 
obligation. For example, the right of a mortgage servicer to receive a 
servicing fee in excess of reasonable compensation from payments it 
receives on mortgages held by a REMIC is not an interest in the REMIC. 
Further, if an obligation with a fixed principal amount provides for 
interest at a fixed or variable rate and for certain contingent payment 
rights (e.g., a shared appreciation provision or a percentage of 
mortgagor profits provision), and the owner of the obligation 
contributes the fixed payment rights to a REMIC and retains the 
contingent

[[Page 109]]

payment rights, the retained contingent payment rights are not an 
interest in the REMIC.
    (iii) Reimbursement rights under credit enhancement contracts. A 
credit enhancer's right to be reimbursed for amounts advanced to a REMIC 
pursuant to the terms of a credit enhancement contract (as defined in 
Sec.  1.860G-2 (c)(2)) is not an interest in the REMIC even if the 
credit enhancer is entitled to receive interest on the amounts advanced.
    (iv) Rights to acquire mortgages. The right to acquire or the 
obligation to purchase mortgages and other assets from a REMIC pursuant 
to a clean-up call (as defined in Sec.  1.860G-2(j)) or a qualified 
liquidation (as defined in section 860F(a)(4)), or on conversion of a 
convertible mortgage (as defined in Sec.  1.860G-2(d)(5)), is not an 
interest in the REMIC.
    (3) Asset test--(i) In general. For purposes of the asset test of 
section 860D(a)(4), substantially all of a qualified entity's assets are 
qualified mortgages and permitted investments if the qualified entity 
owns no more than a de minimis amount of other assets.
    (ii) Safe harbor. The amount of assets other than qualified 
mortgages and permitted investments is de minimis if the aggregate of 
the adjusted bases of those assets is less than one percent of the 
aggregate of the adjusted bases of all of the REMIC's assets. 
Nonetheless, a qualified entity that does not meet this safe harbor may 
demonstrate that it owns no more than a de minimis amount of other 
assets.
    (4) Arrangements test. Generally, a qualified entity must adopt 
reasonable arrangements designed to ensure that--
    (i) Disqualified organizations (as defined in section 860E(e)(5)) do 
not hold residual interests in the qualified entity; and
    (ii) If a residual interest is acquired by a disqualified 
organization, the qualified entity will provide to the Internal Revenue 
Service, and to the persons specified in section 860E(e)(3), information 
needed to compute the tax imposed under section 860E(e) on transfers of 
residual interests to disqualified organizations.
    (5) Reasonable arrangements--(i) Arrangements to prevent 
disqualified organizations from holding residual interests. A qualified 
entity is considered to have adopted reasonable arrangements to ensure 
that a disqualified organization (as defined in section 860E(e)(5)) will 
not hold a residual interest if--
    (A) The residual interest is in registered form (as defined in Sec.  
5f.103-1(c) of this chapter); and
    (B) The qualified entity's organizational documents clearly and 
expressly prohibit a disqualified organization from acquiring beneficial 
ownership of a residual interest, and notice of the prohibition is 
provided through a legend on the document that evidences ownership of 
the residual interest or through a conspicuous statement in a prospectus 
or private offering document used to offer the residual interest for 
sale.
    (ii) Arrangements to ensure that information will be provided. A 
qualified entity is considered to have made reasonable arrangements to 
ensure that the Internal Revenue Service and persons specified in 
section 860E(e)(3) as liable for the tax imposed under section 860E(e) 
receive the information needed to compute the tax if the qualified 
entity's organizational documents require that it provide to the 
Internal Revenue Service and those persons a computation showing the 
present value of the total anticipated excess inclusions with respect to 
the residual interest for periods after the transfer. See Sec.  1.860E-
2(a)(5) for the obligation to furnish information on request.
    (6) Calendar year requirement. A REMIC's taxable year is the 
calendar year. The first taxable year of a REMIC begins on the startup 
day and ends on December 31 of the same year. If the startup day is 
other than January 1, the REMIC has a short first taxable year.
    (c) Segregated pool of assets--(1) Formation of REMIC. A REMIC may 
be formed as a segregated pool of assets rather than as a separate 
entity. To constitute a REMIC, the assets identified as part of the 
segregated pool must be treated for all Federal income tax purposes as 
assets of the REMIC and interests in the REMIC must be based solely on 
assets of the REMIC.

[[Page 110]]

    (2) Identification of assets. Formation of the REMIC does not occur 
until--
    (i) The sponsor identifies the assets of the REMIC, such as through 
execution of an indenture with respect to the assets; and
    (ii) The REMIC issues the regular and residual interests in the 
REMIC.
    (3) Qualified entity defined. For purposes of this section, the term 
``qualified entity'' includes an entity or a segregated pool of assets 
within an entity.
    (d) Election to be treated as a real estate mortgage investment 
conduit--(1) In general. A qualified entity, as defined in paragraph 
(c)(3) of this section, elects to be treated as a REMIC by timely 
filing, for the first taxable year of its existence, a Form 1066, U.S. 
Real Estate Mortgage Investment Conduit Income Tax Return, signed by a 
person authorized to sign that return under Sec.  1.860F-4(c). See Sec.  
1.9100-1 for rules regarding extensions of time for making elections. 
Once made, this election is irrevocable for that taxable year and all 
succeeding taxable years.
    (2) Information required to be reported in the REMIC's first taxable 
year. For the first taxable year of the REMIC's existence, the qualified 
entity, as defined in paragraph (c)(3) of this section, must provide 
either on its return or in a separate statement attached to its return--
    (i) The REMIC's employer identification number, which must not be 
the same as the identification number of any other entity,
    (ii) Information concerning the terms and conditions of the regular 
interests and the residual interest of the REMIC, or a copy of the 
offering circular or prospectus containing such information,
    (iii) A description of the prepayment and reinvestment assumptions 
that are made pursuant to section 1272(a)(6) and the regulations 
thereunder, including a statement supporting the selection of the 
prepayment assumption,
    (iv) The form of the electing qualified entity under State law or, 
if an election is being made with respect to a segregated pool of assets 
within an entity, the form of the entity that holds the segregated pool 
of assets, and
    (v) Any other information required by the form.
    (3) Requirement to keep sufficient records. A qualified entity, as 
defined in paragraph (c)(3) of this section, that elects to be a REMIC 
must keep sufficient records concerning its investments to show that it 
has complied with the provisions of sections 860A through 860G and the 
regulations thereunder during each taxable year.

[T.D. 8366, 56 FR 49516, Sept. 30, 1991; T.D. 8458, 57 FR 61301, Dec. 
24, 1992]



Sec.  1.860E-1  Treatment of taxable income of a residual interest holder 
in excess of daily accruals.

    (a) Excess inclusion cannot be offset by otherwise allowable 
deductions--(1) In general. Except as provided in paragraph (a)(3) of 
this section, the taxable income of any holder of a residual interest 
for any taxable year is in no event less than the sum of the excess 
inclusions attributable to that holder's residual interests for that 
taxable year. In computing the amount of a net operating loss (as 
defined in section 172(c)) or the amount of any net operating loss 
carryover (as defined in section 172(b)(2)), the amount of any excess 
inclusion is not included in gross income or taxable income. Thus, for 
example, if a residual interest holder has $100 of gross income, $25 of 
which is an excess inclusion, and $90 of business deductions, the holder 
has taxable income of $25, the amount of the excess inclusion, and a net 
operating loss of $15 ($75 of other income - $90 of business 
deductions).
    (2) Affiliated groups. If a holder of a REMIC residual interest is a 
member of an affiliated group filing a consolidated income tax return, 
the taxable income of the affiliated group cannot be less than the sum 
of the excess inclusions attributable to all residual interests held by 
members of the affiliated group.
    (3) Special rule for certain financial institutions--(i) In general. 
If an organization to which section 593 applies holds a residual 
interest that has significant value (as defined in paragraph (a)(3)(iii) 
of this section), section 860E(a)(1) and paragraph (a)(1) of this 
section do not apply to that organization with respect to that interest. 
Consequently, an organization to which section 593 applies may use its 
allowable deductions to

[[Page 111]]

offset an excess inclusion attributable to a residual interest that has 
significant value, but, except as provided in section 860E(a)(4)(A), may 
not use its allowable deductions to offset an excess inclusion 
attributable to a residual interest held by any other member of an 
affiliated group, if any, of which the organization is a member. 
Further, a net operating loss of any other member of an affiliated group 
of which the organization is a member may not be used to offset an 
excess inclusion attributable to a residual interest held by that 
organization.
    (ii) Ordering rule--(A) In general. In computing taxable income for 
any year, an organization to which section 593 applies is treated as 
having applied its allowable deductions for the year first to offset 
that portion of its gross income that is not an excess inclusion and 
then to offset that portion of its income that is an excess inclusion.
    (B) Example. The following example illustrates the provisions of 
paragraph (a)(3)(ii) of this section:

    Example. Corp. X, a corporation to which section 593 applies, is a 
member of an affiliated group that files a consolidated return. For a 
particular taxable year, Corp. X has gross income of $1,000, and of this 
amount, $150 is an excess inclusion attributable to a residual interest 
that has significant value. Corp. X has $975 of allowable deductions for 
the taxable year. Corp. X must apply its allowable deductions first to 
offset the $850 of gross income that is not an excess inclusion, and 
then to offset the portion of its gross income that is an excess 
inclusion. Thus, Corp. X has $25 of taxable income ($1,000-$975), and 
that $25 is an excess inclusion that may not be offset by losses 
sustained by other members of the affiliated group.

    (iii) Significant value. A residual interest has significant value 
if--
    (A) The aggregate of the issue prices of the residual interests in 
the REMIC is at least 2 percent of the aggregate of the issue prices of 
all residual and regular interests in the REMIC; and
    (B) The anticipated weighted average life of the residual interests 
is at least 20 percent of the anticipated weighted average life of the 
REMIC.
    (iv) Determining anticipated weighted average life--(A) Anticipated 
weighted average life of the REMIC. The anticipated weighted average 
life of a REMIC is the weighted average of the anticipated weighted 
average lives of all classes of interests in the REMIC. This weighted 
average is determined under the formula in paragraph (a)(3)(iv)(B) of 
this section, applied by treating all payments taken into account in 
computing the anticipated weighted average lives of regular and residual 
interests in the REMIC as principal payments on a single regular 
interest.
    (B) Regular interests that have a specified principal amount. 
Generally, the anticipated weighted average life of a regular interest 
is determined by--
    (1) Multiplying the amount of each anticipated principal payment to 
be made on the interest by the number of years (including fractions 
thereof) from the startup day (as defined in section 860G(a)(9) and 
Sec.  1.860G-2(k)) to the related principal payment date;
    (2) Adding the results; and
    (3) Dividing the sum by the total principal paid on the regular 
interest.
    (C) Regular interests that have no specified principal amount or 
that have only a nominal principal amount, and all residual interests. 
If a regular interest has no specified principal amount, or if the 
interest payments to be made on a regular interest are 
disproportionately high relative to its specified principal amount (as 
determined by reference to Sec.  1.860G-1(b)(5)(i)), then, for purposes 
of computing the anticipated weighted average life of the interest, all 
anticipated payments on that interest, regardless of their designation 
as principal or interest, must be taken into account in applying the 
formula set out in paragraph (a)(3)(iv)(B) of this section. Moreover, 
for purposes of computing the weighted average life of a residual 
interest, all anticipated payments on that interest, regardless of their 
designation as principal or interest, must be taken into account in 
applying the formula set out in paragraph (a)(3)(iv)(B) of this section.
    (D) Anticipated payments. The anticipated principal payments to be 
made on a regular interest subject to paragraph (a)(3)(iv)(B) of this 
section, and the anticipated payments to be made on a regular interest 
subject to paragraph (a)(3)(iv)(C) of this section or on a residual 
interest, must be determined based on--

[[Page 112]]

    (1) The prepayment and reinvestment assumptions adopted under 
section 1272(a)(6), or that would have been adopted had the REMIC's 
regular interests been issued with original issue discount; and
    (2) Any required or permitted clean up calls or any required 
qualified liquidation provided for in the REMIC's organizational 
documents.
    (b) Treatment of residual interests held by REITs, RICs, common 
trust funds, and subchapter T cooperatives. [Reserved]
    (c) Transfers of noneconomic residual interests--(1) In general. A 
transfer of a noneconomic residual interest is disregarded for all 
Federal tax purposes if a significant purpose of the transfer was to 
enable the transferor to impede the assessment or collection of tax. A 
significant purpose to impede the assessment or collection of tax exists 
if the transferor, at the time of the transfer, either knew or should 
have known (had ``improper knowledge'') that the transferee would be 
unwilling or unable to pay taxes due on its share of the taxable income 
of the REMIC.
    (2) Noneconomic residual interest. A residual interest is a 
noneconomic residual interest unless, at the time of the transfer--
    (i) The present value of the expected future distributions on the 
residual interest at least equals the product of the present value of 
the anticipated excess inclusions and the highest rate of tax specified 
in section 11(b)(1) for the year in which the transfer occurs; and
    (ii) The transferor reasonably expects that, for each anticipated 
excess inclusion, the transferee will receive distributions from the 
REMIC at or after the time at which the taxes accrue on the anticipated 
excess inclusion in an amount sufficient to satisfy the accrued taxes.
    (3) Computations. The present value of the expected future 
distributions and the present value of the anticipated excess inclusions 
must be computed under the procedure specified in Sec.  1.860E-2(a)(4) 
for determining the present value of anticipated excess inclusions in 
connection with the transfer of a residual interest to a disqualified 
organization.
    (4) Safe harbor for establishing lack of improper knowledge. A 
transferor is presumed not to have improper knowledge if--
    (i) The transferor conducted, at the time of the transfer, a 
reasonable investigation of the financial condition of the transferee 
and, as a result of the investigation, the transferor found that the 
transferee had historically paid its debts as they came due and found no 
significant evidence to indicate that the transferee will not continue 
to pay its debts as they come due in the future;
    (ii) The transferee represents to the transferor that it understands 
that, as the holder of the noneconomic residual interest, the transferee 
may incur tax liabilities in excess of any cash flows generated by the 
interest and that the transferee intends to pay taxes associated with 
holding the residual interest as they become due;
    (iii) The transferee represents that it will not cause income from 
the noneconomic residual interest to be attributable to a foreign 
permanent establishment or fixed base (within the meaning of an 
applicable income tax treaty) of the transferee or another U.S. 
taxpayer; and
    (iv) The transfer satisfies either the asset test in paragraph 
(c)(5) of this section or the formula test in paragraph (c)(7) of this 
section.
    (5) Asset test. The transfer satisfies the asset test if it meets 
the requirements of paragraphs (c)(5)(i), (ii) and (iii) of this 
section.
    (i) At the time of the transfer, and at the close of each of the 
transferee's two fiscal years preceding the transferee's fiscal year of 
transfer, the transferee's gross assets for financial reporting purposes 
exceed $100 million and its net assets for financial reporting purposes 
exceed $10 million. For purposes of the preceding sentence, the gross 
assets and net assets of a transferee do not include any obligation of 
any related person (as defined in paragraph (c)(6)(ii) of this section) 
or any other asset if a principal purpose for holding or acquiring the 
other asset is to permit the transferee to satisfy the conditions of 
this paragraph (c)(5)(i).
    (ii) The transferee must be an eligible corporation (defined in 
paragraph (c)(6)(i) of this section) and must agree in writing that any 
subsequent transfer

[[Page 113]]

of the interest will be to another eligible corporation in a transaction 
that satisfies paragraphs (c)(4)(i), (ii), and (iii) and this paragraph 
(c)(5). The direct or indirect transfer of the residual interest to a 
foreign permanent establishment (within the meaning of an applicable 
income tax treaty) of a domestic corporation is a transfer that is not a 
transfer to an eligible corporation. A transfer also fails to meet the 
requirements of this paragraph (c)(5)(ii) if the transferor knows, or 
has reason to know, that the transferee will not honor the restrictions 
on subsequent transfers of the residual interest.
    (iii) A reasonable person would not conclude, based on the facts and 
circumstances known to the transferor on or before the date of the 
transfer, that the taxes associated with the residual interest will not 
be paid. The consideration given to the transferee to acquire the 
noneconomic residual interest in the REMIC is only one factor to be 
considered, but the transferor will be deemed to know that the 
transferee cannot or will not pay if the amount of consideration is so 
low compared to the liabilities assumed that a reasonable person would 
conclude that the taxes associated with holding the residual interest 
will not be paid. In determining whether the amount of consideration is 
too low, the specific terms of the formula test in paragraph (c)(7) of 
this section need not be used.
    (6) Definitions for asset test. The following definitions apply for 
purposes of paragraph (c)(5) of this section:
    (i) Eligible corporation means any domestic C corporation (as 
defined in section 1361(a)(2)) other than--
    (A) A corporation which is exempt from, or is not subject to, tax 
under section 11;
    (B) An entity described in section 851(a) or 856(a);
    (C) A REMIC; or
    (D) An organization to which part I of subchapter T of chapter 1 of 
subtitle A of the Internal Revenue Code applies.
    (ii) Related person is any person that--
    (A) Bears a relationship to the transferee enumerated in section 
267(b) or 707(b)(1), using ``20 percent'' instead of ``50 percent'' 
where it appears under the provisions; or
    (B) Is under common control (within the meaning of section 52(a) and 
(b)) with the transferee.
    (7) Formula test. The transfer satisfies the formula test if the 
present value of the anticipated tax liabilities associated with holding 
the residual interest does not exceed the sum of--
    (i) The present value of any consideration given to the transferee 
to acquire the interest;
    (ii) The present value of the expected future distributions on the 
interest; and
    (iii) The present value of the anticipated tax savings associated 
with holding the interest as the REMIC generates losses.
    (8) Conditions and limitations on formula test. The following rules 
apply for purposes of the formula test in paragraph (c)(7) of this 
section.
    (i) The transferee is assumed to pay tax at a rate equal to the 
highest rate of tax specified in section 11(b)(1). If the transferee has 
been subject to the alternative minimum tax under section 55 in the 
preceding two years and will compute its taxable income in the current 
taxable year using the alternative minimum tax rate, then the tax rate 
specified in section 55(b)(1)(B) may be used in lieu of the highest rate 
specified in section 11(b)(1).
    (ii) The direct or indirect transfer of the residual interest to a 
foreign permanent establishment or fixed base (within the meaning of an 
applicable income tax treaty) of a domestic transferee is not eligible 
for the formula test.
    (iii) Present values are computed using a discount rate equal to the 
Federal short-term rate prescribed by section 1274(d) for the month of 
the transfer and the compounding period used by the taxpayer.
    (9) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Transfer to partnership. X transfers a noneconomic 
residual interest in a REMIC to Partnership P in a transaction that does 
not satisfy the formula test of paragraph (c)(7) of this section. Y and 
Z are the partners of P. Even if Y and Z are eligible corporations that 
satisfy the requirements of paragraph (c)(5)(i) of this section, the 
transfer fails to satisfy the asset test requirements found in paragraph 
(c)(5)(ii) of this section because P is a partnership rather

[[Page 114]]

than an eligible corporation within the meaning of (c)(6)(i) of this 
section.
    Example 2. Transfer to a corporation without capacity to carry 
additional residual interests. During the first ten months of a year, 
Bank transfers five residual interests to Corporation U under 
circumstances meeting the requirements of the asset test in paragraph 
(c)(5) of this section. Bank is the major creditor of U and consequently 
has access to U's financial records and has knowledge of U's financial 
circumstances. During the last month of the year, Bank transfers three 
additional residual interests to U in a transaction that does not meet 
the formula test of paragraph (c)(7) of this section. At the time of 
this transfer, U's financial records indicate it has retained the 
previously transferred residual interests. U's financial circumstances, 
including the aggregate tax liabilities it has assumed with respect to 
REMIC residual interests, would cause a reasonable person to conclude 
that U will be unable to meet its tax liabilities when due. The 
transfers in the last month of the year fail to satisfy the 
investigation requirement in paragraph (c)(4)(i) of this section and the 
asset test requirement of paragraph (c)(5)(iii) of this section because 
Bank has reason to know that U will not be able to pay the tax due on 
those interests.
    Example 3. Transfer to a foreign permanent establishment of an 
eligible corporation. R transfers a noneconomic residual interest in a 
REMIC to the foreign permanent establishment of Corporation T. Solely 
because of paragraph (c)(8)(ii) of this section, the transfer does not 
satisfy the formula test of paragraph (c)(7) of this section. In 
addition, even if T is an eligible corporation, the transfer does not 
satisfy the asset test because the transfer fails the requirements of 
paragraph (c)(5)(ii) of this section.

    (10) Effective dates. Paragraphs (c)(4) through (c)(9) of this 
section are applicable to transfers occurring on or after February 4, 
2000, except for paragraphs (c)(4)(iii) and (c)(8)(iii) of this section, 
which are applicable for transfers occurring on or after August 19, 
2002. For the dates of applicability of paragraphs (a) through (c)(3) 
and (d) of this section, see Sec.  1.860A-1.
    (d) Transfers to foreign persons. Paragraph (c) of this section does 
not apply to transfers of residual interests to which Sec.  1.860G-
3(a)(1), concerning transfers to certain foreign persons, applies.

[T.D. 8458, 57 FR 61302, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993; T.D. 
9004, 67 FR 47453, July 19, 2002]



Sec.  1.860E-2  Tax on transfers of residual interests 
to certain organizations.

    (a) Transfers to disqualified organizations--(1) Payment of tax. Any 
excise tax due under section 860E(e)(1) must be paid by the later of 
March 24, 1993, or April 15th of the year following the calendar year in 
which the residual interest is transferred to a disqualified 
organization. The Commissioner may prescribe rules for the manner and 
method of collecting the tax.
    (2) Transitory ownership. For purposes of section 860E (e) and this 
section, a transfer of a residual interest to a disqualified 
organization in connection with the formation of a REMIC is disregarded 
if the disqualified organization has a binding contract to sell the 
interest and the sale occurs within 7 days of the startup day (as 
defined in section 860G(a)(9) and Sec.  1.860G-2(k)).
    (3) Anticipated excess inclusions. The anticipated excess inclusions 
are the excess inclusions that are expected to accrue in each calendar 
quarter (or portion thereof) following the transfer of the residual 
interest. The anticipated excess inclusions must be determined as of the 
date the residual interest is transferred and must be based on--
    (i) Events that have occurred up to the time of the transfer;
    (ii) The prepayment and reinvestment assumptions adopted under 
section 1272(a)(6), or that would have been adopted had the REMIC's 
regular interests been issued with original issue discount; and
    (iii) Any required or permitted clean up calls, or required 
qualified liquidation provided for in the REMIC's organizational 
documents.
    (4) Present value computation. The present value of the anticipated 
excess inclusions is determined by discounting the anticipated excess 
inclusions from the end of each remaining calendar quarter in which 
those excess inclusions are expected to accrue to the date the 
disqualified organization acquires the residual interest. The discount 
rate to be used for this present value computation is the applicable 
Federal rate (as specified in section 1274(d)(1)) that would apply to a 
debt instrument that was issued on the date the disqualified 
organization acquired

[[Page 115]]

the residual interest and whose term ended on the close of the last 
quarter in which excess inclusions were expected to accrue with respect 
to the residual interest.
    (5) Obligation of REMIC to furnish information. A REMIC is not 
obligated to determine if its residual interests have been transferred 
to a disqualified organization. However, upon request of a person 
designated in section 860E(e)(3), the REMIC must furnish information 
sufficient to compute the present value of the anticipated excess 
inclusions. The information must be furnished to the requesting party 
and to the Internal Revenue Service within 60 days of the request. A 
reasonable fee charged to the requestor is not income derived from a 
prohibited transaction within the meaning of section 860F(a).
    (6) Agent. For purposes of section 860E(e)(3), the term ``agent'' 
includes a broker (as defined in section 6045(c) and Sec.  1.6045-
1(a)(1)), nominee, or other middleman.
    (7) Relief from liability--(i) Transferee furnishes information 
under penalties of perjury. For purposes of section 860E(e)(4), a 
transferee is treated as having furnished an affidavit if the transferee 
furnishes--
    (A) A social security number, and states under penalties of perjury 
that the social security number is that of the transferee; or
    (B) A statement under penalties of perjury that it is not a 
disqualified organization.
    (ii) Amount required to be paid. The amount required to be paid 
under section 860E(e)(7)(B) is equal to the product of the highest rate 
specified in section 11(b)(1) for the taxable year in which the transfer 
described in section 860E(e)(1) occurs and the amount of excess 
inclusions that accrued and were allocable to the residual interest 
during the period that the disqualified organization held the interest.
    (b) Tax on pass-thru entities--(1) Tax on excess inclusions. Any tax 
due under section 860E(e)(6) must be paid by the later of March 24, 
1993, or by the fifteenth day of the fourth month following the close of 
the taxable year of the pass-thru entity in which the disqualified 
person is a record holder. The Commissioner may prescribe rules for the 
manner and method of collecting the tax.
    (2) Record holder furnishes information under penalties of perjury. 
For purposes of section 860E(e)(6)(D), a record holder is treated as 
having furnished an affidavit if the record holder furnishes--
    (i) A social security number and states, under penalties of perjury, 
that the social security number is that of the record holder; or
    (ii) A statement under penalties of perjury that it is not a 
disqualified organization.
    (3) Deductibility of tax. Any tax imposed on a pass-thru entity 
pursuant to section 860E(e)(6)(A) is deductible against the gross amount 
of ordinary income of the pass-thru entity. For example, in the case of 
a REIT, the tax is deductible in determining real estate investment 
trust taxable income under section 857(b)(2).
    (4) Allocation of tax. Dividends paid by a RIC or by a REIT are not 
preferential dividends within the meaning of section 562(c) solely 
because the tax expense incurred by the RIC or REIT under section 
860E(e)(6) is allocated solely to the shares held by disqualified 
organizations.

[T.D. 8458, 57 FR 61304, Dec. 24, 1992]



Sec.  1.860F-1  Qualified liquidations.

    A plan of liquidation need not be in any special form. If a REMIC 
specifies the first day in the 90-day liquidation period in a statement 
attached to its final return, then the REMIC will be considered to have 
adopted a plan of liquidation on the specified date.

[T.D. 8458, 57 FR 61304, Dec. 24, 1992]



Sec.  1.860F-2  Transfers to a REMIC.

    (a) Formation of a REMIC--(1) In general. For Federal income tax 
purposes, a REMIC formation is characterized as the contribution of 
assets by a sponsor (as defined in paragraph (b)(1) of this section) to 
a REMIC in exchange for REMIC regular and residual interests. If, 
instead of exchanging its interest in mortgages and related assets for 
regular and residual interests, the sponsor arranges to have the REMIC 
issue some or all of the regular and residual interests for cash, after 
which the sponsor

[[Page 116]]

sells its interests in mortgages and related assets to the REMIC, the 
transaction is, nevertheless, viewed for Federal income tax purposes as 
the sponsor's exchange of mortgages and related assets for regular and 
residual interests, followed by a sale of some or all of those 
interests. The purpose of this rule is to ensure that the tax 
consequences associated with the formation of a REMIC are not affected 
by the actual sequence of steps taken by the sponsor.
    (2) Tiered arrangements--(i) Two or more REMICs formed pursuant to a 
single set of organizational documents. Two or more REMICs can be 
created pursuant to a single set of organizational documents even if for 
state law purposes or for Federal securities law purposes those 
documents create only one organization. The organizational documents 
must, however, clearly and expressly identify the assets of, and the 
interests in, each REMIC, and each REMIC must satisfy all of the 
requirements of section 860D and the related regulations.
    (ii) A REMIC and one or more investment trusts formed pursuant to a 
single set of documents. A REMIC (or two or more REMICs) and one or more 
investment trusts can be created pursuant to a single set of 
organizational documents and the separate existence of the REMIC(s) and 
the investment trust(s) will be respected for Federal income tax 
purposes even if for state law purposes or for Federal securities law 
purposes those documents create only one organization. The 
organizational documents for the REMIC(s) and the investment trust(s) 
must, however, require both the REMIC(s) and the investment trust(s) to 
account for items of income and ownership of assets for Federal tax 
purposes in a manner that respects the separate existence of the 
multiple entities. See Sec.  1.860G-2(i) concerning issuance of regular 
interests coupled with other contractual rights for an illustration of 
the provisions of this paragraph.
    (b) Treatment of sponsor--(1) Sponsor defined. A sponsor is a person 
who directly or indirectly exchanges qualified mortgages and related 
assets for regular and residual interests in a REMIC. A person 
indirectly exchanges interests in qualified mortgages and related assets 
for regular and residual interests in a REMIC if the person transfers, 
other than in a nonrecognition transaction, the mortgages and related 
assets to another person who acquires a transitory ownership interest in 
those assets before exchanging them for interests in the REMIC, after 
which the transitory owner then transfers some or all of the interests 
in the REMIC to the first person.
    (2) Nonrecognition of gain or loss. The sponsor does not recognize 
gain or loss on the direct or indirect transfer of any property to a 
REMIC in exchange for regular or residual interests in the REMIC. 
However, the sponsor, upon a subsequent sale of the REMIC regular or 
residual interests, may recognize gain or loss with respect to those 
interests.
    (3) Basis of contributed assets allocated among interests--(i) In 
general. The aggregate of the adjusted bases of the regular and residual 
interests received by the sponsor in the exchange described in paragraph 
(a) of this section is equal to the aggregate of the adjusted bases of 
the property transferred by the sponsor in the exchange, increased by 
the amount of organizational expenses (as described in paragraph 
(b)(3)(ii) of this section). That total is allocated among all the 
interests received in proportion to their fair market values on the 
pricing date (as defined in paragraph (b)(3)(iii) of this section) if 
any, or, if none, the startup day (as defined in section 860G(a)(9) and 
Sec.  1.860G-2(k)).
    (ii) Organizational expenses--(A) Organizational expense defined. An 
organizational expense is an expense that is incurred by the sponsor or 
by the REMIC and that is directly related to the creation of the REMIC. 
Further, the organizational expense must be incurred during a period 
beginning a reasonable time before the startup day and ending before the 
date prescribed by law for filing the first REMIC tax return (determined 
without regard to any extensions of time to file). The following are 
examples of organizational expenses: legal fees for services related to 
the formation of the REMIC, such as preparation of a pooling and 
servicing agreement and trust indenture; accounting

[[Page 117]]

fees related to the formation of the REMIC; and other administrative 
costs related to the formation of the REMIC.
    (B) Syndication expenses. Syndication expenses are not 
organizational expenses. Syndication expenses are those expenses 
incurred by the sponsor or other person to market the interests in a 
REMIC, and, thus, are applied to reduce the amount realized on the sale 
of the interests. Examples of syndication expenses are brokerage fees, 
registration fees, fees of an underwriter or placement agent, and 
printing costs of the prospectus or placement memorandum and other 
selling or promotional material.
    (iii) Pricing date. The term ``pricing date'' means the date on 
which the terms of the regular and residual interests are fixed and the 
prices at which a substantial portion of the regular interests will be 
sold are fixed.
    (4) Treatment of unrecognized gain or loss--(i) Unrecognized gain on 
regular interests. For purposes of section 860F(b)(1)(C)(i), the sponsor 
must include in gross income the excess of the issue price of a regular 
interest over the sponsor's basis in the interest as if the excess were 
market discount (as defined in section 1278(a)(2)) on a bond and the 
sponsor had made an election under section 1278(b) to include this 
market discount currently in gross income. The sponsor is not, however, 
by reason of this paragraph (b)(4)(i), deemed to have made an election 
under section 1278(b) with respect to any other bonds.
    (ii) Unrecognized loss on regular interests. For purposes of section 
860F(b)(1)(D)(i), the sponsor treats the excess of the sponsor's basis 
in a regular interest over the issue price of the interest as if that 
excess were amortizable bond premium (as defined in section 171(b)) on a 
taxable bond and the sponsor had made an election under section 171(c). 
The sponsor is not, however, by reason of this paragraph (b)(4)(ii), 
deemed to have made an election under section 171(c) with respect to any 
other bonds.
    (iii) Unrecognized gain on residual interests. For purposes of 
section 860F(b)(1)(C)(ii), the sponsor must include in gross income the 
excess of the issue price of a residual interest over the sponsor's 
basis in the interest ratably over the anticipated weighted average life 
of the REMIC (as defined in Sec.  1.860E-1(a)(3)(iv)).
    (iv) Unrecognized loss on residual interests. For purposes of 
section 860F(b)(1)(D)(ii), the sponsor deducts the excess of the 
sponsor's basis in a residual interest over the issue price of the 
interest ratably over the anticipated weighted average life of the 
REMIC.
    (5) Additions to or reductions of the sponsor's basis. The sponsor's 
basis in a regular or residual interest is increased by any amount 
included in the sponsor's gross income under paragraph (b)(4) of this 
section. The sponsor's basis in a regular or residual interest is 
decreased by any amount allowed as a deduction and by any amount applied 
to reduce interest payments to the sponsor under paragraph (b)(4)(ii) of 
this section.
    (6) Transferred basis property. For purposes of paragraph (b)(4) of 
this section, a transferee of a regular or residual interest is treated 
in the same manner as the sponsor to the extent that the basis of the 
transferee in the interest is determined in whole or in part by 
reference to the basis of the interest in the hands of the sponsor.
    (c) REMIC's basis in contributed assets. For purposes of section 
860F(b)(2), the aggregate of the REMIC's bases in the assets contributed 
by the sponsor to the REMIC in a transaction described in paragraph (a) 
of this section is equal to the aggregate of the issue prices 
(determined under section 860G(a)(10) and Sec.  1.86G-1(d)) of all 
regular and residual interests in the REMIC.

[T.D. 8458, 57 FR 61304, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993]



Sec.  1.860F-4  REMIC reporting requirements and other administrative rules.

    (a) In general. Except as provided in paragraph (c) of this section, 
for purposes of subtitle F of the Internal Revenue Code, a REMIC is 
treated as a partnership and any holder of a residual interest in the 
REMIC is treated as a partner. A REMIC is not subject, however, to the 
rules of subchapter C of chapter 63 of the Internal Revenue

[[Page 118]]

Code, relating to the treatment of partnership items, for a taxable year 
if there is at no time during the taxable year more than one holder of a 
residual interest in the REMIC. The identity of a holder of a residual 
interest in a REMIC is not treated as a partnership item with respect to 
the REMIC for purposes of subchapter C of chapter 63.
    (b) REMIC tax return--(1) In general. To satisfy the requirement 
under section 6031 to make a return of income for each taxable year, a 
REMIC must file the return required by paragraph (b)(2) of this section. 
The due date and any extensions for filing the REMIC's annual return are 
determined as if the REMIC were a partnership.
    (2) Income tax return. The REMIC must make a return, as required by 
section 6011(a), for each taxable year on Form 1066, U.S. Real Estate 
Mortgage Investment Conduit Income Tax Return. The return must include--
    (i) The amount of principal outstanding on each class of regular 
interests as of the close of the taxable year,
    (ii) The amount of the daily accruals determined under section 
860E(c), and
    (iii) The information specified in Sec.  1.860D-1(d)(2) (i), (iv), 
and (v).
    (c) Signing of REMIC return--(1) In general. Although a REMIC is 
generally treated as a partnership for purposes of subtitle F, for 
purposes of determining who is authorized to sign a REMIC's income tax 
return for any taxable year, the REMIC is not treated as a partnership 
and the holders of residual interests in the REMIC are not treated as 
partners. Rather, the REMIC return must be signed by a person who could 
sign the return of the entity absent the REMIC election. Thus, the 
return of a REMIC that is a corporation or trust under applicable State 
law must be signed by a corporate officer or a trustee, respectively. 
The return of a REMIC that consists of a segregated pool of assets must 
be signed by a person who could sign the return of the entity that owns 
the assets of the REMIC under applicable State law.
    (2) REMIC whose startup day is before November 10, 1988--(i) In 
general. The income tax return of a REMIC whose startup day is before 
November 10, 1988, may be signed by any person who held a residual 
interest during the taxable year to which the return relates, or, as 
provided in section 6903, by a fiduciary, as defined in section 
7701(a)(6), who is acting for the REMIC and who has furnished adequate 
notice in the manner prescribed in Sec.  301.6903-1(b) of this chapter.
    (ii) Startup day. For purposes of paragraph (c)(2) of this section, 
startup day means any day selected by a REMIC that is on or before the 
first day on which interests in such REMIC are issued.
    (iii) Exception. A REMIC whose startup day is before November 10, 
1988, may elect to have paragraph (c)(1) of this section apply, instead 
of paragraph (c)(2) of this section, in determining who is authorized to 
sign the REMIC return. See section 1006(t)(18)(B) of the Technical and 
Miscellaneous Revenue Act of 1988 (102 Stat. 3426) and Sec.  5h.6(a)(1) 
of this chapter for the time and manner for making this election.
    (d) Designation of tax matters person. A REMIC may designate a tax 
matters person in the same manner in which a partnership may designate a 
tax matters partner under Sec.  301.6231(a)(7)-1T of this chapter. For 
purposes of applying that section, all holders of residual interests in 
the REMIC are treated as general partners.
    (e) Notice to holders of residual interests--(1) Information 
required. As of the close of each calendar quarter, a REMIC must provide 
to each person who held a residual interest in the REMIC during that 
quarter notice on Schedule Q (Form 1066) of information specified in 
paragraphs (e)(1) (i) and (ii) of this section.
    (i) In general. Each REMIC must provide to each of its residual 
interest holders the following information--
    (A) That person's share of the taxable income or net loss of the 
REMIC for the calendar quarter;
    (B) The amount of the excess inclusion (as defined in section 860E 
and the regulations thereunder), if any, with respect to that person's 
residual interest for the calendar quarter;
    (C) If the holder of a residual interest is also a pass-through 
interest holder (as defined in Sec.  1.67-3T(a)(2)), the allocable 
investment expenses (as defined in Sec.  1.67-3T(a)(4)) for the calendar 
quarter, and

[[Page 119]]

    (D) Any other information required by Schedule Q (Form 1066).
    (ii) Information with respect to REMIC assets--(A) 95 percent asset 
test. For calendar quarters after 1988, each REMIC must provide to each 
of its residual interest holders the following information--
    (1) The percentage of REMIC assets that are qualifying real property 
loans under section 593,
    (2) The percentage of REMIC assets that are assets described in 
section 7701(a)(19), and
    (3) The percentage of REMIC assets that are real estate assets 
defined in section 856(c)(6)(B), computed by reference to the average 
adjusted basis (as defined in section 1011) of the REMIC assets during 
the calendar quarter (as described in paragraph (e)(1)(iii) of this 
section). If the percentage of REMIC assets represented by a category is 
at least 95 percent, then the REMIC need only specify that the 
percentage for that category was at least 95 percent.
    (B) Additional information required if the 95 percent test not met. 
If, for any calendar quarter after 1988, less than 95 percent of the 
assets of the REMIC are real estate assets defined in section 
856(c)(6)(B), then, for that calendar quarter, the REMIC must also 
provide to any real estate investment trust (REIT) that holds a residual 
interest the following information--
    (1) The percentage of REMIC assets described in section 
856(c)(5)(A), computed by reference to the average adjusted basis of the 
REMIC assets during the calendar quarter (as described in paragraph 
(e)(1)(iii) of this section),
    (2) The percentage of REMIC gross income (other than gross income 
from prohibited transactions defined in section 860F(a)(2)) described in 
section 856(c)(3)(A) through (E), computed as of the close of the 
calendar quarter, and
    (3) The percentage of REMIC gross income (other than gross income 
from prohibited transactions defined in section 860F(a)(2)) described in 
section 856(c)(3)(F), computed as of the close of the calendar quarter. 
For purposes of this paragraph (e)(1)(ii)(B)(3), the term ``foreclosure 
property'' contained in section 856(c)(3)(F) has the meaning specified 
in section 860G(a)(8).


In determining whether a REIT satisfies the limitations of section 
856(c)(2), all REMIC gross income is deemed to be derived from a source 
specified in section 856(c)(2).
    (C) For calendar quarters in 1987. For calendar quarters in 1987, 
the percentages of assets required in paragraphs (e)(1)(ii) (A) and (B) 
of this section may be computed by reference to the fair market value of 
the assets of the REMIC as of the close of the calendar quarter (as 
described in paragraph (e)(1)(iii) of this section), instead of by 
reference to the average adjusted basis during the calendar quarter.
    (D) For calendar quarters in 1988 and 1989. For calendar quarters in 
1988 and 1989, the percentages of assets required in paragraphs 
(e)(1)(ii) (A) and (B) of this section may be computed by reference to 
the average fair market value of the assets of the REMIC during the 
calendar quarter (as described in paragraph (e)(1)(iii) of this 
section), instead of by reference to the average adjusted basis of the 
assets of the REMIC during the calendar quarter.
    (iii) Special provisions. For purposes of paragraph (e)(1)(ii) of 
this section, the percentage of REMIC assets represented by a specified 
category computed by reference to average adjusted basis (or fair market 
value) of the assets during a calendar quarter is determined by dividing 
the average adjusted bases (or for calendar quarters before 1990, fair 
market value) of the assets in the specified category by the average 
adjusted basis (or, for calendar quarters before 1990, fair market 
value) of all the assets of the REMIC as of the close of each month, 
week, or day during that calendar quarter. The monthly, weekly, or daily 
computation period must be applied uniformly during the calendar quarter 
to all categories of assets and may not be changed in succeeding 
calendar quarters without the consent of the Commissioner.
    (2) Quarterly notice required--(i) In general. Schedule Q must be 
mailed (or otherwise delivered) to each holder of a residual interest 
during a calendar quarter no later than the last day of the month 
following the close of the calendar quarter.
    (ii) Special rule for 1987. Notice to any holder of a REMIC residual 
interest of

[[Page 120]]

the information required in paragraph (e)(1) of this section for any of 
the four calendar quarters of 1987 must be mailed (or otherwise 
delivered) to each holder no later than March 28, 1988.
    (3) Nominee reporting--(i) In general. If a REMIC is required under 
paragraphs (e) (1) and (2) of this section to provide notice to an 
interest holder who is a nominee of another person with respect to an 
interest in the REMIC, the nominee must furnish that notice to the 
person for whom it is a nominee.
    (ii) Time for furnishing statement. The nominee must furnish the 
notice required under paragraph (e)(3)(i) of this section to the person 
for whom it is a nominee no later than 30 days after receiving this 
information.
    (4) Reports to the Internal Revenue Service. For each person who was 
a residual interest holder at any time during a REMIC's taxable year, 
the REMIC must attach a copy of Schedule Q to its income tax return for 
that year for each quarter in which that person was a residual interest 
holder. Quarterly notice to the Internal Revenue Service is not 
required.
    (f) Information returns for persons engaged in a trade or business. 
See Sec.  1.6041-1(b)(2) for the treatment of a REMIC under sections 
6041 and 6041A.

[T.D. 8366, 56 FR 49516, Sept. 30, 1991, as amended by T.D. 8458, 57 FR 
61306, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993; T.D. 9184, 70 FR 9219, 
Feb. 25, 2005]



Sec.  1.860G-1  Definition of regular and residual interests.

    (a) Regular interest--(1) Designation as a regular interest. For 
purposes of section 860G(a)(1), a REMIC designates an interest as a 
regular interest by providing to the Internal Revenue Service the 
information specified in Sec.  1.860D-1(d)(2)(ii) in the time and manner 
specified in Sec.  1.860D-1(d)(2).
    (2) Specified portion of the interest payments on qualified 
mortgages--(i) In general. For purposes of section 860G(a)(1)(B)(ii), a 
specified portion of the interest payments on qualified mortgages means 
a portion of the interest payable on qualified mortgages, but only if 
the portion can be expressed as--
    (A) A fixed percentage of the interest that is payable at either a 
fixed rate or at a variable rate described in paragraph (a)(3) of this 
section on some or all of the qualified mortgages;
    (B) A fixed number of basis points of the interest payable on some 
or all of the qualified mortgages; or
    (C) The interest payable at either a fixed rate or at a variable 
rate described in paragraph (a)(3) of this section on some or all of the 
qualified mortgages in excess of a fixed number of basis points or in 
excess of a variable rate described in paragraph (a)(3) of this section.
    (ii) Specified portion cannot vary. The portion must be established 
as of the startup day (as defined in section 860G(a)(9) and Sec.  
1.860G-2(k)) and, except as provided in paragraph (a)(2)(iii) of this 
section, it cannot vary over the period that begins on the startup day 
and ends on the day that the interest holder is no longer entitled to 
receive payments.
    (iii) Defaulted or delinquent mortgages. A portion is not treated as 
varying over time if an interest holder's entitlement to a portion of 
the interest on some or all of the qualified mortgages is dependent on 
the absence of defaults or delinquencies on those mortgages.
    (iv) No minimum specified principal amount is required. If an 
interest in a REMIC consists of a specified portion of the interest 
payments on the REMIC's qualified mortgages, no minimum specified 
principal amount need be assigned to that interest. The specified 
principal amount can be zero.
    (v) Specified portion includes portion of interest payable on 
regular interest. (A) The specified portions that meet the requirements 
of paragraph (a)(2)(i) of this section include a specified portion that 
can be expressed as a fixed percentage of the interest that is payable 
on some or all of the qualified mortgages where--
    (1) Each of those qualified mortgages is a regular interest issued 
by another REMIC; and
    (2) With respect to that REMIC in which it is a regular interest, 
each of those regular interests bears interest that can be expressed as 
a specified portion as described in paragraph (a)(2)(i)(A), (B), or (C) 
of this section.
    (B) See Sec.  1.860A-1(a) for the effective date of this paragraph 
(a)(2)(v).

[[Page 121]]

    (vi) Examples. The following examples, each of which describes a 
pass-thru trust that is intended to qualify as a REMIC, illustrate the 
provisions of this paragraph (a)(2).

    Example 1. (i) A sponsor transferred a pool of fixed rate mortgages 
to a trustee in exchange for two classes of certificates. The Class A 
certificate holders are entitled to all principal payments on the 
mortgages and to interest on outstanding principal at a variable rate 
based on the current value of One-Month LIBOR, subject to a lifetime cap 
equal to the weighted average rate payable on the mortgages. The Class B 
certificate holders are entitled to all interest payable on the 
mortgages in excess of the interest paid on the Class A certificates. 
The Class B certificates are subordinate to the Class A certificates so 
that cash flow shortfalls due to defaults or delinquencies on the 
mortgages will be borne first by the Class B certificate holders.
    (ii) The Class B certificate holders are entitled to all interest 
payable on the pooled mortgages in excess of a variable rate described 
in paragraph (a)(3)(vi) of this section. Moreover, the portion of the 
interest payable to the Class B certificate holders is not treated as 
varying over time solely because payments on the Class B certificates 
may be reduced as a result of defaults or delinquencies on the pooled 
mortgages. Thus, the Class B certificates provide for interest payments 
that consist of a specified portion of the interest payable on the 
pooled mortgages under paragraph (a)(2)(i)(C) of this section.
    Example 2. (i) A sponsor transferred a pool of variable rate 
mortgages to a trustee in exchange for two classes of certificates. The 
mortgages call for interest payments at a variable rate based on the 
current value of the One-Year Constant Maturity Treasury Index 
(hereinafter ``CMTI'') plus 200 basis points, subject to a lifetime cap 
of 12 percent. Class C certificate holders are entitled to all principal 
payments on the mortgages and interest on the outstanding principal at a 
variable rate based on the One-Year CMTI plus 100 basis points, subject 
to a lifetime cap of 12 percent. The interest rate on the Class C 
certificates is reset at the same time the rate is reset on the pooled 
mortgages.
    (ii) The Class D certificate holders are entitled to all interest 
payments on the mortgages in excess of the interest paid on the Class C 
certificates. So long as the One-Year CMTI is at 10 percent or lower, 
the Class D certificate holders are entitled to 100 basis points of 
interest on the pooled mortgages. If, however, the index exceeds 10 
percent on a reset date, the Class D certificate holders' entitlement 
shrinks, and it disappears if the index is at 11 percent or higher.
    (iii) The Class D certificate holders are entitled to all interest 
payable on the pooled mortgages in excess of a qualified variable rate 
described in paragraph (a)(3) of this section. Thus, the Class D 
certificates provide for interest payments that consist of a specified 
portion of the interest payable on the qualified mortgages under 
paragraph (a)(2)(i)(C) of this section.
    Example 3. (i) A sponsor transferred a pool of fixed rate mortgages 
to a trustee in exchange for two classes of certificates. The fixed 
interest rate payable on the mortgages varies from mortgage to mortgage, 
but all rates are between 8 and 10 percent. The Class E certificate 
holders are entitled to receive all principal payments on the mortgages 
and interest on outstanding principal at 7 percent. The Class F 
certificate holders are entitled to receive all interest on the 
mortgages in excess of the interest paid on the Class E certificates.
    (ii) The Class F certificates provide for interest payments that 
consist of a specified portion of the interest payable on the mortgages 
under paragraph (a)(2)(i) of this section. Although the portion of the 
interest payable to the Class F certificate holders varies from mortgage 
to mortgage, the interest payable can be expressed as a fixed percentage 
of the interest payable on each particular mortgage.

    (3) Variable rate. A regular interest may bear interest at a 
variable rate. For purposes of section 860G(a)(1)(B)(i), a variable rate 
of interest is a rate described in this paragraph (a)(3).
    (i) Rate based on current interest rate. A qualified floating rate 
as defined in Sec.  1.1275-5(b)(1) (but without the application of 
paragraph (b)(2) or (3) of that section) set at a current value, as 
defined in Sec.  1.1275-5(a)(4), is a variable rate. In addition, a rate 
equal to the highest, lowest, or average of two or more qualified 
floating rates is a variable rate. For example, a rate based on the 
average cost of funds of one or more financial institutions is a 
variable rate.
    (ii) Weighted average rate--(A) In general. A rate based on a 
weighted average of the interest rates on some or all of the qualified 
mortgages held by a REMIC is a variable rate. The qualified mortgages 
taken into account must, however, bear interest at a fixed rate or at a 
rate described in this paragraph (a)(3). Generally, a weighted average 
interest rate is a rate that, if applied to the aggregate outstanding 
principal balance of a pool of mortgage loans for an accrual period, 
produces an amount of interest that equals the sum of the

[[Page 122]]

interest payable on the pooled loans for that accrual period. Thus, for 
an accrual period in which a pool of mortgage loans comprises $300,000 
of loans bearing a 7 percent interest rate and $700,000 of loans bearing 
a 9.5 percent interest rate, the weighted average rate for the pool of 
loans is 8.75 percent.
    (B) Reduction in underlying rate. For purposes of paragraph 
(a)(3)(ii)(A) of this section, an interest rate is considered to be 
based on a weighted average rate even if, in determining that rate, the 
interest rate on some or all of the qualified mortgages is first subject 
to a cap or a floor, or is first reduced by a number of basis points or 
a fixed percentage. A rate determined by taking a weighted average of 
the interest rates on the qualified mortgage loans net of any servicing 
spread, credit enhancement fees, or other expenses of the REMIC is a 
rate based on a weighted average rate for the qualified mortgages. 
Further, the amount of any rate reduction described above may vary from 
mortgage to mortgage.
    (iii) Additions, subtractions, and multiplications. A rate is a 
variable rate if it is--
    (A) Expressed as the product of a rate described in paragraph 
(a)(3)(i) or (ii) of this section and a fixed multiplier;
    (B) Expressed as a constant number of basis points more or less than 
a rate described in paragraph (a)(3)(i) or (ii) of this section; or
    (C) Expressed as the product, plus or minus a constant number of 
basis points, of a rate described in paragraph (a)(3)(i) or (ii) of this 
section and a fixed multiplier (which may be either a positive or a 
negative number).
    (iv) Caps and floors. A rate is a variable rate if it is a rate that 
would be described in paragraph (a)(3)(i) through (iii) of this section 
except that it is--
    (A) Limited by a cap or ceiling that establishes either a maximum 
rate or a maximum number of basis points by which the rate may increase 
from one accrual or payment period to another or over the term of the 
interest; or
    (B) Limited by a floor that establishes either a minimum rate or a 
maximum number of basis points by which the rate may decrease from one 
accrual or payment period to another or over the term of the interest.
    (v) Funds-available caps--(A) In general. A rate is a variable rate 
if it is a rate that would be described in paragraph (a)(3)(i) through 
(iv) of this section except that it is subject to a ``funds-available'' 
cap. A funds-available cap is a limit on the amount of interest to be 
paid on an instrument in any accrual or payment period that is based on 
the total amount available for the distribution, including both 
principal and interest received by an issuing entity on some or all of 
its qualified mortgages as well as amounts held in a reserve fund. The 
term ``funds-available cap'' does not, however, include any cap or limit 
on interest payments used as a device to avoid the standards of 
paragraph (a)(3)(i) through (iv) of this section.
    (B) Facts and circumstances test. In determining whether a cap or 
limit on interest payments is a funds-available cap within the meaning 
of this section and not a device used to avoid the standards of 
paragraph (a)(3)(i) through (iv) of this section, one must consider all 
of the facts and circumstances. Facts and circumstances that must be 
taken into consideration are--
    (1) Whether the rate of the interest payable to the regular interest 
holders is below the rate payable on the REMIC's qualified mortgages on 
the start-up day; and
    (2) Whether, historically, the rate of interest payable to the 
regular interest holders has been consistently below that payable on the 
qualified mortgages.
    (C) Examples. The following examples, both of which describe a pass-
thru trust that is intended to qualify as a REMIC, illustrate the 
provisions of this paragraph (a)(3)(v).

    Example 1. (i) A sponsor transferred a pool of mortgages to a 
trustee in exchange for two classes of certificates. The pool of 
mortgages has an aggregate principal balance of $100x. Each mortgage in 
the pool provides for interest payments based on the eleventh district 
cost of funds index (hereinafter COFI) plus a margin. The initial 
weighted average rate for the pool is COFI plus 200 basis points. The 
trust issued a Class X certificate that has a principal amount of $100x 
and that provides for interest payments at a rate equal to One-Year 
LIBOR plus 100 basis

[[Page 123]]

points, subject to a cap described below. The Class R certificate, which 
the sponsor designated as the residual interest, entitles its holder to 
all funds left in the trust after the Class X certificates have been 
retired. The Class R certificate holder is not entitled to current 
distributions.
    (ii) At the time the certificates were issued, COFI equalled 4.874 
percent and One-Year LIBOR equalled 3.375 percent. Thus, the initial 
weighted average pool rate was 6.874 percent and the Class X certificate 
rate was 4.375 percent. Based on historical data, the sponsor does not 
expect the rate paid on the Class X certificate to exceed the weighted 
average rate on the pool.
    (iii) Initially, under the terms of the trust instrument, the excess 
of COFI plus 200 over One-Year LIBOR plus 100 (excess interest) will be 
applied to pay expenses of the trust, to fund any required reserves, and 
then to reduce the principal balance on the Class X certificate. 
Consequently, although the aggregate principal balance of the mortgages 
initially matched the principal balance of the Class X certificate, the 
principal balance on the Class X certificate will pay down faster than 
the principal balance on the mortgages as long as the weighted average 
rate on the mortgages is greater than One-Year LIBOR plus 100. If, 
however, the rate on the Class X certificate (One-Year LIBOR plus 100) 
ever exceeds the weighted average rate on the mortgages, then the Class 
X certificate holders will receive One-Year LIBOR plus 100 subject to a 
cap based on the current funds that are available for distribution.
    (iv) The funds available cap here is not a device used to avoid the 
standards of paragraph (a)(3) (i) through (iv) of this section. First, 
on the date the Class X certificates were issued, a significant spread 
existed between the weighted average rate payable on the mortgages and 
the rate payable on the Class X certificate. Second, historical data 
suggest that the weighted average rate payable on the mortgages will 
continue to exceed the rate payable on the Class X certificate. Finally, 
because the excess interest will be applied to reduce the outstanding 
principal balance of the Class X certificate more rapidly than the 
outstanding principal balance on the mortgages is reduced, One-Year 
LIBOR plus 100 basis points would have to exceed the weighted average 
rate on the mortgages by an increasingly larger amount before the funds 
available cap would be triggered. Accordingly, the rate paid on the 
Class X certificates is a variable rate.
    Example 2. (i) The facts are the same as those in Example 1, except 
that the pooled mortgages are commercial mortgages that provide for 
interest payments based on the gross profits of the mortgagors, and the 
rate on the Class X certificates is 400 percent on One-Year LIBOR (a 
variable rate under paragraph (a)(3)(iii) of this section), subject to a 
cap equal to current funds available to the trustee for distribution.
    (ii) Initially, 400 percent of One-Year LIBOR exceeds the weighted 
average rate payable on the mortgages. Furthermore, historical data 
suggest that there is a significant possibility that, in the future, 400 
percent of One-Year LIBOR will exceed the weighted average rate on the 
mortgages.
    (iii) The facts and circumstances here indicate that the use of 400 
percent of One-Year LIBOR with the above-described cap is a device to 
pass through to the Class X certificate holder contingent interest based 
on mortgagor profits. Consequently, the rate paid on the Class X 
certificate here is not a variable rate.

    (vi) Combination of rates. A rate is a variable rate if it is based 
on--
    (A) One fixed rate during one or more accrual or payment periods and 
a different fixed rate or rates, or a rate or rates described in 
paragraph (a)(3) (i) through (v) of this section, during other accrual 
or payment periods; or
    (B) A rate described in paragraph (a)(3) (i) through (v) of this 
section during one or more accrual or payment periods and a fixed rate 
or rates, or a different rate or rates described in paragraph (a)(3) (i) 
through (v) of this section in other periods.
    (4) Fixed terms on the startup day. For purposes of section 
860G(a)(1), a regular interest in a REMIC has fixed terms on the startup 
day if, on the startup day, the REMIC's organizational documents 
irrevocably specify--
    (i) The principal amount (or other similar amount) of the regular 
interest;
    (ii) The interest rate or rates used to compute any interest 
payments (or other similar amounts) on the regular interest; and
    (iii) The latest possible maturity date of the interest.
    (5) Contingencies prohibited. Except for the contingencies specified 
in paragraph (b)(3) of this section, the principal amount (or other 
similar amount) and the latest possible maturity date of the interest 
must not be contingent.
    (b) Special rules for regular interests--(1) Call premium. An 
interest in a REMIC does not qualify as a regular interest if the terms 
of the interest entitle the holder of that interest to the payment of 
any premium that is determined with reference to the length of

[[Page 124]]

time that the regular interest is outstanding and is not described in 
paragraph (b)(2) of this section.
    (2) Customary prepayment penalties received with respect to 
qualified mortgages. An interest in a REMIC does not fail to qualify as 
a regular interest solely because the REMIC's organizational documents 
provide that the REMIC must allocate among and pay to its regular 
interest holders any customary prepayment penalties that the REMIC 
receives with respect to its qualified mortgages. Moreover, a REMIC may 
allocate prepayment penalties among its classes of interests in any 
manner specified in the REMIC's organizational documents. For example, a 
REMIC could allocate all or substantially all of a prepayment penalty 
that it receives to holders of an interest-only class of interests 
because that class would be most significantly affected by prepayments.
    (3) Certain contingencies disregarded. An interest in a REMIC does 
not fail to qualify as a regular interest solely because it is issued 
subject to some or all of the contingencies described in paragraph 
(b)(3) (i) through (vi) of this section.
    (i) Prepayments, income, and expenses. An interest does not fail to 
qualify as a regular interest solely because--
    (A) The timing of (but not the right to or amount of) principal 
payments (or other similar amounts) is affected by the extent of 
prepayments on some or all of the qualified mortgages held by the REMIC 
or the amount of income from permitted investments (as defined in Sec.  
1.860G-2(g)); or
    (B) The timing of interest and principal payments is affected by the 
payment of expenses incurred by the REMIC.
    (ii) Credit losses. An interest does not fail to qualify as a 
regular interest solely because the amount or the timing of payments of 
principal or interest (or other similar amounts) with respect to a 
regular interest is affected by defaults on qualified mortgages and 
permitted investments, unanticipated expenses incurred by the REMIC, or 
lower than expected returns on permitted investments.
    (iii) Subordinated interests. An interest does not fail to qualify 
as a regular interest solely because that interest bears all, or a 
disproportionate share, of the losses stemming from cash flow shortfalls 
due to defaults or delinquencies on qualified mortgages or permitted 
investments, unanticipated expenses incurred by the REMIC, lower than 
expected returns on permitted investments, or prepayment interest 
shortfalls before other regular interests or the residual interest bear 
losses occasioned by those shortfalls.
    (iv) Deferral of interest. An interest does not fail to qualify as a 
regular interest solely because that interest, by its terms, provides 
for deferral of interest payments.
    (v) Prepayment interest shortfalls. An interest does not fail to 
qualify as a regular interest solely because the amount of interest 
payments is affected by prepayments of the underlying mortgages.
    (vi) Remote and incidental contingencies. An interest does not fail 
to qualify as a regular interest solely because the amount or timing of 
payments of principal or interest (or other similar amounts) with 
respect to the interest is subject to a contingency if there is only a 
remote likelihood that the contingency will occur. For example, an 
interest could qualify as a regular interest even though full payment of 
principal and interest on that interest is contingent upon the absence 
of significant cash flow shortfalls due to the operation of the Soldiers 
and Sailors Civil Relief Act, 50 U.S.C. app. 526 (1988).
    (4) Form of regular interest. A regular interest in a REMIC may be 
issued in the form of debt, stock, an interest in a partnership or 
trust, or any other form permitted by state law. If a regular interest 
in a REMIC is not in the form of debt, it must, except as provided in 
paragraph (a)(2)(iv) of this section, entitle the holder to a specified 
amount that would, were the interest issued in debt form, be identified 
as the principal amount of the debt.
    (5) Interest disproportionate to principal--(i) In general. An 
interest in a REMIC does not qualify as a regular interest if the amount 
of interest (or other similar amount) payable to the holder is 
disproportionately high relative to the principal amount or other

[[Page 125]]

specified amount described in paragraph (b)(4) of this section 
(specified principal amount). Interest payments (or other similar 
amounts) are considered disproportionately high if the issue price (as 
determined under paragraph (d) of this section) of the interest in the 
REMIC exceeds 125 percent of its specified principal amount.
    (ii) Exception. A regular interest in a REMIC that entitles the 
holder to interest payments consisting of a specified portion of 
interest payments on qualified mortgages qualifies as a regular interest 
even if the amount of interest is disproportionately high relative to 
the specified principal amount.
    (6) Regular interest treated as a debt instrument for all Federal 
income tax purposes. In determining the tax under chapter 1 of the 
Internal Revenue Code, a REMIC regular interest (as defined in section 
860G(a)(1)) is treated as a debt instrument that is an obligation of the 
REMIC. Thus, sections 1271 through 1288, relating to bonds and other 
debt instruments, apply to a regular interest. For special rules 
relating to the accrual of original issue discount on regular interests, 
see section 1272(a)(6).
    (c) Residual interest. A residual interest is an interest in a REMIC 
that is issued on the startup day and that is designated as a residual 
interest by providing the information specified in Sec.  1.860D-
1(d)(2)(ii) at the time and in the manner provided in Sec.  1.860D-
1(d)(2). A residual interest need not entitle the holder to any 
distributions from the REMIC.
    (d) Issue price of regular and residual interests--(1) In general. 
The issue price of any REMIC regular or residual interest is determined 
under section 1273(b) as if the interest were a debt instrument and, if 
issued for property, as if the requirements of section 1273(b)(3) were 
met. Thus, if a class of interests is publicly offered, then the issue 
price of an interest in that class is the initial offering price to the 
public at which a substantial amount of the class is sold. If the 
interest is in a class that is not publicly offered, the issue price is 
the price paid by the first buyer of that interest regardless of the 
price paid for the remainder of the class. If the interest is in a class 
that is retained by the sponsor, the issue price is its fair market 
value on the pricing date (as defined in Sec.  1.860F-2(b)(3)(iii)), if 
any, or, if none, the startup day, regardless of whether the property 
exchanged therefor is publicly traded.
    (2) The public. The term ``the public'' for purposes of this section 
does not include brokers or other middlemen, nor does it include the 
sponsor who acquires all of the regular and residual interests from the 
REMIC on the startup day in a transaction described in Sec.  1.860F-
2(a).

[T.D. 8458, 57 FR 61306, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993; 58 FR 
15089, Mar. 19, 1993; T.D. 8614, 60 FR 42787, Aug. 17, 1995]



Sec.  1.860G-2  Other rules.

    (a) Obligations principally secured by an interest in real 
property--(1) Tests for determining whether an obligation is principally 
secured. For purposes of section 860G(a)(3)(A), an obligation is 
principally secured by an interest in real property only if it satisfies 
either the test set out in paragraph (a)(1)(i) or the test set out in 
paragraph (a)(1)(ii) of this section.
    (i) The 80-percent test. An obligation is principally secured by an 
interest in real property if the fair market value of the interest in 
real property securing the obligation--
    (A) Was at least equal to 80 percent of the adjusted issue price of 
the obligation at the time the obligation was originated (see paragraph 
(b)(1) of this section concerning the origination date for obligations 
that have been significantly modified); or
    (B) Is at least equal to 80 percent of the adjusted issue price of 
the obligation at the time the sponsor contributes the obligation to the 
REMIC.
    (ii) Alternative test. For purposes of section 860G(a)(3)(A), an 
obligation is principally secured by an interest in real property if 
substantially all of the proceeds of the obligation were used to acquire 
or to improve or protect an interest in real property that, at the 
origination date, is the only security for the obligation. For purposes 
of this test, loan guarantees made by the United States or any state (or 
any political subdivision, agency, or instrumentality of the United 
States or of any state), or other third party credit

[[Page 126]]

enhancement are not viewed as additional security for a loan. An 
obligation is not considered to be secured by property other than real 
property solely because the obligor is personally liable on the 
obligation.
    (2) Treatment of liens. For purposes of paragraph (a)(1)(i) of this 
section, the fair market value of the real property interest must be 
first reduced by the amount of any lien on the real property interest 
that is senior to the obligation being tested, and must be further 
reduced by a proportionate amount of any lien that is in parity with the 
obligation being tested.
    (3) Safe harbor--(i) Reasonable belief that an obligation is 
principally secured. If, at the time the sponsor contributes an 
obligation to a REMIC, the sponsor reasonably believes that the 
obligation is principally secured by an interest in real property within 
the meaning of paragraph (a)(1) of this section, then the obligation is 
deemed to be so secured for purposes of section 860G(a)(3). A sponsor 
cannot avail itself of this safe harbor with respect to an obligation if 
the sponsor actually knows or has reason to know that the obligation 
fails both of the tests set out in paragraph (a)(1) of this section.
    (ii) Basis for reasonable belief. For purposes of paragraph 
(a)(3)(i) of this section, a sponsor may base a reasonable belief 
concerning any obligation on--
    (A) Representations and warranties made by the originator of the 
obligation; or
    (B) Evidence indicating that the originator of the obligation 
typically made mortgage loans in accordance with an established set of 
parameters, and that any mortgage loan originated in accordance with 
those parameters would satisfy at least one of the tests set out in 
paragraph (a)(1) of this section.
    (iii) Later discovery that an obligation is not principally secured. 
If, despite the sponsor's reasonable belief concerning an obligation at 
the time it contributed the obligation to the REMIC, the REMIC later 
discovers that the obligation is not principally secured by an interest 
in real property, the obligation is a defective obligation and loses its 
status as a qualified mortgage 90 days after the date of discovery. See 
paragraph (f) of this section, relating to defective obligations.
    (4) Interests in real property; real property. The definition of 
``interests in real property'' set out in Sec.  1.856-3(c), and the 
definition of ``real property'' set out in Sec.  1.856-3(d), apply to 
define those terms for purposes of section 860G(a)(3) and paragraph (a) 
of this section.
    (5) Obligations secured by an interest in real property. Obligations 
secured by interests in real property include the following: mortgages, 
deeds of trust, and installment land contracts; mortgage pass-thru 
certificates guaranteed by GNMA, FNMA, FHLMC, or CMHC (Canada Mortgage 
and Housing Corporation); other investment trust interests that 
represent undivided beneficial ownership in a pool of obligations 
principally secured by interests in real property and related assets 
that would be considered to be permitted investments if the investment 
trust were a REMIC, and provided the investment trust is classified as a 
trust under Sec.  301.7701-4(c) of this chapter; and obligations secured 
by manufactured housing treated as single family residences under 
section 25(e)(10) (without regard to the treatment of the obligations or 
the properties under state law).
    (6) Obligations secured by other obligations; residual interests. 
Obligations (other than regular interests in a REMIC) that are secured 
by other obligations are not principally secured by interests in real 
property even if the underlying obligations are secured by interests in 
real property. Thus, for example, a collateralized mortgage obligation 
issued by an issuer that is not a REMIC is not an obligation principally 
secured by an interest in real property. A residual interest (as defined 
in section 860G(a)(2)) is not an obligation principally secured by an 
interest in real property.
    (7) Certain instruments that call for contingent payments are 
obligations. For purposes of section 860G(a)(3) and (4), the term 
``obligation'' includes any instrument that provides for total 
noncontingent principal payments that at least equal the instrument's 
issue price even if that instrument also provides for contingent 
payments. Thus, for example, an instrument that was issued

[[Page 127]]

for $100x and that provides for noncontingent principal payments of 
$100x, interest payments at a fixed rate, and contingent payments based 
on a percentage of the mortgagor's gross receipts, is an obligation.
    (8) Release of a lien on an interest in real property securing a 
qualified mortgage; defeasance. If a REMIC releases its lien on an 
interest in real property that secures a qualified mortgage, that 
mortgage ceases to be a qualified mortgage on the date the lien is 
released unless--
    (i) The REMIC releases its lien in a modification that--
    (A) Either is not a significant modification as defined in paragraph 
(b)(2) of this section or is one of the listed exceptions set forth in 
paragraph (b)(3) of this section; and
    (B) Following that modification, the obligation continues to be 
principally secured by an interest in real property as determined by 
paragraph (b)(7) of this section; or
    (ii) The mortgage is defeased in the following manner--
    (A) The mortgagor pledges substitute collateral that consists solely 
of government securities (as defined in section 2(a)(16) of the 
Investment Company Act of 1940 as amended (15 U.S.C. 80a-1));
    (B) The mortgage documents allow such a substitution;
    (C) The lien is released to facilitate the disposition of the 
property or any other customary commercial transaction, and not as part 
of an arrangement to collateralize a REMIC offering with obligations 
that are not real estate mortgages; and
    (D) The release is not within 2 years of the startup day.
    (9) Stripped bonds and coupons. The term ``qualified mortgage'' 
includes stripped bonds and stripped coupons (as defined in section 
1286(e) (2) and (3)) if the bonds (as defined in section 1286(e)(1)) 
from which such stripped bonds or stripped coupons arose would have been 
qualified mortgages.
    (b) Assumptions and modifications--(1) Significant modifications are 
treated as exchanges of obligations. If an obligation is significantly 
modified in a manner or under circumstances other than those described 
in paragraph (b)(3) of this section, then the modified obligation is 
treated as one that was newly issued in exchange for the unmodified 
obligation that it replaced. Consequently--
    (i) If such a significant modification occurs after the obligation 
has been contributed to the REMIC and the modified obligation is not a 
qualified replacement mortgage, the modified obligation will not be a 
qualified mortgage and the deemed disposition of the unmodified 
obligation will be a prohibited transaction under section 860F(a)(2); 
and
    (ii) If such a significant modification occurs before the obligation 
is contributed to the REMIC, the modified obligation will be viewed as 
having been originated on the date the modification occurs for purposes 
of the tests set out in paragraph (a)(1) of this section.
    (2) Significant modification defined. For purposes of paragraph 
(b)(1) of this section, a ``significant modification'' is any change in 
the terms of an obligation that would be treated as an exchange of 
obligations under section 1001 and the related regulations.
    (3) Exceptions. For purposes of paragraph (b)(1) of this section, 
the following changes in the terms of an obligation are not significant 
modifications regardless of whether they would be significant 
modifications under paragraph (b)(2) of this section--
    (i) Changes in the terms of the obligation occasioned by default or 
a reasonably foreseeable default;
    (ii) Assumption of the obligation;
    (iii) Waiver of a due-on-sale clause or a due-on-encumbrance clause;
    (iv) Conversion of an interest rate by a mortgagor pursuant to the 
terms of a convertible mortgage;
    (v) A modification that releases, substitutes, adds, or otherwise 
alters a substantial amount of the collateral for, a guarantee on, or 
other form of credit enhancement for, a recourse or nonrecourse 
obligation, so long as the obligation continues to be principally 
secured by an interest in real property following the release, 
substitution, addition, or other alteration as determined by paragraph 
(b)(7) of this section; and

[[Page 128]]

    (vi) A change in the nature of the obligation from recourse (or 
substantially all recourse) to nonrecourse (or substantially all 
nonrecourse), or from nonrecourse (or substantially all nonrecourse) to 
recourse (or substantially all recourse), so long as the obligation 
continues to be principally secured by an interest in real property 
following such a change as determined by paragraph (b)(7) of this 
section.
    (4) Modifications that are not significant modifications. If an 
obligation is modified and the modification is not a significant 
modification for purposes of paragraph (b)(1) of this section, then the 
modified obligation is not treated as one that was newly originated on 
the date of modification.
    (5) Assumption defined. For purposes of paragraph (b)(3) of this 
section, a mortgage has been assumed if--
    (i) The buyer of the mortgaged property acquires the property 
subject to the mortgage, without assuming any personal liability;
    (ii) The buyer becomes liable for the debt but the seller also 
remains liable; or
    (iii) The buyer becomes liable for the debt and the seller is 
released by the lender.
    (6) Pass-thru certificates. If a REMIC holds as a qualified mortgage 
a pass-thru certificate or other investment trust interest of the type 
described in paragraph (a)(5) of this section, the modification of a 
mortgage loan that backs the pass-thru certificate or other interest is 
not a modification of the pass-thru certificate or other interest unless 
the investment trust structure was created to avoid the prohibited 
transaction rules of section 860F(a).
    (7) Test for determining whether an obligation continues to be 
principally secured following certain types of modifications. (i) For 
purposes of paragraphs (a)(8)(i), (b)(3)(v), and (b)(3)(vi) of this 
section, the obligation continues to be principally secured by an 
interest in real property following the modification only if, as of the 
date of the modification, the obligation satisfies either paragraph 
(b)(7)(ii) or paragraph (b)(7)(iii) of this section.
    (ii) The fair market value of the interest in real property securing 
the obligation, determined as of the date of the modification, must be 
at least 80 percent of the adjusted issue price of the modified 
obligation, determined as of the date of the modification. If, as of the 
date of the modification, the servicer reasonably believes that the 
obligation satisfies the criterion in the preceding sentence, then the 
obligation is deemed to do so. A reasonable belief does not exist if the 
servicer actually knows, or has reason to know, that the criterion is 
not satisfied. For purposes of this paragraph (b)(7)(ii), a servicer 
must base a reasonable belief on--
    (A) A current appraisal performed by an independent appraiser;
    (B) An appraisal that was obtained in connection with the 
origination of the obligation and, if appropriate, that has been updated 
for the passage of time and for any other changes that might affect the 
value of the interest in real property;
    (C) The sales price of the interest in real property in the case of 
a substantially contemporary sale in which the buyer assumes the 
seller's obligations under the mortgage; or
    (D) Some other commercially reasonable valuation method.
    (iii) If paragraph (b)(7)(ii) of this section is not satisfied, the 
fair market value of the interest in real property that secures the 
obligation immediately after the modification must equal or exceed the 
fair market value of the interest in real property that secured the 
obligation immediately before the modification. The criterion in the 
preceding sentence must be established by a current appraisal, an 
original (and updated) appraisal, or some other commercially reasonable 
valuation method; and the servicer must not actually know, or have 
reason to know, that the criterion in the preceding sentence is not 
satisfied.
    (iv) Example. The following example illustrates the rules of this 
paragraph (b)(7).

    Example. (i) S services mortgage loans that are held by R, a REMIC. 
Borrower B is the issuer of one of the mortgage loans held by R. The 
original amount of B's mortgage loan was $100,000, and the loan was 
secured by real property X. At the time the loan was contributed to R, 
property X had a fair market value of $90,000. Sometime after the loan 
was

[[Page 129]]

contributed to R, B experienced financial difficulties such that it was 
reasonably foreseeable that B might default on the loan if the loan was 
not modified. Accordingly, S altered various terms of B's loan to 
substantially reduce the risk of default. The alterations included the 
release of the lien on property X and the substitution of real property 
Y for property X as collateral for the loan. At the time the loan was 
modified, its adjusted issue price was $100,000. The fair market value 
of property X immediately before the modification (as determined by a 
commercially reasonable valuation method) was $70,000, and the fair 
market value of property Y immediately after the modification (as 
determined by a commercially reasonable valuation method) was $75,000.
    (ii) The alterations to B's loan are a significant modification 
within the meaning of Sec.  1.1001-3(e). The modification, however, is 
described in paragraphs (a)(8)(i) and (b)(3) of this section. 
Accordingly, the modified loan continues to be a qualified mortgage if, 
immediately after the modification, the modified loan continues to be 
principally secured by an interest in real property, as determined by 
paragraph (b)(7) of this section.
    (iii) Because the modification includes the release of the lien on 
property X and substitution of property Y for property X, the modified 
loan must satisfy paragraph (b)(7)(i) of this section (which requires 
satisfaction of either paragraph (b)(7)(ii) or paragraph (b)(7)(iii) of 
this section). The modified loan does not satisfy paragraph (b)(7)(ii) 
of this section because property Y is worth less than $80,000 (the 
amount equal to 80 percent of the adjusted issue price of the modified 
mortgage loan). The modified loan, however, satisfies paragraph 
(b)(7)(iii) of this section because the fair market value of the 
interest in real estate (real property Y) that secures the obligation 
immediately after the modification ($75,000) exceeds the fair market 
value of the interest in real estate (real property X) that secured the 
obligation immediately before the modification ($70,000). Accordingly, 
the modified loan satisfies paragraph (b)(7)(i) of this section and 
continues to be principally secured by an interest in real property.

    (c) Treatment of certain credit enhancement contracts--(1) In 
general. A credit enhancement contract (as defined in paragraph (c) (2) 
and (3) of this section) is not treated as a separate asset of the REMIC 
for purposes of the asset test set out in section 860D(a)(4) and Sec.  
1.860D-1(b)(3), but instead is treated as part of the mortgage or pool 
of mortgages to which it relates. Furthermore, any collateral supporting 
a credit enhancement contract is not treated as an asset of the REMIC 
solely because it supports the guarantee represented by that contract. 
See paragraph (g)(1)(ii) of this section for the treatment of payments 
made pursuant to credit enhancement contracts as payments received under 
a qualified mortgage.
    (2) Credit enhancement contracts. For purposes of this section, a 
credit enhancement contract is any arrangement whereby a person agrees 
to guarantee full or partial payment of the principal or interest 
payable on a qualified mortgage or on a pool of such mortgages, or full 
or partial payment on one or more classes of regular interests or on the 
class of residual interests, in the event of defaults or delinquencies 
on qualified mortgages, unanticipated losses or expenses incurred by the 
REMIC, or lower than expected returns on cash flow investments. Types of 
credit enhancement contracts may include, but are not limited to, pool 
insurance contracts, certificate guarantee insurance contracts, letters 
of credit, guarantees, or agreements whereby the REMIC sponsor, a 
mortgage servicer, or other third party agrees to make advances 
described in paragraph (c)(3) of this section.
    (3) Arrangements to make certain advances. The arrangements 
described in this paragraph (c)(3) are credit enhancement contracts 
regardless of whether, under the terms of the arrangement, the payor is 
obligated, or merely permitted, to advance funds to the REMIC.
    (i) Advances of delinquent principal and interest. An arrangement by 
a REMIC sponsor, mortgage servicer, or other third party to advance to 
the REMIC out of its own funds an amount to make up for delinquent 
payments on qualified mortgages is a credit enhancement contract.
    (ii) Advances of taxes, insurance payments, and expenses. An 
arrangement by a REMIC sponsor, mortgage servicer, or other third party 
to pay taxes and hazard insurance premiums on, or other expenses 
incurred to protect the REMIC's security interest in, property securing 
a qualified mortgage in the event that the mortgagor fails to pay such 
taxes, insurance premiums, or other expenses is a credit enhancement 
contract.

[[Page 130]]

    (iii) Advances to ease REMIC administration. An agreement by a REMIC 
sponsor, mortgage servicer, or other third party to advance temporarily 
to a REMIC amounts payable on qualified mortgages before such amounts 
are actually due to level out the stream of cash flows to the REMIC or 
to provide for orderly administration of the REMIC is a credit 
enhancement contract. For example, if two mortgages in a pool have 
payment due dates on the twentieth of the month, and all the other 
mortgages have payment due dates on the first of each month, an 
agreement by the mortgage servicer to advance to the REMIC on the 
fifteenth of each month the payments not yet received on the two 
mortgages together with the amounts received on the other mortgages is a 
credit enhancement contract.
    (4) Deferred payment under a guarantee arrangement. A guarantee 
arrangement does not fail to qualify as a credit enhancement contract 
solely because the guarantor, in the event of a default on a qualified 
mortgage, has the option of immediately paying to the REMIC the full 
amount of mortgage principal due on acceleration of the defaulted 
mortgage, or paying principal and interest to the REMIC according to the 
original payment schedule for the defaulted mortgage, or according to 
some other deferred payment schedule. Any deferred payments are payments 
pursuant to a credit enhancement contract even if the mortgage is 
foreclosed upon and the guarantor, pursuant to subrogation rights set 
out in the guarantee arrangement, is entitled to receive immediately the 
proceeds of foreclosure.
    (d) Treatment of certain purchase agreements with respect to 
convertible mortgages--(1) In general. For purposes of sections 
860D(a)(4) and 860G(a)(3), a purchase agreement (as described in 
paragraph (d)(3) of this section) with respect to a convertible mortgage 
(as described in paragraph (d)(5) of this section) is treated as 
incidental to the convertible mortgage to which it relates. 
Consequently, the purchase agreement is part of the mortgage or pool of 
mortgages and is not a separate asset of the REMIC.
    (2) Treatment of amounts received under purchase agreements. For 
purposes of sections 860A through 860G and for purposes of determining 
the accrual of original issue discount and market discount under 
sections 1272(a)(6) and 1276, respectively, a payment under a purchase 
agreement described in paragraph (d)(3) of this section is treated as a 
prepayment in full of the mortgage to which it relates. Thus, for 
example, a payment under a purchase agreement with respect to a 
qualified mortgage is considered a payment received under a qualified 
mortgage within the meaning of section 860G(a)(6) and the transfer of 
the mortgage is not a disposition of the mortgage within the meaning of 
section 860F(a)(2)(A).
    (3) Purchase agreement. A purchase agreement is a contract between 
the holder of a convertible mortgage and a third party under which the 
holder agrees to sell and the third party agrees to buy the mortgage for 
an amount equal to its current principal balance plus accrued but unpaid 
interest if and when the mortgagor elects to convert the terms of the 
mortgage.
    (4) Default by the person obligated to purchase a convertible 
mortgage. If the person required to purchase a convertible mortgage 
defaults on its obligation to purchase the mortgage upon conversion, the 
REMIC may sell the mortgage in a market transaction and the proceeds of 
the sale will be treated as amounts paid pursuant to a purchase 
agreement.
    (5) Convertible mortgage. A convertible mortgage is a mortgage that 
gives the obligor the right at one or more times during the term of the 
mortgage to elect to convert from one interest rate to another. The new 
rate of interest must be determined pursuant to the terms of the 
instrument and must be intended to approximate a market rate of interest 
for newly originated mortgages at the time of the conversion.
    (e) Prepayment interest shortfalls. An agreement by a mortgage 
servicer or other third party to make payments to the REMIC to make up 
prepayment interest shortfalls is not treated as a separate asset of the 
REMIC and payments made pursuant to such an agreement are treated as 
payments on the qualified mortgages. With respect to

[[Page 131]]

any mortgage that prepays, the prepayment interest shortfall for the 
accrual period in which the mortgage prepays is an amount equal to the 
excess of the interest that would have accrued on the mortgage during 
that accrual period had it not prepaid, over the interest that accrued 
from the beginning of that accrual period up to the date of the 
prepayment.
    (f) Defective obligations--(1) Defective obligation defined. For 
purposes of sections 860G(a)(4)(B)(ii) and 860F(a)(2), a defective 
obligation is a mortgage subject to any of the following defects.
    (i) The mortgage is in default, or a default with respect to the 
mortgage is reasonably foreseeable.
    (ii) The mortgage was fraudulently procured by the mortgagor.
    (iii) The mortgage was not in fact principally secured by an 
interest in real property within the meaning of paragraph (a)(1) of this 
section.
    (iv) The mortgage does not conform to a customary representation or 
warranty given by the sponsor or prior owner of the mortgage regarding 
the characteristics of the mortgage, or the characteristics of the pool 
of mortgages of which the mortgage is a part. A representation that 
payments on a qualified mortgage will be received at a rate no less than 
a specified minimum or no greater than a specified maximum is not 
customary for this purpose.
    (2) Effect of discovery of defect. If a REMIC discovers that an 
obligation is a defective obligation, and if the defect is one that, had 
it been discovered before the startup day, would have prevented the 
obligation from being a qualified mortgage, then, unless the REMIC 
either causes the defect to be cured or disposes of the defective 
obligation within 90 days of discovering the defect, the obligation 
ceases to be a qualified mortgage at the end of that 90 day period. Even 
if the defect is not cured, the defective obligation is, nevertheless, a 
qualified mortgage from the startup day through the end of the 90 day 
period. Moreover, even if the REMIC holds the defective obligation 
beyond the 90 day period, the REMIC may, nevertheless, exchange the 
defective obligation for a qualified replacement mortgage so long as the 
requirements of section 860G(a)(4)(B) are satisfied. If the defect is 
one that does not affect the status of an obligation as a qualified 
mortgage, then the obligation is always a qualified mortgage regardless 
of whether the defect is or can be cured. For example, if a sponsor 
represented that all mortgages transferred to a REMIC had a 10 percent 
interest rate, but it was later discovered that one mortgage had a 9 
percent interest rate, the 9 percent mortgage is defective, but the 
defect does not affect the status of that obligation as a qualified 
mortgage.
    (g) Permitted investments--(1) Cash flow investment--(i) In general. 
For purposes of section 860G(a)(6) and this section, a cash flow 
investment is an investment of payments received on qualified mortgages 
for a temporary period between receipt of those payments and the 
regularly scheduled date for distribution of those payments to REMIC 
interest holders. Cash flow investments must be passive investments 
earning a return in the nature of interest.
    (ii) Payments received on qualified mortgages. For purposes of 
paragraph (g)(1) of this section, the term ``payments received on 
qualified mortgages'' includes--
    (A) Payments of interest and principal on qualified mortgages, 
including prepayments of principal and payments under credit enhancement 
contracts described in paragraph (c)(2) of this section;
    (B) Proceeds from the disposition of qualified mortgages;
    (C) Cash flows from foreclosure property and proceeds from the 
disposition of such property;
    (D) A payment by a sponsor or prior owner in lieu of the sponsor's 
or prior owner's repurchase of a defective obligation, as defined in 
paragraph (f) of this section, that was transferred to the REMIC in 
breach of a customary warranty; and
    (E) Prepayment penalties required to be paid under the terms of a 
qualified mortgage when the mortgagor prepays the obligation.
    (iii) Temporary period. For purposes of section 860G(a)(6) and this 
paragraph (g)(1), a temporary period generally is

[[Page 132]]

that period from the time a REMIC receives payments on qualified 
mortgages and permitted investments to the time the REMIC distributes 
the payments to interest holders. A temporary period may not exceed 13 
months. Thus, an investment held by a REMIC for more than 13 months is 
not a cash flow investment. In determining the length of time that a 
REMIC has held an investment that is part of a commingled fund or 
account, the REMIC may employ any reasonable method of accounting. For 
example, if a REMIC holds mortgage cash flows in a commingled account 
pending distribution, the first-in, first-out method of accounting is a 
reasonable method for determining whether all or part of the account 
satisfies the 13 month limitation.
    (2) Qualified reserve funds. The term qualified reserve fund means 
any reasonably required reserve to provide for full payment of expenses 
of the REMIC or amounts due on regular or residual interests in the 
event of defaults on qualified mortgages, prepayment interest shortfalls 
(as defined in paragraph (e) of this section), lower than expected 
returns on cash flow investments, or any other contingency that could be 
provided for under a credit enhancement contract (as defined in 
paragraph (c) (2) and (3) of this section).
    (3) Qualified reserve asset--(i) In general. The term ``qualified 
reserve asset'' means any intangible property (other than a REMIC 
residual interest) that is held both for investment and as part of a 
qualified reserve fund. An asset need not generate any income to be a 
qualified reserve asset.
    (ii) Reasonably required reserve--(A) In general. In determining 
whether the amount of a reserve is reasonable, it is appropriate to 
consider the credit quality of the qualified mortgages, the extent and 
nature of any guarantees relating to either the qualified mortgages or 
the regular and residual interests, the expected amount of expenses of 
the REMIC, and the expected availability of proceeds from qualified 
mortgages to pay the expenses. To the extent that a reserve exceeds a 
reasonably required amount, the amount of the reserve must be promptly 
and appropriately reduced. If at any time, however, the amount of the 
reserve fund is less than is reasonably required, the amount of the 
reserve fund may be increased by the addition of payments received on 
qualified mortgages or by contributions from holders of residual 
interests.
    (B) Presumption that a reserve is reasonably required. The amount of 
a reserve fund is presumed to be reasonable (and an excessive reserve is 
presumed to have been promptly and appropriately reduced) if it does not 
exceed the amount required by a third party insurer or guarantor, who 
does not own directly or indirectly (within the meaning of section 
267(c)) an interest in the REMIC (as defined in Sec.  1.860D-1(b)(1)), 
as a condition of providing credit enhancement.
    (C) Presumption may be rebutted. The presumption in paragraph 
(g)(3)(ii)(B) of this section may be rebutted if the amounts required by 
the third party insurer are not commercially reasonable considering the 
factors described in paragraph (g)(3)(ii)(A) of this section.
    (D) Applicability date. Paragraphs (g)(3)(ii)(B) and (g)(3)(ii)(C) 
of this section apply on and after July 6, 2011.
    (h) Outside reserve funds. A reserve fund that is maintained to pay 
expenses of the REMIC, or to make payments to REMIC interest holders is 
an outside reserve fund and not an asset of the REMIC only if the 
REMIC's organizational documents clearly and expressly--
    (1) Provide that the reserve fund is an outside reserve fund and not 
an asset of the REMIC;
    (2) Identify the owner(s) of the reserve fund, either by name, or by 
description of the class (e.g., subordinated regular interest holders) 
whose membership comprises the owners of the fund; and
    (3) Provide that, for all Federal tax purposes, amounts transferred 
by the REMIC to the fund are treated as amounts distributed by the REMIC 
to the designated owner(s) or transferees of the designated owner(s).
    (i) Contractual rights coupled with regular interests in tiered 
arrangements--(1) In general. If a REMIC issues a regular interest to a 
trustee of an investment

[[Page 133]]

trust for the benefit of the trust certificate holders and the trustee 
also holds for the benefit of those certificate holders certain other 
contractual rights, those other rights are not treated as assets of the 
REMIC even if the investment trust and the REMIC were created 
contemporaneously pursuant to a single set of organizational documents. 
The organizational documents must, however, require that the trustee 
account for the contractual rights as property that the trustee holds 
separate and apart from the regular interest.
    (2) Example. The following example, which describes a tiered 
arrangement involving a pass-thru trust that is intended to qualify as a 
REMIC and a pass-thru trust that is intended to be classified as a trust 
under Sec.  301.7701-4(c) of this chapter, illustrates the provisions of 
paragraph (i)(1) of this section.

    Example. (i) A sponsor transferred a pool of mortgages to a trustee 
in exchange for two classes of certificates. The pool of mortgages has 
an aggregate principal balance of $100x. Each mortgage in the pool 
provides for interest payments based on the eleventh district cost of 
funds index (hereinafter COFI) plus a margin. The trust (hereinafter 
REMIC trust) issued a Class N bond, which the sponsor designates as a 
regular interest, that has a principal amount of $100x and that provides 
for interest payments at a rate equal to One-Year LIBOR plus 100 basis 
points, subject to a cap equal to the weighted average pool rate. The 
Class R interest, which the sponsor designated as the residual interest, 
entitles its holder to all funds left in the trust after the Class N 
bond has been retired. The Class R interest holder is not entitled to 
current distributions.
    (ii) On the same day, and under the same set of documents, the 
sponsor also created an investment trust. The sponsor contributed to the 
investment trust the Class N bond together with an interest rate cap 
contract. Under the interest rate cap contract, the issuer of the cap 
contract agrees to pay to the trustee for the benefit of the investment 
trust certificate holders the excess of One-Year LIBOR plus 100 basis 
points over the weighted average pool rate (COFI plus a margin) times 
the outstanding principal balance of the Class N bond in the event One-
Year LIBOR plus 100 basis points ever exceeds the weighted average pool 
rate. The trustee (the same institution that serves as REMIC trust 
trustee), in exchange for the contributed assets, gave the sponsor 
certificates representing undivided beneficial ownership interests in 
the Class N bond and the interest rate cap contract. The organizational 
documents require the trustee to account for the regular interest and 
the cap contract as discrete property rights.
    (iii) The separate existence of the REMIC trust and the investment 
trust are respected for all Federal income tax purposes. Thus, the 
interest rate cap contract is an asset beneficially owned by the several 
certificate holders and is not an asset of the REMIC trust. 
Consequently, each certificate holder must allocate its purchase price 
for the certificate between its undivided interest in the Class N bond 
and its undivided interest in the interest rate cap contract in 
accordance with the relative fair market values of those two property 
rights.

    (j) Clean-up call--(1) In general. For purposes of section 
860F(a)(5)(B), a clean-up call is the redemption of a class of regular 
interests when, by reason of prior payments with respect to those 
interests, the administrative costs associated with servicing that class 
outweigh the benefits of maintaining the class. Factors to consider in 
making this determination include--
    (i) The number of holders of that class of regular interests;
    (ii) The frequency of payments to holders of that class;
    (iii) The effect the redemption will have on the yield of that class 
of regular interests;
    (iv) The outstanding principal balance of that class; and
    (v) The percentage of the original principal balance of that class 
still outstanding.
    (2) Interest rate changes. The redemption of a class of regular 
interests undertaken to profit from a change in interest rates is not a 
clean-up call.
    (3) Safe harbor. Although the outstanding principal balance is only 
one factor to consider, the redemption of a class of regular interests 
with an outstanding principal balance of no more than 10 percent of its 
original principal balance is always a clean-up call.
    (k) Startup day. The term ``startup day'' means the day on which the 
REMIC issues all of its regular and residual interests. A sponsor may, 
however, contribute property to a REMIC in exchange for regular and 
residual interests over any period of 10 consecutive days and the REMIC 
may designate any one of those 10 days as its startup day. The day so 
designated is

[[Page 134]]

then the startup day, and all interests are treated as issued on that 
day.

[T.D. 8458, 57 FR 61309, Dec. 24, 1992; 58 FR 8098, Feb. 11, 1993; T.D. 
9463, 74 FR 47438, Sept. 16, 2009; T.D. 9533, 76 FR 39282, July 6, 2011; 
T.D. 9637, 78 FR 54760, Sept. 6, 2013]



Sec.  1.860G-3  Treatment of foreign persons.

    (a) Transfer of a residual interest with tax avoidance potential--
(1) In general. A transfer of a residual interest that has tax avoidance 
potential is disregarded for all Federal tax purposes if the transferee 
is a foreign person. Thus, if a residual interest with tax avoidance 
potential is transferred to a foreign holder at formation of the REMIC, 
the sponsor is liable for the tax on any excess inclusion that accrues 
with respect to that residual interest.
    (2) Tax avoidance potential--(i) Defined. A residual interest has 
tax avoidance potential for purposes of this section unless, at the time 
of the transfer, the transferor reasonably expects that, for each excess 
inclusion, the REMIC will distribute to the transferee residual interest 
holder an amount that will equal at least 30 percent of the excess 
inclusion, and that each such amount will be distributed at or after the 
time at which the excess inclusion accrues and not later than the close 
of the calendar year following the calendar year of accrual.
    (ii) Safe harbor. For purposes of paragraph (a)(2)(i) of this 
section, a transferor has a reasonable expectation if the 30-percent 
test would be satisfied were the REMIC's qualified mortgages to prepay 
at each rate within a range of rates from 50 percent to 200 percent of 
the rate assumed under section 1272(a)(6) with respect to the qualified 
mortgages (or the rate that would have been assumed had the mortgages 
been issued with original issue discount).
    (3) Effectively connected income. Paragraph (a)(1) of this section 
will not apply if the transferee's income from the residual interest is 
subject to tax under section 871(b) or section 882.
    (4) Transfer by a foreign holder. If a foreign person transfers a 
residual interest to a United States person or a foreign holder in whose 
hands the income from a residual interest would be effectively connected 
income, and if the transfer has the effect of allowing the transferor to 
avoid tax on accrued excess inclusions, then the transfer is disregarded 
and the transferor continues to be treated as the owner of the residual 
interest for purposes of section 871(a), 881, 1441, or 1442.
    (b) Accounting for REMIC net income--(1) Allocation of partnership 
income to a foreign partner. A domestic partnership shall separately 
state its allocable share of REMIC taxable income or net loss in 
accordance with Sec.  1.702-1(a)(8). If a domestic partnership allocates 
all or some portion of its allocable share of REMIC taxable income to a 
partner that is a foreign person, the amount allocated to the foreign 
partner shall be taken into account by the foreign partner for purposes 
of sections 871(a), 881, 1441, and 1442 as if that amount was received 
on the last day of the partnership's taxable year, except to the extent 
that some or all of the amount is required to be taken into account by 
the foreign partner at an earlier time under section 860G(b) as a result 
of a distribution by the partnership to the foreign partner or a 
disposition of the foreign partner's indirect interest in the REMIC 
residual interest. A disposition in whole or in part of the foreign 
partner's indirect interest in the REMIC residual interest may occur as 
a result of a termination of the REMIC, a disposition of the 
partnership's residual interest in the REMIC, a disposition of the 
foreign partner's interest in the partnership, or any other reduction in 
the foreign partner's allocable share of the portion of the REMIC net 
income or deduction allocated to the partnership. See Sec.  1.871-
14(d)(2) for the treatment of interest received on a regular or residual 
interest in a REMIC. For a partnership's withholding obligations with 
respect to excess inclusion amounts described in this paragraph (b)(1), 
see Sec. Sec.  1.1441-2(b)(5), 1.1441-2(d)(4), 1.1441-5(b)(2)(i)(A), and 
Sec. Sec.  1.1446-1 through 1.1446-7.
    (2) Excess inclusion income allocated by certain pass-through 
entities to a foreign person. If an amount is allocated under section 
860E(d)(1) to a foreign person that is a shareholder of a real estate

[[Page 135]]

investment trust or a regulated investment company, a participant in a 
common trust fund, or a patron of an organization to which part I of 
subchapter T applies and if the amount so allocated is governed by 
section 860E(d)(2) (treating it ``as an excess inclusion with respect to 
a residual interest held by'' the taxpayer), the amount shall be taken 
into account for purposes of sections 871(a), 881, 1441, and 1442 at the 
same time as the time prescribed for other income of the shareholder, 
participant, or patron from the trust, company, fund, or organization.

[T.D. 8458, 57 FR 61313, Dec. 24, 1992, as amended by T.D. 9272, 71 FR 
43365, Aug. 1, 2006; T.D. 9415, 73 FR 40172, July 14, 2008]

  TAX BASED ON INCOME FROM SOURCES WITHIN OR WITHOUT THE UNITED STATES

                   Determination of Sources of Income



Sec.  1.861-1  Income from sources within the United States.

    (a) Categories of income. Part I (section 861 and following), 
subchapter N, chapter 1 of the Code, and the regulations thereunder 
determine the sources of income for purposes of the income tax. These 
sections explicitly allocate certain important sources of income to the 
United States or to areas outside the United States, as the case may be; 
and, with respect to the remaining income (particularly that derived 
partly from sources within and partly from sources without the United 
States), authorize the Secretary or his delegate to determine the income 
derived from sources within the United States, either by rules of 
separate allocation or by processes or formulas of general 
apportionment. The statute provides for the following three categories 
of income:
    (1) Within the United States. The gross income from sources within 
the United States, consisting of the items of gross income specified in 
section 861(a) plus the items of gross income allocated or apportioned 
to such sources in accordance with section 863(a). See Sec. Sec.  1.861-
2 to 1.861-7, inclusive, and Sec.  1.863-1. The taxable income from 
sources within the United States, in the case of such income, shall be 
determined by deducting therefrom, in accordance with sections 861(b) 
and 863(a), the expenses, losses, and other deductions properly 
apportioned or allocated thereto and a ratable part of any other 
expenses, losses, or deductions which cannot definitely be allocated to 
some item or class of gross income. See Sec. Sec.  1.861-8 and 1.863-1.
    (2) Without the United States. The gross income from sources without 
the United States, consisting of the items of gross income specified in 
section 862(a) plus the items of gross income allocated or apportioned 
to such sources in accordance with section 863(a). See Sec. Sec.  1.862-
1 and 1.863-1. The taxable income from sources without the United 
States, in the case of such income, shall be determined by deducting 
therefrom, in accordance with sections 862(b) and 863(a), the expenses, 
losses, and other deductions properly apportioned or allocated thereto 
and a ratable part of any other expenses, losses, or deductions which 
cannot definitely be allocated to some item or class of gross income. 
See Sec. Sec.  1.862-1 and 1.863-1.
    (3) Partly within and partly without the United States. The gross 
income derived from sources partly within and partly without the United 
States, consisting of the items specified in section 863(b) (1), (2), 
and (3). The taxable income allocated or apportioned to sources within 
the United States, in the case of such income, shall be determined in 
accordance with section 863 (a) or (b). See Sec. Sec.  1.863-2 to 1.863-
5, inclusive.
    (4) Exceptions. An owner of certain aircraft or vessels first leased 
on or before December 28, 1980, may elect to treat income in respect of 
these aircraft or vessels as income from sources within the United 
States for purposes of sections 861(a) and 862(a). See Sec.  1.861-9. An 
owner of certain aircraft, vessels, or spacecraft first leased after 
December 28, 1980, must treat income in respect of these craft as income 
from sources within the United States for purposes of sections 861(a) 
and 862(a). See Sec.  1.861-9A.
    (b) Taxable income from sources within the United States. The 
taxable income from sources within the United States shall consist of 
the taxable income described in paragraph (a)(1) of this section plus 
the taxable income allocated

[[Page 136]]

or apportioned to such sources, as indicated in paragraph (a)(3) of this 
section.
    (c) Computation of income. If a taxpayer has gross income from 
sources within or without the United States, together with gross income 
derived partly from sources within and partly from sources without the 
United States, the amounts thereof, together with the expenses and 
investment applicable thereto, shall be segregated; and the taxable 
income from sources within the United States shall be separately 
computed therefrom.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7928, 48 FR 
55845, Dec. 16, 1983]



Sec.  1.861-2  Interest.

    (a) In general. (1) Gross income consisting of interest from the 
United States or any agency or instrumentality thereof (other than a 
possession of the United States or an agency or instrumentality of a 
possession), a State or any political subdivision thereof, or the 
District of Columbia, and interest from a resident of the United States 
on a bond, note, or other interest-bearing obligation issued, assumed or 
incurred by such person shall be treated as income from sources within 
the United States. Thus, for example, income from sources within the 
United States includes interest received on any refund of income tax 
imposed by the United States, a State or any political subdivision 
thereof, or the District of Columbia. Interest other than that described 
in this paragraph is not to be treated as income from sources within the 
United States. See paragraph (a)(7) of this section for special rules 
concerning substitute interest paid or accrued pursuant to a securities 
lending transaction.
    (2) The term ``resident of the United States'', as used in this 
paragraph, includes (i) an individual who at the time of payment of the 
interest is a resident of the United States, (ii) a domestic 
corporation, (iii) a domestic partnership which at any time during its 
taxable year is engaged in trade or business in the United States, or 
(iv) a foreign corporation or a foreign partnership, which at any time 
during its taxable year is engaged in trade or business in the United 
States.
    (3) The method by which, or the place where, payment of the interest 
is made is immaterial in determining whether interest is derived from 
sources within the United States.
    (4) For purposes of this section, the term ``interest'' includes all 
amounts treated as interest under section 483, and the regulations 
thereunder. It also includes original issue discount, as defined in 
section 1232(b)(1), whether or not the underlying bond, debenture, note, 
certificate, or other evidence of indebtedness is a capital asset in the 
hands of the taxpayer within the meaning of section 1221.
    (5) If interest is paid on an obligation of a resident of the United 
States by a nonresident of the United States acting in the nonresident's 
capacity as a guarantor of the obligation of the resident, the interest 
will be treated as income from sources within the United States.
    (6) In the case of interest received by a nonresident alien 
individual or foreign corporation this paragraph (a) applies whether or 
not the interest is effectively connected for the taxable year with the 
conduct of a trade or business in the United States by such individual 
or corporation.
    (7) A substitute interest payment is a payment, made to the 
transferor of a security in a securities lending transaction or a sale-
repurchase transaction, of an amount equivalent to an interest payment 
which the owner of the transferred security is entitled to receive 
during the term of the transaction. A securities lending transaction is 
a transfer of one or more securities that is described in section 
1058(a) or a substantially similar transaction. A sale-repurchase 
transaction is an agreement under which a person transfers a security in 
exchange for cash and simultaneously agrees to receive a substantially 
identical securities from the transferee in the future in exchange for 
cash. A substitute interest payment shall be sourced in the same manner 
as the interest accruing on the transferred security for purposes of 
this section and Sec.  1.862-1. See also Sec. Sec.  1.864-5(b)(2)(iii), 
1.871-7(b)(2), 1.881-2(b)(2) and for the character of such payments and 
Sec.  1.894-1(c) for the

[[Page 137]]

application tax treaties to these transactions.
    (b) Interest not derived from U.S. sources. Notwithstanding 
paragraph (a) of this section, interest shall be treated as income from 
sources without the United States to the extent provided by 
subparagraphs (A) through (H), of section 861(a)(1) and by the following 
subparagraphs of this paragraph.
    (1) Interest on bank deposits and on similar amounts. (i) Interest 
paid or credited before January 1, 1977, to a nonresident alien 
individual or foreign corporation on--
    (a) Deposits with persons, including citizens of the United States 
or alien individuals and foreign or domestic partnerships or 
corporations, carrying on the banking business in the United States,
    (b) Deposits or withdrawable accounts with savings institutions 
chartered and supervised as savings and loan or similar associations 
under Federal or State law, or
    (c) Amounts held by an insurance company under an agreement to pay 
interest thereon, shall be treated as income from sources without the 
United States if such interest is not effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by such nonresident alien individual or foreign corporation. If 
such interest is effectively connected for the taxable year with the 
conduct of a trade or business in the United States by such nonresident 
alien individual or foreign corporation, it shall be treated as income 
from sources within the United States under paragraph (a) of this 
section unless it is treated as income from sources without the United 
States under another subparagraph of this paragraph. For a special rule 
for determining whether such interest is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States, see paragraph (c)(1)(ii) or Sec.  1.864-4.
    (ii) Paragraph (b)(1)(i)(b) of this section applies to interest on 
deposits or withdrawable accounts described therein only to the extent 
that the interest paid or credited by the savings institution described 
therein is deductible under section 591 in determining the taxable 
income of such institution; and, for this purpose, whether an amount is 
deductible under section 591 shall be determined without regard to 
section 265, relating to deductions allocable to tax-exempt income. 
Thus, for example, such subdivision does not apply to amounts paid by a 
savings and loan or similar association on or with respect to its 
nonwithdrawable capital stock or on or with respect to funds held in 
restricted accounts which represent a proprietary interest in such 
association. Paragraph (b)(1)(i)(b) of this section also applies to so-
called dividends paid or credited on deposits or withdrawable accounts 
if such dividends are deductible under section 591 without reference to 
section 265.
    (iii) For purposes of paragraph (b)(1)(i)(c) of this section, 
amounts held by an insurance company under an agreement to pay interest 
thereon include policyholder dividends left with the company to 
accumulate, prepaid insurance premiums, proceeds of policies left on 
deposit with the company, and overcharges of premiums. Such subdivision 
does not apply to (a) the so-called ``interest element'' in the case of 
annuity or installment payments under life insurance or endowment 
contracts or (b) interest paid by an insurance company to its creditors 
on notes, bonds, or similar evidences of indebtedness, if the debtor-
creditor relationship does not arise by virtue of a contract of 
insurance with the insurance company.
    (iv) For purposes of paragraph (b)(1)(i) of this section, interest 
received by a partnership shall be treated as received by each partner 
of such partnership to the extent of his distributive share of such 
item.
    (2) Interest from a resident alien individual or domestic 
corporation deriving substantial income from sources without the United 
States. Interest received from a resident alien individual or a domestic 
corporation shall be treated as income from sources without the United 
States when it is shown to the satisfaction of the district director 
(or, if applicable, the Director of International Operations) that less 
than 20 percent of the gross income from all sources of such individual 
or corporation has been derived from sources within the United

[[Page 138]]

States, as determined under the provisions of sections 861 to 863, 
inclusive, and the regulations thereunder, for the 3-year period ending 
with the close of the taxable year of such individual or corporation 
preceding its taxable year in which such interest is paid or credited, 
or for such part of such period as may be applicable. If 20 percent or 
more of the gross income from all sources of such individual or 
corporation has been derived from sources within the United States, as 
so determined, for such 3-year period (or part thereof), the entire 
amount of the interest from such individual or corporation shall be 
treated as income from sources within the United States.
    (3) Interest from a foreign corporation not deriving major portion 
of its income from a U.S. business. (i) Interest from a foreign 
corporation which, at any time during the taxable year, is engaged in 
trade or business in the United States shall be treated as income from 
sources without the United States when it is shown to the satisfaction 
of the district director (or, if applicable, the Director of 
International Operations) that (a) less than 50 percent of the gross 
income from all sources of such foreign corporation for the 3-year 
period ending with the close of its taxable year preceding its taxable 
year in which such interest is paid or credited (or for such part of 
such period as the corporation has been in existence) was effectively 
connected with the conduct by such corporation of a trade or business in 
the United States, as determined under section 864(c) and Sec.  1.864-3, 
or (b) such foreign corporation had gross income for such 3-year period 
(or part thereof) but none was effectively connected with the conduct of 
a trade or business in the United States.
    (ii) If 50 percent or more of the gross income from all sources of 
such foreign corporation for such 3-year period (or part thereof) was 
effectively connected with the conduct by such corporation of a trade or 
business in the United States, see section 861(a)(1)(D) and paragraph 
(c)(1) of this section for determining the portion of interest from such 
corporation which is treated as income from sources within the United 
States.
    (iii) For purposes of this paragraph the gross income which is 
effectively connected with the conduct of a trade or business in the 
United States includes the gross income which, pursuant to section 882 
(d) or (e) and the regulations thereunder, is treated as income which is 
effectively connected with the conduct of a trade or business in the 
United States.
    (iv) This paragraph does not apply to interest paid or credited 
after December 31, 1969, by a branch in the United States of a foreign 
corporation if, at the time of payment or crediting, such branch is 
engaged in the commercial banking business in the United States; 
furthermore, such interest is treated under paragraph (a) of this 
section as income from sources within the United States unless it is 
treated as income from sources without the United States under paragraph 
(b) (1) or (4) of this section.
    (4) Bankers' acceptances. Interest derived by a foreign central bank 
of issue from bankers' acceptances shall be treated as income from 
sources without the United States. For this purpose, a foreign central 
bank of issue is a bank which is by law or government sanction the 
principal authority, other than the government itself, issuing 
instruments intended to circulate as currency. Such a bank is generally 
the custodian of the banking reserves of the country under whose laws it 
is organized.
    (5) Foreign banking branch of a domestic corporation or partnership. 
Interest paid or credited on deposits with a branch outside the United 
States (as defined in section 7701(a)(9)) of a domestic corporation or 
of a domestic partnership shall be treated as income from sources 
without the United States, if, at the time of payment or crediting, such 
branch is engaged in the commercial banking business. For purposes of 
applying this paragraph, it is immaterial (i) whether the domestic 
corporation or domestic partnership is carrying on a banking business in 
the United States, (ii) whether the recipient of the interest is a 
citizen or resident of the United States, a foreign corporation, or a 
foreign partnership, (iii) whether the interest is effectively connected 
with the conduct of a trade

[[Page 139]]

or business in the United States by the recipient, or (iv) whether the 
deposits with the branch located outside the United States are payable 
in the currency of a foreign country. Notwithstanding the provisions of 
Sec.  1.863-6, interest to which this paragraph applies shall be treated 
as income from sources within the foreign country, possession of the 
United States, or other territory in which the branch is located.
    (6) Section 4912(c) debt obligations-- (i) In general. Under section 
861(a)(1)(G), interest on a debt obligation shall not be treated as 
income from sources within the United States if--
    (a) The debt obligation was part of an issue of debt obligations 
with respect to which an election has been made under section 4912(c) 
(relating to the treatment of such debt obligations as debt obligations 
of a foreign obligor for purposes of the interest equalization tax),
    (b) The debt obligation had a maturity not exceeding 15 years 
(within the meaning of paragraph (b)(6)(ii) of this section) on the date 
it is originally issued or on the date it is treated under section 
4912(c)(2) as issued by reason of being assumed by a certain domestic 
corporation,
    (c) The debt obligation, when originally issued, was purchased by 
one or more underwriters (within the meaning of paragraph (b)(6)(iii) of 
this section) with a view to distribution through resale (within the 
meaning of paragraph (b)(6)(iv) of this section), and
    (d) The interest on the debt obligation is attributable to periods 
after the effective date of an election under section 4912(c) to treat 
such debt obligations as debt obligations of a foreign obligor for 
purposes of the interest equalization tax.
    (ii) Maturity not exceeding 15 years. The date the debt obligation 
is issued or treated as issued is not included in the 15 year 
computation, but the date of maturity of the debt, obligation is 
included in such computation.
    (iii) Purchased by one or more underwriters. For purposes of this 
paragraph, the debt obligation when originally issued will not be 
treated as purchased by one or more underwriters unless the underwriter 
purchases the debt obligation for his own account and bears the risk of 
gain or loss on resale. Thus, for example, a debt obligation, when 
originally issued, will not be treated as purchased by one or more 
underwriters if the underwriter acts only in the capacity of an agent of 
the issuer. Neither will a debt obligation, when originally issued, be 
treated as purchased by one or more underwriters if the agreement 
between the underwriter and issuer is merely for a ``best efforts'' 
underwriting, for the purchase by the underwriter of all or a portion of 
the debt obligations remaining unsold at the expiration of a fixed 
period of time, or for any other arrangement under the terms of which 
the debt obligations are not purchased by the underwriter with a view to 
distribution through resale. The fact that an underwriter is related to 
the issuer will not prevent the underwriter from meeting the 
requirements of this paragraph. In determining whether a related 
underwriter meets the requirements of this paragraph consideration shall 
be given to whether the purchase by the underwriter of the debt 
obligation from the issuer for resale was effected by a transaction 
subject to conditions similar to those which would have been imposed 
between independent persons.
    (iv) With a view to distribution through resale. (a) An underwriter 
who purchased a debt obligation shall be deemed to have purchased it 
with a view to distribution through resale if the requirements of 
paragraph (b)(6)(iv) (b) or (c) of this section are met.
    (b) The requirements of this paragraph (b) is that--
    (1) The debt obligation is registered, approved, or listed for 
trading on one or more foreign securities exchanges or foreign 
established securities markets within 4 months after the date on which 
the underwriter purchases the debt obligation, or by the date of the 
first interest payment on the debt obligation, whichever is later, or
    (2) The debt obligation, or any substantial portion of the issue of 
which the debt obligation is a part, is actually traded on one or more 
foreign securities markets on or within 15 calendar days after the date 
on which the underwriter purchases the debt obligation.


[[Page 140]]



For purposes of this paragraph (b)(6)(iv), a foreign established 
securities market includes any foreign over-the-counter market as 
reflected by the existence of an inter-dealer quotation system for 
regularly disseminating to brokers and dealers quotations of obligations 
by identified brokers or dealers, other than quotations prepared and 
distributed by a broker or dealer in the regular course of his business 
and containing only quotations of such broker or dealer.
    (c) The requirements of this paragraph (c) are that, except as 
provided in paragraph (b)(6)(iv)(d) of this section, the underwriter is 
under no written or implied restriction imposed by the issuer with 
respect to whom he may resell the debt obligation and either--
    (1) Within 30 calendar days after he purchased the debt obligation 
the underwriter or underwriters either (i) sold it or (ii) sold at least 
95 percent of the face amount of the issue of which the debt obligation 
is a part, or
    (2)(i) The debt obligation is evidenced by an instrument which, 
under the laws of the jurisdiction in which it is issued, is either 
negotiable or transferable by assignment (whether or not it is 
registered for trading), and (ii) it appears from all the relevant facts 
and circumstances, including any written statements or assurances made 
by the purchasing underwriter or underwriters, that such debt obligation 
was purchased with a view to distribution through resale.
    (d) The requirements of paragraph (b)(6)(iv)(c) of this paragraph 
may be met whether or not the underwriter is restricted from reselling 
the debt obligations--
    (1) To a United States person (as defined in section 7701(a)(30)) or
    (2) To any particular person or persons pursuant to a restriction 
imposed by, or required to be met in order to comply with, United States 
or foreign securities or other law.
    (v) Statement with return. Any taxpayer who is required to file a 
tax return and who excludes from gross income interest of the type 
specified in this subparagraph must comply with the requirements of 
paragraph (d) of this section.
    (vi) Effect of termination of IET. If the interest equalization tax 
expires, the provisions of section 861(a)(1)(G) and this subparagraph 
shall apply to interest paid on debt obligations only with respect to 
which a section 4912(c) election was made.
    (vii) Definition of term underwriter. For purposes of section 
861(a)(1)(G) and this paragraph, the term ``underwriter'' shall mean any 
underwriter as defined in section 4919(c)(1).
    (c) Special rules--(1) Proration of interest from a foreign 
corporation deriving major portion of its income from a U.S. business. 
If, after applying the first sentence of paragraph (b)(3) of this 
section to interest to which that paragraph applies, it is determined 
that the interest may not be treated as income from sources without the 
United States, the amount of the interest from the foreign corporation 
which at some time during the taxable year is engaged in trade or 
business in the United States which is to be treated as income from 
sources within the United States shall be the amount that bears the same 
ratio to such interest as the gross income of such foreign corporation 
for the 3-year period ending with the close of its taxable year 
preceding its taxable year in which such interest is paid or credited 
(or for such part of such period as the corporation has been in 
existence) which was effectively connected with the conduct by such 
corporation of a trade or business in the United States bears to its 
gross income from all sources for such period.
    (2) Payors having no gross income for period preceding taxable year 
of payment. If the resident alien individual, domestic corporation, or 
foreign corporation, as the case may be, paying interest has no gross 
income from any source for the 3-year period (or part thereof) specified 
in paragraph (b) (2) or (3) of this section, or paragraph (c)(1) of this 
section, the 20-percent test or the 50-percent test, or the 
apportionment formula, as the case may be, described in such paragraph 
shall be applied solely with respect to the taxable year of the payor in 
which the interest is paid or credited. This paragraph applies whether 
the lack of gross income for the 3-year period (or part thereof) stems 
from the business inactivity of the

[[Page 141]]

payor, from the fact that the payor is a corporation which is newly 
created or organized, or from any other cause.
    (3) Transitional rule. For purposes of applying paragraph (b)(3) of 
this section, and paragraph (c)(1) of this section, the gross income of 
the foreign corporation for any period before the first taxable year 
beginning after December 31, 1966, which is from sources within the 
United States (determined as provided by sections 861 through 863, and 
the regulations thereunder, as in effect immediately before amendment by 
section 102 of the Foreign Investors Tax Act of 1966 (Pub. L. 89-809, 80 
Stat. 1541)) shall be treated as gross income for such period which is 
effectively connected with the conduct of a trade or business in the 
United States by such foreign corporation.
    (4) Gross income determinations. In making determinations under 
paragraph (b) (2) or (3) of this section, or paragraph (c) (1) or (3) of 
this section--
    (i) The gross income of a domestic corporation or a resident alien 
individual is to be determined by excluding any items specifically 
excluded from gross income under chapter 1 of the Code, and
    (ii) The gross income of a foreign corporation which is effectively 
connected with the conduct of a trade or business in the United States 
is to be determined under section 882(b)(2) and by excluding any items 
specifically excluded from gross income under chapter 1 of the Code, and
    (iii) The gross income from all sources of a foreign corporation is 
to be determined without regard to section 882(b) and without excluding 
any items otherwise specifically excluded from gross income under 
chapter 1 of the Code.
    (d) Statement with return. Any taxpayer who is required to file a 
return and applies any provision of this section to exclude an amount of 
interest from his gross income must file with his return a statement 
setting forth the amount so excluded, the date of its receipt, the name 
and address of the obligor of the interest, and, if known, the location 
of the records which substantiate the amount of the exclusion. A 
statement from the obligor setting forth such information and indicating 
the amount of interest to be treated as income from sources without the 
United States may be used for this purpose. See Sec. Sec.  1.6012-
1(b)(1)(i) and 1.6012-2(g)(1)(i).
    (e) Effective dates. Except as otherwise provided, this section 
applies with respect to taxable years beginning after December 31, 1966. 
For corresponding rules applicable to taxable years beginning before 
January 1, 1967, (see 26 CFR part 1 revised April 1, 1971). Paragraph 
(a)(7) of this section is applicable to payments made after November 13, 
1997.

[T.D. 7378, 40 FR 45429, Oct. 2, 1975; 40 FR 48508, Oct. 16, 1975, as 
amended by T.D. 8257, 54 FR 31819, Aug. 2, 1989; T.D. 8735, 62 FR 53500, 
Oct. 14, 1997]



Sec.  1.861-3  Dividends.

    (a) General--(1) Dividends included in gross income. Gross income 
from sources within the United States includes a dividend described in 
subparagraph (2), (3), (4), or (5) of this paragraph. For purposes of 
subparagraphs (2), (3), and (4) of this paragraph, the term ``dividend'' 
shall have the same meaning as set forth in section 316 and the 
regulations thereunder. See subparagraph (5) of this paragraph for 
special rules with respect to certain dividends from a DISC or former 
DISC. See also paragraph (a)(6) of this section for special rules 
concerning substitute dividend payments received pursuant to a 
securities lending transaction.
    (2) Dividend from a domestic corporation. A dividend described in 
this paragraph (a)(2) is a dividend from a domestic corporation other 
than a corporation that has an election in effect under section 936. See 
paragraph (a)(5) of this section for the treatment of certain dividends 
from a DISC or former DISC.
    (3) Dividend from a foreign corporation--(i) In general--(a) A 
dividend described in this subparagraph is a dividend from a foreign 
corporation (other than a dividend to which subparagraph (4) of this 
paragraph applies) unless less than 50 percent of the gross income from 
all sources of such foreign corporation for the 3-year period ending 
with the close of its taxable year preceding the taxable year in which 
occurs the declaration of such dividend (or for

[[Page 142]]

such part of such period as the corporation has been in existence) was 
effectively connected with the conduct by such corporation of a trade or 
business in the United States, as determined under section 864(c) and 
Sec.  1.864-3. Thus, no portion of a dividend from a foreign corporation 
shall be treated as income from sources within the United States under 
section 861(a)(2)(B) if less than 50 percent of the gross income of such 
foreign corporation from all sources for such 3-year period (or part 
thereof) was effectively connected with the conduct by such corporation 
of a trade or business in the United States or if such foreign 
corporation had gross income for such 3-year period (or part thereof) 
but none was effectively connected with the conduct by such corporation 
of a trade or business in the United States.
    (b) If 50 percent or more of the gross income from all sources of 
such foreign corporation for such 3-year period (or part thereof) was 
effectively connected with the conduct by such corporation of a trade or 
business in the United States, the amount of the dividend which is to be 
treated as income from sources within the United States under section 
861(a)(2)(B) shall be the amount that bears the same ratio to such 
dividend as the gross income of such foreign corporation for such 3-year 
period (or part thereof) which was effectively connected with the 
conduct by such corporation of a trade or business in the United States 
bears to its gross income from all sources for such period.
    (c) For purposes of this subdivision (i), the gross income which is 
effectively connected with the conduct of a trade or business in the 
United States includes the gross income which, pursuant to section 882 
(d) or (e), is treated as income which is effectively connected with the 
conduct of a trade or business in the United States.
    (ii) Rule applicable in applying limitation on amount of foreign tax 
credit. For purposes of determining under section 904 the limitation 
upon the amount of the foreign tax credit--
    (a) So much of a dividend from a foreign corporation as exceeds (and 
only to the extent it so exceeds) the amount which is 100/85ths of the 
amount of the deduction allowable under section 245(a) in respect of 
such dividend, plus
    (b) An amount which bears the same proportion to any section 78 
dividend to which the dividend from the foreign corporation gives rise 
as the amount of the excess determined under (a) of this subdivision 
bears to the total amount of the dividend from the foreign corporation, 
shall, notwithstanding subdivision (i) of this subparagraph, be treated 
as income from sources without the United States. This subdivision 
applies to a dividend for which no dividends-received deduction is 
allowed under section 245 or for which the 85 percent dividends-received 
deduction is allowed under section 245(a) but does not apply to a 
dividend for which a deduction is allowable under section 245(b). All of 
a dividend for which the 100 percent dividends-received deduction is 
allowed under section 245(b) shall be treated as income from sources 
within the United States for purposes of determining under section 904 
the limitation upon the amount of the foreign tax credit. If the amount 
of a distribution of property other than money (constituting a dividend 
under section 316) is determined by applying section 301(b)(1)(C), such 
amount must be used as the dividend for purposes of applying (a) of this 
subdivision even though the amount used for purposes of section 245(a) 
is determined by applying section 301(b)(1)(D). In making determinations 
under this subdivision, a dividend (other than a section 78 dividend 
referred to in (b) of this subdivision) shall be determined without 
regard to section 78.
    (iii) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. D, a domestic corporation, owns 80 percent of the 
outstanding stock of M, a foreign manufacturing corporation. M, which 
makes its returns on the basis of the calendar year, has earnings and 
profits of $200,000 for 1971 and 60 percent of its gross income for that 
year is effectively connected for 1971 with the conduct of a trade or 
business in the United States. For an uninterrupted period of 36 months 
ending on December 31, 1970, M has been engaged in trade or business in 
the United States and has received gross income effectively connected 
with the conduct of a trade or business in the United States amounting 
to 60 percent of its gross income from all sources for such period. The 
only distribution by M to D for 1971 is a cash dividend of $100,000; of 
this amount,

[[Page 143]]

$60,000 ($100,000 x 60%) is treated under subdivision (i) of this 
subparagraph as income from sources within the United States, and 
$40,000 ($100,000-$60,000) is treated under Sec.  1.862-1(a)(2) as 
income from sources without the United States. Accordingly, under 
section 245(a), D is entitled to a dividends-received deduction of 
$51,000 ($60,000 x 85%), and under subdivision (ii) of this subparagraph 
$40,000 ($100,000-[$51,000 x 100/85]) is treated as income from sources 
without the United States for purposes of determining under section 
904(a) (1) or (2) the limitation upon the amount of the foreign tax 
credit.
    Example 2. (a) The facts are the same as in example (1) except that 
the distribution for 1971 consists of property which has a fair market 
value of $100,000 and an adjusted basis of $30,000 in M's hands 
immediately before the distribution. The amount of the dividend under 
section 316 is $58,000, determined by applying section 301(b)(1)(C) as 
follows:

Portion of adjusted basis of property attributable to gross      $18,000
 income of M effectively connected for 1971 with conduct of
 trade or business in United States ($30,000 x 60%)...........
Portion of fair market value of property attributable to gross    40,000
 income of M not effectively connected for 1971 with conduct
 of trade or business in United States ($100,000 x 40%).......
                                                               ---------
 Total dividend...............................................    58,000
 

    (b) Of the total dividend, $34,800 ($58,000 x 60% (percentage 
applicable to 3-year period)) is treated under subdivision (i) of this 
subparagraph as income from sources within the United States, and 
$23,200 ($58,000 x 40%) is treated under Sec.  1.862-1(a)(2) as income 
from sources without the United States. However, by reason of section 
245(c) the adjusted basis of the property ($30,000) is used under 
section 245(a) in determining the dividends-received deduction. Thus, 
under section 245(a), D is entitled to a dividends-received deduction of 
$15,300 ($30,000 x 60% x 85%).
    (c) Under subdivision (ii) of this subparagraph, the amount of the 
dividend for purposes of applying (a) of that subdivision is the amount 
($58,000) determined by applying section 301(b)(1)(C) rather than the 
amount ($30,000) determined by applying section 301(b)(1)(B). 
Accordingly, under subdivision (ii) of this subparagraph $40,000 
($58,000-[$15,300 x 100/85]) is treated as income from sources without 
the United States for purposes of determining under section 904(a) (1) 
or (2) the limitation upon the amount of the foreign tax credit.
    Example 3. (a) D, a domestic corporation which makes its returns on 
the basis of the calendar year, owns 100 percent of the outstanding 
stock of N, a foreign corporation which is not a less developed country 
corporation under section 902(d). N, which makes its returns on the 
basis of the calendar year, has total gross income for 1971 of $100,000, 
of which $80,000 (including $60,000 from sources within foreign country 
X) is effectively connected for that year with the conduct of a trade or 
business in the United States. For 1971 N is assumed to have paid 
$27,000 of income taxes to country X and to have accumulated profits of 
$81,000 for purposes of section 902(c)(1)(A). N's accumulated profits in 
excess of foreign income taxes amount to $54,000. For 1971 D receives a 
cash dividend of $42,000 from N, which is D's only income for that year.
    (b) For 1971 D chooses the benefits of the foreign tax credit under 
section 901, and as a result is required under section 78 to include in 
gross income an amount equal to the foreign income taxes of $21,000 
($27,000 x $42,000/$54,000) it is deemed to have paid under section 
902(a)(1). Thus, assuming no other deductions for the taxable year, D 
has gross income of $63,000 ($42,000 + $21,000) for 1971 less a 
dividends-received deduction under section 245(a) of $28,560 ([$42,000 x 
$80,000/$100,000] x 85%), or taxable income for 1971 of $34,440.
    (c) Under subdivision (ii) of this subparagraph, for purposes of 
determining under section 904(a) (1) or (2) the limitation upon the 
amount of the foreign tax credit, $12,600 is treated as income from 
sources without the United States, determined as follows:

Excess of dividend from N over amount which is 100/85ths of       $8,400
 amount of sec. 245(a) deduction ($42,000-[$28,560 x 100/85]).
Proportionate part of sec. 78 dividend ($21,000 x $8,400/          4,200
 $42,000).....................................................
                                                               ---------
      Taxable income from sources without the United States...    12,600
 

    Example 4. A, an individual citizen of the United States who makes 
his return on the basis of the calendar year, receives in 1971 a cash 
dividend of $10,000 from M, a foreign corporation, which makes its 
return on the basis of the calendar year. For the 3-year period ending 
with 1970 M has been engaged in trade or business in the United States 
and has received gross income effectively connected with the conduct of 
a trade or business in the United States amounting to 80 percent of its 
gross income from all sources for such period. Of the total dividend, 
$8,000 ($10,000 x 80%) is treated under subdivision (i) of this 
subparagraph as income from sources within the United States and $2,000 
($10,000-$8,000) is treated under Sec.  1.862-1(a)(2) as income from 
sources without the United States. Since under section 245 no dividends 
received-deduction is allowable to an individual, A is entitled under 
subdivision (ii) of this subparagraph to treat the entire dividend of 
$10,000 ($10,000-[$0 x 100/85]) as income from sources without the 
United States for purposes of determining under section 904(a) (1) or 
(2) the limitation upon the amount of the foreign tax credit.


[[Page 144]]


    (4) Dividend from a foreign corporation succeeding to earnings of a 
domestic corporation. A dividend described in this subparagraph is a 
dividend from a foreign corporation, if such dividend is received by a 
corporation after December 31, 1959, but only to the extent that such 
dividend is treated by such recipient corporation under the provisions 
of Sec.  1.243-3 as a dividend from a domestic corporation subject to 
taxation under chapter 1 of the Code. To the extent that this 
subparagraph applies to a dividend received from a foreign corporation, 
subparagraph (3) of this paragraph shall not apply to such dividend.
    (5) Certain dividends from a DISC or former DISC--(i) General rule. 
A dividend described in this subparagraph is a dividend from a 
corporation that is a DISC or former DISC (as defined in section 992(a)) 
other than a dividend that--
    (a) Is deemed paid by a DISC, for taxable years beginning before 
January 1, 1976, under section 995(b)(1)(D) as in effect for taxable 
years beginning before January 1, 1976, and for taxable years beginning 
after December 31, 1975, under section 995(b)(1) (D), (E), and (F) to 
the extent provided in subdivision (iii) of this subparagraph or
    (b) Reduces under Sec.  1.996-3(b)(3) accumulated DISC income (as 
defined in subdivision (ii)(b) of this subparagraph) to the extend 
provided in subdivision (iv) of this subparagraph.


Thus, a dividend deemed paid under section 995(b)(1) (A), (B), or (C) 
(relating to certain deemed distributions in qualified years) will be 
treated in full as gross income from sources within the United States. 
To the extent that a dividend from a DISC or former DISC is paid out of 
other earnings and profits (as defined in Sec.  1.996-3(d)), 
subparagraph (2) of this paragraph shall apply. To the extent that a 
dividend from a DISC or former DISC is paid out of previously taxed 
income (as defined in Sec.  1.996-3(c)), see section 996(a)(3) (relating 
to the exclusion from gross income of amounts distributed out of 
previously taxed income). In determining the source of income of certain 
dividends from a DISC or former DISC, the source of income from any 
transaction which gives rise to gross receipts (as defined in Sec.  
1.993-6), in the hands of the DISC or former DISC, is immaterial.
    (ii) Definitions. For purposes of this subparagraph, the term--
    (a) ``Dividend from'' means any amount actually distributed which is 
a dividend within the meaning of section 316 (including distributions to 
meet qualification requirements under section 992(c)) and any amount 
treated as a distribution taxable as a dividend pursuant to section 
995(b) (relating to deemed distributions in qualified years or upon 
disqualification) or included in gross income as a dividend pursuant to 
section 995(c) (relating to gain on certain dispositions of stock in a 
DISC or former DISC), and
    (b) ``Accumulated DISC income'' means the amount of accumulated DISC 
income as of the close of the taxable year immediately preceding the 
taxable year in which the dividend was made increased by the amount of 
DISC income for the taxable year in which the dividend was made (as 
determined under Sec.  1.996-3(b)(2)).
    (c) ``Nonqualified export taxable income'' means the taxable income 
of a DISC from any transaction which gives rise to gross receipts (as 
defined in Sec.  1.993-6) which are not qualified export receipts (as 
defined in Sec.  1.993-1) other than a transaction giving rise to gain 
described in section 995(b)(1) (B) or (C).


For purposes of subdivisions (i)(b) and (iv) of this subparagraph, if by 
reason of section 995(c), gain is included in the shareholder's gross 
income as a dividend, accumulated DISC income shall be treated as if it 
were reduced under Sec.  1.996-3(b)(3).
    (iii) Determination of source of income for deemed distributions, 
for taxable years beginning before January 1, 1976, under section 
995(b)(1)(D) as in effect for taxable years beginning before January 1, 
1976, and for taxable years beginning after December 31, 1975, under 
section 995(b)(1) (D), (E), and (F). (a) If for its taxable year a DISC 
does not have any nonqualified export taxable income, then for such year 
the entire amount treated, for taxable years beginning before January 1, 
1976, under section 995(b)(1)(D) as in effect for taxable years 
beginning before January 1, 1976, and for taxable years beginning after 
December 31, 1975, under section

[[Page 145]]

995(b)(1) (D), (E), and (F) as a deemed distribution taxable as a 
dividend will be treated as gross income from sources without the United 
States.
    (b) If for its taxable year a DISC has any nonqualified export 
taxable income, then for such year the portion of the amount treated, 
for taxable years beginning before January 1, 1976, under section 
995(b)(1)(D) as in effect for taxable years beginning before January 1, 
1976, and for taxable years beginning after December 31, 1975, under 
section 995(b)(1) (D), (E), and (F) as a deemed distribution taxable as 
a dividend that will be treated as income from sources within the United 
States shall be equal to the amount of such nonqualified export taxable 
income multiplied by the following fraction. The numerator of the 
fraction is the sum of the amounts treated, for taxable years beginning 
before January 1, 1976, under section 995(b)(1)(D) as in effect for 
taxable years beginning before January 1, 1976, and for taxable years 
beginning after December 31, 1975, under section 995(b)(1) (D), (E), and 
(F) as deemed distributions taxable as dividends. The denominator of the 
fraction is the taxable income of the DISC for the taxable year, reduced 
by the amounts treated under section 995(b)(1) (A), (B), and (C) as 
deemed distributions taxable as dividends. However, in no event shall 
the numerator exceed the denominator. The remainder of such dividend 
will be treated as gross income from sources without the United States.
    (iv) Determination of source of income for dividends that reduce 
accumulated DISC income. (a) If no portion of the accumulated DISC 
income of a DISC or former DISC is attributable to nonqualified export 
taxable income from any transaction during a year for which it is (or is 
treated as) a DISC, then the entire amount of any dividend that reduces 
under Sec.  1.996-3(b)(3) accumulated DISC income will be treated as 
income from sources without the United States.
    (b) If any portion of the accumulated DISC income of a DISC or 
former DISC is attributable to nonqualified export taxable income from 
any transaction during a year for which it is (or is treated as) a DISC, 
then the portion of any dividend during its taxable year that reduces 
under Sec.  1.996-3(b)(3) accumulated DISC income that will be treated 
as income from sources within the United States shall be equal to the 
amount of such dividend multiplied by a fraction (determined as of the 
close of such year) the numerator of which is the amount of accumulated 
DISC income attributable to nonqualified export taxable income, and the 
denominator of which is the total amount of accumulated DISC income. The 
remainder of such dividend will be treated as gross income from sources 
without the United States.
    (v) Special rules. For purposes of subdivisions (iii) and (iv) of 
this subparagraph--
    (a) Taxable income shall be determined under Sec.  1.992-3(b)(2)(i) 
(relating to the computation of deficiency distribution), and
    (b) The portion of any deemed distribution taxable as a dividend, 
for taxable years beginning before January 1, 1976, under section 
995(b)(1)(D) as in effect for taxable years beginning before January 1, 
1976, and for taxable years beginning after December 31, 1975, under 
section 995(b)(1)(D), (E), and (F) or amount under Sec.  1.996-3(b)(3) 
(i) through (iv) that is treated as gross income from sources within the 
United States during the taxable year shall be considered to reduce the 
amount of nonqualified export taxable income as of the close of such 
year.
    (vi) Illustrations. This subparagraph may be illustrated by the 
following examples:

    Example 1. (a) 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 1973, Y has $18,000 of taxable 
income from qualified export receipts (none of which are interest and 
gains described in section 995(b)(1)(A), (B), and (C)) and $1,000 of 
nonqualified export taxable income. Under these facts, X is deemed to 
have received a distribution under section 995(b)(1)(D) as in effect for 
taxable years beginning before January 1, 1976, of $9,500, i.e., $19,000 
X \1/2\. X is treated under subdivision (iii)(b) of this subparagraph as 
having $500, i.e., $1,000 X $9,500/$19,000, from sources within the 
United States and $9,000 from sources without the United States.
    (b) For 1972, assume that Y did not have any nonqualified export 
taxable income.

[[Page 146]]

Pursuant to subdivision (v)(b) of this subparagraph, at the beginning of 
1974, $500 of Y's accumulated DISC income is attributable to 
nonqualified export taxable income (iii)(a) of this subparagraph), i.e., 
$1,000--$500.
    Example 2. The facts are the same as in example (1) except that in 
1973, in addition to the taxable income described in such example, Y has 
$450 of taxable income from gross interest from producer's loans 
described in section 995(b)(1)(A). Under these facts, the deemed 
distribution of $450 under section 995(b)(1)(A) is treated in full under 
subdivision (i) of this subparagraph as gross income from sources within 
the United States. The deemed distribution under section 995(b)(1)(D) as 
in effect for taxable years beginning before January 1, 1976, of $9,500 
will be treated in the same manner as in example (1), i.e., $1,000 x 
$9,500 / ($19,450 - $450).
    Example 3. (a) The facts are the same as in example (1) except that 
in 1973, in addition to the distribution described in such example, Y 
makes a deemed distribution taxable as a dividend of $100 under section 
995(b)(1)(G) (relating to foreign investment attributable to producer's 
loans) and actual distributions of all of its previously taxed income 
and of $2,000 taxable as a dividend which reduces accumulated DISC 
income (as defined in subdivision (ii)(b) of this subparagraph). Under 
Sec.  1.996-3(b)(3), accumulated DISC income is first reduced by the 
deemed distribution of $100 and then by the actual distribution taxable 
as a dividend of $2,000. As indicated in example (1), for 1972 Y did not 
have any nonqualified export taxable income. Assume that Y had 
accumulated DISC income of $12,000 at the end of 1973, $500 of which 
under example (1) is attributable to nonqualified export taxable income.
    (b) The distribution from previously taxed income is excluded from 
gross income pursuant to section 996(a)(3).
    (c) Of the deemed distribution of $100, X is treated under 
subdivision (iv)(b) as having $4.17, i.e., $100 x 500/12,000, from 
sources within the United States and $95.83, i.e., $100--$4.17, from 
sources without the United States.
    (d) Of the actual distribution taxable as a dividend of $2,000, X is 
treated under subdivision (iv)(b) as having $83.33, i.e., $2,000 x 500/
12,000, from sources within the United States and $1,916.67, i.e., 
$2,000--$83.33, from sources without the United States.
    (e) The sum of the amounts deemed and actually distributed as 
dividends for 1973 that are treated as gross income from sources within 
the United States is as follows:

------------------------------------------------------------------------
                                                               Amount of
                                                                dividend
                                                                  from
                                                      Total     sources
                                                     dividend    within
                                                                  the
                                                                 United
                                                                 States
------------------------------------------------------------------------
Deemed distribution under sec. 995(b)(1)(D) as in      $9,500    $500.00
 effect for taxable years beginning before January
 1, 1976..........................................
Deemed distribution under section 995(b)(1)(G)....        100       4.17
Actual distribution that reduces accumulated DISC       2,000      83.33
 income...........................................
                                                   ---------------------
      Totals......................................    $11,600    $587.50
------------------------------------------------------------------------


Thus, pursuant to subdivision (v)(b) of this subparagraph, at the 
beginning of 1974 Y has $412.50, i.e., $1,000--$587.50, of nonqualified 
export taxable income.
    (f) The result would be the same if Y made an actual distribution 
taxable as a dividend of $1,500 on March 30, 1973, and another 
distribution of $500 on December 31, 1973.
    Example 4. (a) Z is a corporation which uses the calendar year as 
its taxable year and which elects to be treated as a DISC beginning with 
1972. W is its sole shareholder. At the end of the 1976 Z has previously 
taxed income of $12,000 and accumulated DISC income of $4,000, $900 of 
which is attributable to nonqualified export taxable income. In 1977, Z 
has $20,050 of taxable income from qualified export receipts, of which 
$550 is from gross income from producer's loans described in section 
995(b)(1)(A); Z has $950 of taxable income giving rise to gross receipts 
which are not qualified export receipts, of which $450 is gain described 
in section 995(b)(1)(B). Of its total taxable income of $21,000 (which 
is equal to its earnings and profits for 1977), $1,000 is attributable 
to sales of military property. Z has an international boycott factor 
(determined under section 999) of .10, and made an illegal bribe (within 
the meaning of section 162(c)) of $1,265. The proportion which the 
amount of Z's adjusted base period export receipts bears to Z's export 
gross receipts for 1977 is .40 (see section 995(e)(1)). Z makes a deemed 
distribution taxable as a dividend of $1,000 under section 995(b)(1)(G) 
(relating to foreign investment attributable to producer's loans) and 
actual distributions of $32,000.
    (b) The deemed distributions of $550 under section 995(b)(1)(A) and 
$450 under section 995(b)(1)(B) are treated in full under subdivision 
(i) of this subparagraph as gross income from sources within the United 
States.
    (c) Under these facts, Z has also made the following deemed 
distributions taxable as dividends to W under the following subdivisions 
of section 995(b)(1):

(D).........................    $500,  i.e., \1/2\ x $1,000.
(E).........................   7,800,  i.e.,.40 x [$21,000 - $(550 + 450
                                        + 500)].

[[Page 147]]

 
(F)(i)......................   5,850,  i.e., \1/2\ x [$21,000 - $550 +
                                        450 + 500 + 7,800)].
 (ii).......................     585,  i.e., $5,850 x .10
 (iii)......................    1,265
                             ---------
 Total......................   16,000  .................................
 

    (d) The portion of the total amount of these deemed distributions 
($16,000 that is treated under the subdivision (iii)(b) as gross income 
from sources within the United States is computed as follows:
    (1) The amount of nonqualified export taxable income is $500, i.e., 
taxable income giving rise to gross receipts which are not qualified 
export receipts ($950) minus gain described in section 995(b)(1) (B) or 
(C) ($450).
    (2) $500 x ($16,000/$[21,000-(550 + 450)]) = $400.


The remainder of these distributions, $15,600 ($16,000 minus $400), is 
treated under subdivision (iii)(b) of this subparagraph as gross income 
from sources without the United States.
    (e) The earnings and profits accounts of Z at the end of 1977 are 
computed as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                             Accumulated DISC
                                                                                          income attributable to
                                                                                            taxable income from
                                                                                            translations which
                                                                     Total    Previously    give rise to gross
                                                                   earnings      taxed       receipts which--
                                                                      and       income   -----------------------
                                                                    profits                   Are       Are not
                                                                                           qualified   qualified
                                                                                            export      export
                                                                                           receipts    receipts
----------------------------------------------------------------------------------------------------------------
(1) Balance: January 1, 1977....................................    $16,000     $12,000      $3,100        $900
(2) Earnings and profits for 1977, before actual and section         21,000      17,000       3,900     \1\ 100
 955(b)(1)(G) distributions.....................................
(3) Balance: December 31, 1977..................................     37,000      29,000       7,000       1,000
(4) Distribution under section 995(b)(1)(G).....................  ..........      1,000        (875)   \2\ (125)
(5) Balance.....................................................     37,000      30,000       6,125         875
(6) Actual distribution.........................................    (32,000)    (30,000)     (1,750)   \3\ (250)
(7) Balance: January 1, 1978....................................      5,000   ..........      4,375         625
----------------------------------------------------------------------------------------------------------------
\1\ The total of nonqualified export taxable income ($500) minus the portion of such income, under subdivision
  (iii)(b) of this subparagraph, deemed distributed pursuant to section 995(b)(1)(D), (E), and (F) ($400), as
  computed under (d)(2) of this example.
\2\ Under subdivision (iv)(b) of this subparagraph, $1,000/$8,000 x $1,000.
\3\ Under subdivision (iv)(b) of this subparagraph, $1,000/$8,000 x $2,000 (amount of actual distribution that
  reduces accumulated DISC income).

    (6) Substitute dividend payments. A substitute dividend payment is a 
payment, made to the transferor of a security in a securities lending 
transaction or a sale-repurchase transaction, of an amount equivalent to 
a dividend distribution which the owner of the transferred security is 
entitled to receive during the term of the transaction. A securities 
lending transaction is a transfer of one or more securities that is 
described in section 1058(a) or a substantially similar transaction. A 
sale-repurchase transaction is an agreement under which a person 
transfers a security in exchange for cash and simultaneously agrees to 
receive substantially identical securities from the transferee in the 
future in exchange for cash. A substitute dividend payment shall be 
sourced in the same manner as the distributions with respect to the 
transferred security for purposes of this section and Sec.  1.862-1. See 
also Sec. Sec.  1.864-5(b)(2)(iii), 1.871-7(b)(2) and 1.881-2(b)(2) for 
the character of such payments and Sec.  1.894-1(c) for the application 
of tax treaties to these transactions.
    (b) Special rules--(1) Foreign corporation having no gross income 
for period preceding declaration of dividend. If the foreign corporation 
has no gross income from any source for the 3-year period (or part 
thereof) specified in paragraph (a)(3)(i) of this section, the 50-
percent test, or the apportionment formula, as the case may be, 
described in such paragraph shall be applied solely with respect to the 
taxable year of such corporation in which the declaration of the 
dividend occurs. This subparagraph applies whether the lack of gross 
income for the 3-year period (or part thereof) stems from the business 
inactivity of the foreign corporation, from the fact that such 
corporation is newly created or organized, or from any other cause.
    (2) Transitional rule. For purposes of applying paragraph (a)(3)(i) 
of this section, the gross income of the foreign corporation for any 
period before the

[[Page 148]]

first taxable year beginning after December 31, 1966, which is from 
sources within the United States (determined as provided by sections 861 
through 863, and the regulations thereunder, as in effect immediately 
before amendment by section 102 of the Foreign Investors Tax Act of 1966 
(Pub. L. 89-809, 80 Stat. 1541)) shall be treated as gross income for 
such period which is effectively connected with the conduct of a trade 
or business within the United States by such foreign corporation.
    (3) Gross income determinations. In making determinations under 
subparagraph (2) or (3) of paragraph (a) of this section, or 
subparagraph (2) of this paragraph--
    (i) The gross income of a domestic corporation is to be determined 
by excluding any items specifically excluded from gross income under 
chapter 1 of the Code.
    (ii) The gross income of a foreign corporation which is effectively 
connected with the conduct of a trade or business in the United States 
is to be determined under section 882(b)(2) and by excluding any items 
specifically excluded from gross income under chapter 1 of the Code, and
    (iii) The gross income from all sources of a foreign corporation is 
to be determined without regard to section 882(b) and without excluding 
any items otherwise specifically excluded from gross income under 
chapter 1 of the Code.
    (c) Statement with return. Any taxpayer who is required to file a 
return and applies any provision of this section to exclude any dividend 
from his gross income must file with his return a statement setting 
forth the amount so excluded, the date of its receipt, the name and 
address of the corporation paying the dividend, and, if known, the 
location of the records which substantiate the amount of the exclusion. 
A statement from the paying corporation setting forth such information 
and indicating the amount of the dividend to be treated as income from 
sources within the United States may be used for this purpose. See 
Sec. Sec.  1.6012-1(b)(1)(i) and 1.6012-2 (g)(1)(i).
    (d) Effective/applicability date. Except as otherwise provided in 
this paragraph this section applies with respect to dividends received 
or accrued after December 31, 1966. Paragraph (a)(5) of this section 
applies to certain dividends from a DISC or former DISC in taxable years 
ending after December 31, 1971. Paragraph (a)(6) of this section is 
applicable to payments made after November 13, 1997. For purposes of 
paragraph (a)(5) of this section, any reference to a distribution 
taxable as a dividend under section 995(b)(1)(F) (ii) and (iii) for 
taxable years beginning after December 31, 1975, shall also constitute a 
reference to any distribution taxable as a dividend under section 
995(b)(1)(F) (ii) and (iii) for taxable years beginning after November 
30, 1975, but before January 1, 1976. For corresponding rules applicable 
with respect to dividends received or accrued before January 1, 1967, 
see 26 CFR 1.861-3 (Revised as of January 1, 1972). Paragraph (a)(2) of 
this section applies to taxable years ending after April 9, 2008.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960]

    Editorial Note: For Federal Register citations affecting Sec.  
1.861-3, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.861-4  Compensation for labor or personal services.

    (a) Compensation for labor or personal services performed wholly 
within the United States. (1) Generally, compensation for labor or 
personal services, including fees, commissions, fringe benefits, and 
similar items, performed wholly within the United States is gross income 
from sources within the United States.
    (i) The labor or services are performed by a nonresident alien 
individual temporarily present in the United States for a period or 
periods not exceeding a total of 90 days during his taxable year,
    (ii) The compensation for such labor or services does not exceed in 
the aggregate a gross amount of $3,000, and
    (iii) The compensation is for labor or services performed as an 
employee of, or under any form of contract with--
    (a) A nonresident alien individual, foreign partnership, or foreign 
corporation, not engaged in trade or business within the United States, 
or

[[Page 149]]

    (b) An individual who is a citizen or resident of the United States, 
a domestic partnership, or a domestic corporation, if such labor or 
services are performed for an office or place of business maintained in 
a foreign country or in a possession of the United States by such 
individual, partnership, or corporation.
    (2) As a general rule, the term ``day'', as used in subparagraph 
(1)(i) of this paragraph, means a calendar day during any portion of 
which the nonresident alien individual is physically present in the 
United States.
    (3) Solely for purposes of applying this paragraph, the nonresident 
alien individual, foreign partnership, or foreign corporation for which 
the nonresident alien individual is performing personal services in the 
United States shall not be considered to be engaged in trade or business 
in the United States by reason of the performance of such services by 
such individual.
    (4) In determining for purposes of subparagraph (1)(ii) of this 
paragraph whether compensation received by the nonresident alien 
individual exceeds in the aggregate a gross amount of $3,000, any 
amounts received by the individual from an employer as advances or 
reimbursements for travel expenses incurred on behalf of the employer 
shall be omitted from the compensation received by the individual, to 
the extent of expenses incurred, where he was required to account and 
did account to his employer for such expenses and has met the tests for 
such accounting provided in Sec.  1.162-17 and paragraph (e)(4) of Sec.  
1.274-5. If advances or reimbursements exceed such expenses, the amount 
of the excess shall be included as compensation for personal services 
for purposes of such subparagraph. Pensions and retirement pay 
attributable to labor or personal services performed in the United 
States are not to be taken into account for purposes of subparagraph 
(1)(ii) of this paragraph. (5) For definition of the term ``United 
States'', when used in a geographical sense, see sections 638 and 
7701(a)(9).
    (b) Compensation for labor or personal services performed partly 
within and partly without the United States--(1) Compensation for labor 
or personal services performed by persons other than individuals--(i) In 
general. In the case of compensation for labor or personal services 
performed partly within and partly without the United States by a person 
other than an individual, the part of that compensation that is 
attributable to the labor or personal services performed within the 
United States, and that is therefore included in gross income as income 
from sources within the United States, is determined on the basis that 
most correctly reflects the proper source of the income under the facts 
and circumstances of the particular case. In many cases, the facts and 
circumstances will be such that an apportionment on the time basis, as 
defined in paragraph (b)(2)(ii)(E) of this section, will be acceptable.
    (ii) Example. The application of paragraph (b)(1)(i) is illustrated 
by the following example.

    Example. Corp X, a domestic corporation, receives compensation of 
$150,000 under a contract for services to be performed concurrently in 
the United States and in several foreign countries by numerous Corp X 
employees. Each Corp X employee performing services under this contract 
performs his or her services exclusively in one jurisdiction. Although 
the number of employees (and hours spent by employees) performing 
services under the contract within the United States equals the number 
of employees (and hours spent by employees) performing services under 
the contract without the United States, the compensation paid to 
employees performing services under the contract within the United 
States is higher because of the more sophisticated nature of the 
services performed by the employees within the United States. 
Accordingly, the payroll cost for employees performing services under 
the contract within the United States is $20,000 out of a total contract 
payroll cost of $30,000. Under these facts and circumstances, a 
determination based upon relative payroll costs would be the basis that 
most correctly reflects the proper source of the income received under 
the contract. Thus, of the $150,000 of compensation included in Corp X's 
gross income, $100,000 ($150,000 x $20,000/$30,000) is attributable to 
the labor or personal services performed within the United States and 
$50,000 ($150,000 x $10,000/$30,000) is attributable to the labor or 
personal services performed without the United States.

    (2) Compensation for labor or personal services performed by an 
individual--(i) In general. Except as provided in paragraph (b)(2)(ii) 
of this section, in the

[[Page 150]]

case of compensation for labor or personal services performed partly 
within and partly without the United States by an individual, the part 
of such compensation that is attributable to the labor or personal 
services performed within the United States, and that is therefore 
included in gross income as income from sources within the United 
States, is determined on the basis that most correctly reflects the 
proper source of that income under the facts and circumstances of the 
particular case. In many cases, the facts and circumstances will be such 
that an apportionment on a time basis, as defined in paragraph 
(b)(2)(ii)(E) of this section, will be acceptable.
    (ii) Employee compensation--(A) In general. Except as provided in 
paragraph (b)(2)(ii)(B) or (C) of this section, in the case of 
compensation for labor or personal services performed partly within and 
partly without the United States by an individual as an employee, the 
part of such compensation that is attributable to the labor or personal 
services performed within the United States, and that is therefore 
included in gross income as income from sources within the United 
States, is determined on a time basis, as defined in paragraph 
(b)(2)(ii)(E) of this section.
    (B) Certain fringe benefits sourced on a geographical basis. Except 
as provided in paragraph (b)(2)(ii)(C) of this section, items of 
compensation of an individual as an employee for labor or personal 
services performed partly within and partly without the United States 
that are described in paragraphs (b)(2)(ii)(D)(1) through (6) of this 
section are sourced on a geographical basis in accordance with those 
paragraphs.
    (C) Exceptions and special rules--(1) Alternative basis--(i) 
Individual as an employee generally. An individual may determine the 
source of his or her compensation as an employee for labor or personal 
services performed partly within and partly without the United States 
under an alternative basis if the individual establishes to the 
satisfaction of the Commissioner that, under the facts and circumstances 
of the particular case, the alternative basis more properly determines 
the source of the compensation than a basis described in paragraph 
(b)(2)(ii)(A) or (B), whichever is applicable, of this section. An 
individual that uses an alternative basis must retain in his or her 
records documentation setting forth why the alternative basis more 
properly determines the source of the compensation. In addition, the 
individual must provide the information related to the alternative basis 
required by applicable Federal tax forms and accompanying instructions.
    (ii) Determination by Commissioner. The Commissioner may, under the 
facts and circumstances of the particular case, determine the source of 
compensation that is received by an individual as an employee for labor 
or personal services performed partly within and partly without the 
United States under an alternative basis other than a basis described in 
paragraph (b)(2)(ii)(A) or (B) of this section if such compensation 
either is not for a specific time period or constitutes in substance a 
fringe benefit described in paragraph (b)(2)(ii)(D) of this section 
notwithstanding a failure to meet any requirement of paragraph 
(b)(2)(ii)(D) of this section. The Commissioner may make this 
determination only if such alternative basis determines the source of 
compensation in a more reasonable manner than the basis used by the 
individual pursuant to paragraph (b)(2)(ii)(A) or (B) of this section.
    (2) Ruling or other administrative pronouncement with respect to 
groups of taxpayers. The Commissioner may, by ruling or other 
administrative pronouncement applying to similarly situated taxpayers 
generally, permit individuals to determine the source of their 
compensation as an employee for labor or personal services performed 
partly within and partly without the United States under an alternative 
basis. Any such individual shall be treated as having met the 
requirement to establish such alternative basis to the satisfaction of 
the Commissioner under the facts and circumstances of the particular 
case, provided that the individual meets the other requirements of 
paragraph (b)(2)(ii)(C)(1)(i) of this section. The Commissioner also 
may, by

[[Page 151]]

ruling or other administrative pronouncement, indicate the circumstances 
in which he will require individuals to determine the source of certain 
compensation as an employee for labor or personal services performed 
partly within and partly without the United States under an alternative 
basis pursuant to the authority under paragraph (b)(2)(ii)(C)(1)(ii) of 
this section.
    (3) Artists and athletes. [Reserved]
    (D) Fringe benefits sourced on a geographical basis. Except as 
provided in paragraph (b)(2)(ii)(C) of this section, compensation of an 
individual as an employee for labor or personal services performed 
partly within and partly without the United States in the form of the 
following fringe benefits is sourced on a geographical basis as 
indicated in this paragraph (b)(2)(ii)(D). The amount of the 
compensation in the form of the fringe benefit must be reasonable, and 
the individual must substantiate such amounts by adequate records or by 
sufficient evidence under rules similar to those set forth in Sec.  
1.274-5T(c) or (h) or Sec.  1.132-5. For purposes of this paragraph 
(b)(2)(ii)(D), the term principal place of work has the same meaning 
that it has for purposes of section 217 and Sec.  1.217-2(c)(3).
    (1) Housing fringe benefit. The source of compensation in the form 
of a housing fringe benefit is determined based on the location of the 
individual's principal place of work. For purposes of this paragraph 
(b)(2)(ii)(D)(1), a housing fringe benefit includes payments to or on 
behalf of an individual (and the individual's family if the family 
resides with the individual) only for rent, utilities (other than 
telephone charges), real and personal property insurance, occupancy 
taxes not deductible under section 164 or 216(a), nonrefundable fees 
paid for securing a leasehold, rental of furniture and accessories, 
household repairs, residential parking, and the fair rental value of 
housing provided in kind by the individual's employer. A housing fringe 
benefit does not include payments for expenses or items set forth in 
Sec.  1.911-4(b)(2).
    (2) Education fringe benefit. The source of compensation in the form 
of an education fringe benefit for the education expenses of the 
individual's dependents is determined based on the location of the 
individual's principal place of work. For purposes of this paragraph 
(b)(2)(ii)(D)(2), an education fringe benefit includes payments only for 
qualified tuition and expenses of the type described in section 
530(b)(4)(A)(i) (regardless of whether incurred in connection with 
enrollment or attendance at a school) and expenditures for room and 
board and uniforms as described in section 530(b)(4)(A)(ii) with respect 
to education at an elementary or secondary educational institution.
    (3) Local transportation fringe benefit. The source of compensation 
in the form of a local transportation fringe benefit is determined based 
on the location of the individual's principal place of work. For 
purposes of this paragraph (b)(2)(ii)(D)(3), an individual's local 
transportation fringe benefit is the amount that the individual receives 
as compensation for local transportation of the individual or the 
individual's spouse or dependents at the location of the individual's 
principal place of work. The amount treated as a local transportation 
fringe benefit is limited to the actual expenses incurred for local 
transportation and the fair rental value of any vehicle provided by the 
employer and used predominantly by the individual or the individual's 
spouse or dependents for local transportation. For this purpose, actual 
expenses incurred for local transportation do not include the cost 
(including interest) of the purchase by the individual, or on behalf of 
the individual, of an automobile or other vehicle.
    (4) Tax reimbursement fringe benefit. The source of compensation in 
the form of a foreign tax reimbursement fringe benefit is determined 
based on the location of the jurisdiction that imposed the tax for which 
the individual is reimbursed.
    (5) Hazardous or hardship duty pay fringe benefit. The source of 
compensation in the form of a hazardous or hardship duty pay fringe 
benefit is determined based on the location of the hazardous or hardship 
duty zone for which the hazardous or hardship duty pay fringe benefit is 
paid. For purposes of

[[Page 152]]

this paragraph (b)(2)(ii)(D)(5), a hazardous or hardship duty zone is 
any place in a foreign country which is either designated by the 
Secretary of State as a place where living conditions are 
extraordinarily difficult, notably unhealthy, or where excessive 
physical hardships exist, and for which a post differential of 15 
percent or more would be provided under section 5925(b) of title 5 of 
the U.S. Code to any officer or employee of the U.S. Government present 
at that place, or where a civil insurrection, civil war, terrorism, or 
wartime conditions threatens physical harm or imminent danger to the 
health and well-being of the individual. Compensation provided an 
employee during the period that the employee performs labor or personal 
services in a hazardous or hardship duty zone may be treated as a 
hazardous or hardship duty pay fringe benefit only if the employer 
provides the hazardous or hardship duty pay fringe benefit only to 
employees performing labor or personal services in a hazardous or 
hardship duty zone. The amount of compensation treated as a hazardous or 
hardship duty pay fringe benefit may not exceed the maximum amount that 
the U.S. government would allow its officers or employees present at 
that location.
    (6) Moving expense reimbursement fringe benefit. Except as otherwise 
provided in this paragraph (b)(2)(ii)(D)(6), the source of compensation 
in the form of a moving expense reimbursement is determined based on the 
location of the employee's new principal place of work. The source of 
such compensation is determined based on the location of the employee's 
former principal place of work, however, if the individual provides 
sufficient evidence that such determination of source is more 
appropriate under the facts and circumstances of the particular case. 
For purposes of this paragraph (b)(2)(ii)(D)(6), sufficient evidence 
generally requires an agreement, between the employer and the employee, 
or a written statement of company policy, which is reduced to writing 
before the move and which is entered into or established to induce the 
employee or employees to move to another country. Such written statement 
or agreement must state that the employer will reimburse the employee 
for moving expenses that the employee incurs to return to the employee's 
former principal place of work regardless of whether he or she continues 
to work for the employer after returning to that location. The writing 
may contain certain conditions upon which the right to reimbursement is 
determined as long as those conditions set forth standards that are 
definitely ascertainable and can only be fulfilled prior to, or through 
completion of, the employee's return move to the employee's former 
principal place of work.
    (E) Time basis. The amount of compensation for labor or personal 
services performed within the United States determined on a time basis 
is the amount that bears the same relation to the individual's total 
compensation as the number of days of performance of the labor or 
personal services by the individual within the United States bears to 
his or her total number of days of performance of labor or personal 
services. A unit of time less than a day may be appropriate for purposes 
of this calculation. The time period for which the compensation for 
labor or personal services is made is presumed to be the calendar year 
in which the labor or personal services are performed, unless the 
taxpayer establishes to the satisfaction of the Commissioner, or the 
Commissioner determines, that another distinct, separate, and continuous 
period of time is more appropriate. For example, a transfer during a 
year from a position in the United States to a foreign posting that 
lasted through the end of that year would generally establish two 
separate time periods within that taxable year. The first of these time 
periods would be the portion of the year preceding the start of the 
foreign posting, and the second of these time periods would be the 
portion of the year following the start of the foreign posting. However, 
in the case of a foreign posting that requires short-term returns to the 
United States to perform services for the employer, such short-term 
returns would not be sufficient to establish distinct, separate, and 
continuous time periods within the foreign posting time period but would 
be relevant to the allocation of compensation relating to the overall

[[Page 153]]

time period. In each case, the source of the compensation on a time 
basis is based upon the number of days (or unit of time less than a day, 
if appropriate) in that separate time period.
    (F) Multi-year compensation arrangements. The source of multi-year 
compensation is determined generally on a time basis, as defined in 
paragraph (b)(2)(ii)(E) of this section, over the period to which such 
compensation is attributable. For purposes of this paragraph 
(b)(2)(ii)(F), multi-year compensation means compensation that is 
included in the income of an individual in one taxable year but that is 
attributable to a period that includes two or more taxable years. The 
determination of the period to which such compensation is attributable, 
for purposes of determining its source, is based upon the facts and 
circumstances of the particular case. For example, an amount of 
compensation that specifically relates to a period of time that includes 
several calendar years is attributable to the entirety of that multi-
year period. The amount of such compensation that is treated as from 
sources within the United States is the amount that bears the same 
relationship to the total multi-year compensation as the number of days 
(or unit of time less than a day, if appropriate) that labor or personal 
services were performed within the United States in connection with the 
project bears to the total number of days (or unit of time less than a 
day, if appropriate) that labor or personal services were performed in 
connection with the project. In the case of stock options, the facts and 
circumstances generally will be such that the applicable period to which 
the compensation is attributable is the period between the grant of an 
option and the date on which all employment-related conditions for its 
exercise have been satisfied (the vesting of the option).
    (G) Examples. The following examples illustrate the application of 
this paragraph (b)(2)(ii):

    Example 1. B, a nonresident alien individual, was employed by Corp 
M, a domestic corporation, from March 1 to December 25 of the taxable 
year, a total of 300 days, for which B received compensation in the 
amount of $80,000. Under B's employment contract with Corp M, B was 
subject to call at all times by Corp M and was in a payment status on a 
7-day week basis. Pursuant to that contract, B performed services (or 
was available to perform services) within the United States for 180 days 
and performed services (or was available to perform services) without 
the United States for 120 days. None of B's $80,000 compensation was for 
fringe benefits as identified in paragraph (b)(2)(ii)(D) of this 
section. B determined the amount of compensation that is attributable to 
his labor or personal services performed within the United States on a 
time basis under paragraph (b)(2)(ii)(A) and (E) of this section. B did 
not assert, pursuant to paragraph (b)(2)(ii)(C)(1)(i) of this section, 
that, under the particular facts and circumstances, an alternative basis 
more properly determines the source of that compensation than the time 
basis. Therefore, B must include in income from sources within the 
United States $48,000 ($80,000 x 180/300) of his compensation from 
Corporation M.
    Example 2. (i) Same facts as in Example 1 except that Corp M had a 
company-wide arrangement with its employees, including B, that they 
would receive an education fringe benefit, as described in paragraph 
(b)(2)(ii)(D)(2) of this section, while working in the United States. 
During the taxable year, B incurred education expenses for his dependent 
daughter that qualified for the education fringe benefit in the amount 
of $10,000, for which B received a reimbursement from Corp M. B did not 
maintain adequate records or sufficient evidence of this fringe benefit 
as required by paragraph (b)(2)(ii)(D) of this section. When B filed his 
Federal income tax return for the taxable year, B did not apply 
paragraphs (b)(2)(ii)(B) and (D)(2) of this section to treat the 
compensation in the form of the education fringe benefit as income from 
sources within the United States, the location of his principal place of 
work during the 300-day period. Rather, B combined the $10,000 
reimbursement with his base compensation of $80,000 and applied the time 
basis of paragraph (b)(2)(ii)(A) of this section to determine the source 
of his gross income.
    (ii) On audit, B argues that because he failed to substantiate the 
education fringe benefit in accordance with paragraph (b)(2)(ii)(D) of 
this section, his entire employment compensation from Corp M is sourced 
on a time basis pursuant to paragraph (b)(2)(ii)(A) of this section. The 
Commissioner, after reviewing Corp M's fringe benefit arrangement, 
determines, pursuant to paragraph (b)(2)(ii)(C)(1)(ii) of this section, 
that the $10,000 educational expense reimbursement constitutes in 
substance a fringe benefit described in paragraph (b)(2)(ii)(D)(2) of 
this section, notwithstanding a failure to meet all of the requirements 
of paragraph (b)(2)(ii)(D) of this section, and that an alternative 
geographic source basis, under the facts and circumstances of this 
particular

[[Page 154]]

case, is a more reasonable manner to determine the source of the 
compensation than the time basis used by B.
    Example 3. (i) A, a United States citizen, is employed by Corp N, a 
domestic corporation. A's principal place of work is in the United 
States. A earns an annual salary of $100,000. During the first quarter 
of the calendar year (which is also A's taxable year), A performed 
services entirely within the United States. At the beginning of the 
second quarter of the calendar year, A was transferred to Country X for 
the remainder of the year and received, in addition to her annual 
salary, $30,000 in fringe benefits that are attributable to her new 
principal place of work in Country X. Corp N paid these fringe benefits 
separately from A's annual salary. Corp N supplied A with a statement 
detailing that $25,000 of the fringe benefit was paid for housing, as 
defined in paragraph (b)(2)(ii)(D)(1) of this section, and $5,000 of the 
fringe benefit was paid for local transportation, as defined in 
paragraph (b)(2)(ii)(D)(3) of this section. None of the local 
transportation fringe benefit is excluded from the employee's gross 
income as a qualified transportation fringe benefit under section 
132(a)(5). Under A's employment contract, A was required to work on a 5-
day week basis, Monday through Friday. During the last three quarters of 
the year, A performed services 30 days in the United States and 150 days 
in Country X and other foreign countries.
    (ii) A determined the source of all of her compensation from Corp N 
pursuant to paragraphs (b)(2)(ii)(A), (B), and (D)(1) and (3) of this 
section. A did not assert, pursuant to paragraph (b)(2)(ii)(C)(1)(i) of 
this section, that, under the particular facts and circumstances, an 
alternative basis more properly determines the source of that 
compensation than the bases set forth in paragraphs (b)(2)(ii)(A), (B), 
and (D)(1) and (3) of this section. However, in applying the time basis 
set forth in paragraph (b)(2)(ii)(E) of this section, A establishes to 
the satisfaction of the Commissioner that the first quarter of the 
calendar year and the last three quarters of the calendar year are two 
separate, distinct, and continuous periods of time. Accordingly, $25,000 
of A's annual salary is attributable to the first quarter of the year 
(25 percent of $100,000). This amount is entirely compensation that was 
attributable to the labor or personal services performed within the 
United States and is, therefore, included in gross income as income from 
sources within the United States. The balance of A's compensation as an 
employee of Corp N, $105,000 (which includes the $30,000 in fringe 
benefits that are attributable to the location of A's principal place of 
work in Country X), is compensation attributable to the final three 
quarters of her taxable year. During those three quarters, A's periodic 
performance of services in the United States does not result in 
distinct, separate, and continuous periods of time. Of the $75,000 paid 
for annual salary, $12,500 (30/180 x $75,000) is compensation that was 
attributable to the labor or personal services performed within the 
United States and $62,500 (150/180 x $75,000) is compensation that was 
attributable to the labor or personal services performed outside the 
United States. Pursuant to paragraphs (b)(2)(ii)(B) and (D)(1) and (3) 
of this section, A sourced the $25,000 received for the housing fringe 
benefit and the $5,000 received for the local transportation fringe 
benefit based on the location of her principal place of work, Country X. 
Accordingly, A included the $30,000 in fringe benefits in her gross 
income as income from sources without the United States.
    Example 4. Same facts as in Example 3. Of the 150 days during which 
A performed services in Country X and in other foreign countries (during 
the final three quarters of A's taxable year), she performed 30 days of 
those services in Country Y. Country Y is a country designated by the 
Secretary of State as a place where living conditions are extremely 
difficult, notably unhealthy, or where excessive physical hardships 
exist and for which a post differential of 15 percent or more would be 
provided under section 5925(b) of title 5 of the U.S. Code to any 
officer or employee of the U.S. government present at that place. Corp N 
has a policy of paying its employees a $65 premium per day for each day 
worked in countries so designated. The $65 premium per day does not 
exceed the maximum amount that the U. S. government would pay its 
officers or employees stationed in Country Y. Because A performed 
services in Country Y for 30 days, she earned additional compensation of 
$1,950. The $1,950 is considered a hazardous duty or hardship pay fringe 
benefit and is sourced under paragraphs (b)(2)(ii)(B) and (D)(5) of this 
section based on the location of the hazardous or hardship duty zone, 
Country Y. Accordingly, A included the amount of the hazardous duty or 
hardship pay fringe benefit ($1,950) in her gross income as income from 
sources without the United States.
    Example 5. (i) During 2006 and 2007, Corp P, a domestic corporation, 
employed four United States citizens, E, F, G, and H to work in its 
manufacturing plant in Country V. As part of his or her compensation 
package, each employee arranged for local transportation unrelated to 
Corp P's business needs. None of the local transportation fringe benefit 
is excluded from the employee's gross income as a qualified 
transportation fringe benefit under section 132(a)(5) and (f).
    (ii) Under the terms of the compensation package that E negotiated 
with Corp P, Corp P permitted E to use an automobile owned by Corp P. In 
addition, Corp P agreed to reimburse E for all expenses incurred by E in 
maintaining and operating the automobile,

[[Page 155]]

including gas and parking. Provided that the local transportation fringe 
benefit meets the requirements of paragraph (b)(2)(ii)(D)(3) of this 
section, E's compensation with respect to the fair rental value of the 
automobile and reimbursement for the expenses E incurred is sourced 
under paragraphs (b)(2)(ii)(B) and (D)(3) of this section based on E's 
principal place of work in Country V. Thus, the local transportation 
fringe benefit will be included in E's gross income as income from 
sources without the United States.
    (iii) Under the terms of the compensation package that F negotiated 
with Corp P, Corp P let F use an automobile owned by Corp P. However, 
Corp P did not agree to reimburse F for any expenses incurred by F in 
maintaining and operating the automobile. Provided that the local 
transportation fringe benefit meets the requirements of paragraph 
(b)(2)(ii)(D)(3) of this section, F's compensation with respect to the 
fair rental value of the automobile is sourced under paragraphs 
(b)(2)(ii)(B) and (D)(3) of this section based on F's principal place of 
work in Country V. Thus, the local transportation fringe benefit will be 
included in F's gross income as income from sources without the United 
States.
    (iv) Under the terms of the compensation package that G negotiated 
with Corp P, Corp P agreed to reimburse G for the purchase price of an 
automobile that G purchased in Country V. Corp P did not agree to 
reimburse G for any expenses incurred by G in maintaining and operating 
the automobile. Because the cost to purchase an automobile is not a 
local transportation fringe benefit as defined in paragraph 
(b)(2)(ii)(D)(3) of this section, the source of the compensation to G 
will be determined pursuant to paragraph (b)(2)(ii)(A) or (C) of this 
section.
    (v) Under the terms of the compensation package that H negotiated 
with Corp P, Corp P agreed to reimburse H for the expenses that H 
incurred in maintaining and operating an automobile, including gas and 
parking, which H purchased in Country V. Provided that the local 
transportation fringe benefit meets the requirements of paragraph 
(b)(2)(ii)(D)(3) of this section, H's compensation with respect to the 
reimbursement for the expenses H incurred is sourced under paragraphs 
(b)(2)(ii)(B) and (D)(3) of this section based on H's principal place of 
work in Country V. Thus, the local transportation fringe benefit will be 
included in H's gross income as income from sources without the United 
States.
    Example 6. (i) On January 1, 2006, Company Q compensates employee J 
with a grant of options to which section 421 does not apply that do not 
have a readily ascertainable fair market value when granted. The stock 
options permit J to purchase 100 shares of Company Q stock for $5 per 
share. The stock options do not become exercisable unless and until J 
performs services for Company Q (or a related company) for 5 years. J 
works for Company Q for the 5 years required by the stock option grant. 
In years 2006-08, J performs all of his services for Company Q within 
the United States. In 2009, J performs \1/2\ of his services for Company 
Q within the United States and \1/2\ of his services for Company Q 
without the United States. In year 2010, J performs his services 
entirely without the United States. On December 31, 2012, J exercises 
the options when the stock is worth $10 per share. J recognizes $500 in 
taxable compensation (($10-$5) x 100) in 2012.
    (ii) Under the facts and circumstances, the applicable period is the 
5-year period between the date of grant (January 1, 2006) and the date 
the stock options become exercisable (December 31, 2010). On the date 
the stock options become exercisable, J performs all services necessary 
to obtain the compensation from Company Q. Accordingly, the services 
performed after the date the stock options become exercisable are not 
taken into account in sourcing the compensation from the stock options. 
Therefore, pursuant to paragraph (b)(2)(ii)(A), since J performs 3\1/2\ 
years of services for Company Q within the United States and 1\1/2\ 
years of services for Company Q without the United States during the 5-
year period, \7/10\ of the $500 of compensation (or $350) recognized in 
2012 is income from sources within the United States and the remaining 
\3/10\ of the compensation (or $150) is income from sources without the 
United States.
    (c) Coastwise travel. Except as to income excluded by paragraph (a) 
of this section, wages received for services rendered inside the 
territorial limits of the United States and wages of an alien seaman 
earned on a coastwise vessel are to be regarded as from sources within 
the United States.
    (d) Effective date. This section applies with respect to taxable 
years beginning after December 31, 1966. For corresponding rules 
applicable to taxable years beginning before January 1, 1967, see 26 CFR 
1.861-4 (Revised as of January 1, 1972). Paragraph (b) and the first 
sentence of paragraph (a)(1) of this section apply to taxable years 
beginning on or after July 14, 2005.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 7378, 40 FR 45433, Oct. 2, 1975; 40 FR 48508, Oct. 16, 
1975; T.D. 9212, 70 FR 40665, July 14, 2005]



Sec.  1.861-5  Rentals and royalties.

    Gross income from sources within the United States includes rentals 
or

[[Page 156]]

royalties from property located in the United States or from any 
interest in such property, including rentals or royalties for the use 
of, or for the privilege of using, in the United States, patents, 
copyrights, secret processes and formulas, good will, trademarks, trade 
brands, franchises, and other like property. The income arising from the 
rental of property, whether tangible or intangible, located within the 
United States, or from the use of property, whether tangible or 
intangible, within the United States, is from sources within the United 
States. For taxable years beginning after December 31, 1966, gains 
described in section 871(a)(1)(D) and section 881(a)(4) from the sale or 
exchange after October 4, 1966, of patents, copyrights, and other like 
property shall be treated, as provided in section 871(e)(2), as rentals 
or royalties for the use of, or privilege of using, property or an 
interest in property. See paragraph (e) of Sec.  1.871-11.

[T.D. 7378, 40 FR 45434, Oct. 2, 1975]



Sec.  1.861-6  Sale of real property.

    Gross income from sources within the United States includes gain, 
computed under the provisions of section 1001 and the regulations 
thereunder, derived from the sale or other disposition of real property 
located in the United States. For the treatment of capital gains and 
losses, see subchapter P (section 1201 and following), chapter 1 of the 
Code, and the regulations thereunder.



Sec.  1.861-7  Sale of personal property.

    (a) General. Gains, profits, and income derived from the purchase 
and sale of personal property shall be treated as derived entirely from 
the country in which the property is sold. Thus, gross income from 
sources within the United States includes gains, profits, and income 
derived from the purchase of personal property without the United States 
and its sale within the United States.
    (b) Purchase within a possession. Notwithstanding paragraph (a) of 
this section, income derived from the purchase of personal property 
within a possession of the United States and its sale within the United 
States shall be treated as derived partly from sources within and partly 
from sources without the United States. See section 863(b)(3) and Sec.  
1.863-2.
    (c) Country in which sold. For the purposes of part I (section 861 
and following), subchapter N, chapter 1 of the Code, and the regulations 
thereunder, a sale of personal property is consummated at the time when, 
and the place where, the rights, title, and interest of the seller in 
the property are transferred to the buyer. Where bare legal title is 
retained by the seller, the sale shall be deemed to have occurred at the 
time and place of passage to the buyer of beneficial ownership and the 
risk of loss. However, in any case in which the sales transaction is 
arranged in a particular manner for the primary purpose of tax 
avoidance, the foregoing rules will not be applied. In such cases, all 
factors of the transaction, such as negotiations, the execution of the 
agreement, the location of the property, and the place of payment, will 
be considered, and the sale will be treated as having been consummated 
at the place where the substance of the sale occurred.
    (d) Production and sale. For provisions respecting the source of 
income derived from the sale of personal property produced by the 
taxpayer, see section 863(b)(2) and paragraphs (b) of Sec. Sec.  1.863-1 
and 1.863-2.
    (e) Section 306 stock. For determining the source of gain on the 
disposition of section 306 stock, see section 306(f) and the regulations 
thereunder.



Sec.  1.861-8  Computation of taxable income from sources 
within the United States and from other sources and activities.

    (a) In general--(1) Scope. Sections 861(b) and 863(a) state in 
general terms how to determine taxable income of a taxpayer from sources 
within the United States after gross income from sources within the 
United States has been determined. Sections 862(b) and 863(a) state in 
general terms how to determine taxable income of a taxpayer from sources 
without the United States after gross income from sources without the 
United States has been determined. This section provides specific 
guidance for applying the cited Code

[[Page 157]]

sections by prescribing rules for the allocation and apportionment of 
expenses, losses, and other deductions (referred to collectively in this 
section as ``deductions'') of the taxpayer. The rules contained in this 
section apply in determining taxable income of the taxpayer from 
specific sources and activities under other sections of the Code, 
referred to in this section as operative sections. See paragraph (f)(1) 
of this section for a list and description of operative sections. The 
operative sections include, among others, sections 871(b) and 882 
(relating to taxable income of a nonresident alien individual or a 
foreign corporation which is effectively connected with the conduct of a 
trade or business in the United States), section 904(a)(1) (as in effect 
before enactment of the Tax Reform Act of 1976, relating to taxable 
income from sources within specific foreign countries), and section 
904(a)(2) (as in effect before enactment of the Tax Reform Act of 1976, 
or section 904(a) after such enactment, relating to taxable income from 
all sources without the United States).
    (2) Allocation and apportionment of deductions in general. A 
taxpayer to which this section applies is required to allocate 
deductions to a class of gross income and, then, if necessary to make 
the determination required by the operative section of the Code, to 
apportion deductions within the class of gross income between the 
statutory grouping of gross income (or among the statutory groupings) 
and the residual grouping of gross income. Except for deductions, if 
any, which are not definitely related to gross income (see paragraphs 
(c)(3) and (e)(9) of this section) and which, therefore, are ratably 
apportioned to all gross income, all deductions of the taxpayer (except 
the deductions for personal exemptions enumerated in paragraph (e)(11) 
of this section) must be so allocated and apportioned. As further 
detailed below, allocations and apportionments are made on the basis of 
the factual relationship of deductions to gross income.
    (3) Class of gross income. For purposes of this section, the gross 
income to which a specific deduction is definitely related is referred 
to as a ``class of gross income'' and may consist of one or more items 
(or subdivisions of these items) of gross income enumerated in section 
61, namely:
    (i) Compensation for services, including fees, commissions, and 
similar items;
    (ii) Gross income derived from business;
    (iii) Gains derived from dealings in property;
    (iv) Interest;
    (v) Rents;
    (vi) Royalties;
    (vii) Dividends;
    (viii) Alimony and separate maintenance payments;
    (ix) Annuities;
    (x) Income from life insurance and endowment contracts;
    (xi) Pensions;
    (xii) Income from discharge of indebtedness;
    (xiii) Distributive share of partnership gross income;
    (xiv) Income in respect of a decedent;
    (xv) Income from an interest in an estate or trust.
    (4) Statutory grouping of gross income and residual grouping of 
gross income. For purposes of this section, the term ``statutory 
grouping of gross income'' or ``statutory grouping'' means the gross 
income from a specific source or activity which must first be determined 
in order to arrive at ``taxable income'' from which specific source or 
activity under an operative section. (See paragraph (f)(1) of this 
section.) Gross income from other sources or activities is referred to 
as the ``residual grouping of gross income'' or ``residual grouping.'' 
For example, for purposes of determining taxable income from sources 
within specific foreign countries and possessions of the United States, 
in order to apply the per-country limitation to the foreign tax credit 
(as in effect before enactment of the Tax Reform Act of 1976), the 
statutory groupings are the separate gross incomes from sources within 
each country and possession. Moreover, if the taxpayer has income 
subject to section 904(d) (as in effect after enactment of the Tax 
Reform Act of 1976), such income constitutes one or more separate 
statutory groupings. In the case of the per-country limitation, the 
residual grouping is the aggregate of gross income from sources within 
the United

[[Page 158]]

States. In some instances, where the operative section so requires, the 
statutory grouping or the residual grouping may include, or consist 
entirely of, excluded income. See paragraph (d)(2) of this section with 
respect to the allocation and apportionment of deductions to excluded 
income.
    (5) Effective date--(i) Taxable years beginning after December 31, 
1976. The provisions of this section apply to taxable years beginning 
after December 31, 1976.
    (ii) Paragraph (e)(4), the last sentence of paragraph (f)(4)(i), and 
paragraph (g), Examples 17, 18, and 30 of this section are generally 
applicable for taxable years beginning after July 31, 2009. In addition, 
a person may elect to apply the provisions of paragraph (e)(4) of this 
section to earlier years. Such election shall be made in accordance with 
the rules set forth in Sec.  1.482-9(n)(2).
    (iii) Taxable years beginning before January 1, 1977. For taxable 
years beginning before January 1, 1977, Sec.  1.861-8 applies as in 
effect on October 23, 1957 (T.D. 6258), as amended on August 22, 1966 
(T.D. 6892) and on September 29, 1975 (T.D. 7378). The specific rules 
for allocation and apportionment of deductions set forth in this section 
may, at the option of the taxpayer, apply to those taxable years on a 
deduction-by-deduction basis if the rules are applied consistently to 
all taxable years with respect to which action by the Internal Revenue 
Service is not barred by any statute of limitations. Thus, for example, 
a calendar year taxpayer may choose to have the rules of paragraph 
(e)(2) of this section apply for the allocation and apportionment of all 
interest expenses for the two taxable years ending December 31, 1975 and 
1976, which are open years under examination, and may justify the 
allocation and apportionment of all research and development expenses 
for those years on a basis supportable under Sec.  1.861-8 as in effect 
for 1975 and 1976 without regard to the rules of paragraph (e)(3) of 
this section.
    (b) Allocation--(1) In general. For purposes of this section, the 
gross income to which a specific deduction is definitely related is 
referred to as a ``class of gross income'' and may consist of one or 
more items of gross income. The rules emphasize the factual relationship 
between the deduction and a class of gross income. See paragraph (d)(1) 
of this section which provides that in a taxable year there may be no 
item of gross income in a class or less gross income than deductions 
allocated to the class, and paragraph (d)(2) of this section which 
provides that a class of gross income may include excluded income. 
Allocation is accomplished by determining, with respect to each 
deduction, the class of gross income to which the deduction is 
definitely related and then allocating the deduction to such class of 
gross income (without regard to the taxpayable year in which such gross 
income is received or accrued or is expected to be received or accrued). 
The classes of gross income are not predetermined but must be determined 
on the basis of the deductions to be allocated. Although most deductions 
will be definitely related to some class of a taxpayer's total gross 
income, some deductions are related to all gross income. In addition, 
some deductions are treated as not definitely related to any gross 
income and are ratably apportioned to all gross income. (See paragraph 
(e)(9) of this section.) In allocating deductions it is not necessary to 
differentiate between deductions related to one item of gross income and 
deductions related to another item of gross income where both items of 
gross income are exclusively within the same statutory grouping or 
exclusively within the residual grouping.
    (2) Relationship to activity or property. A deduction shall be 
considered definitely related to a class of gross income and therefore 
allocable to such class if it is incurred as a result of, or incident 
to, an activity or in connection with property from which such class of 
gross income is derived. Where a deduction is incurred as a result of, 
or incident to, an activity or in connection with property, which 
activity or property generates, has generated, or could reasonably have 
been expected to generate gross income, such deduction shall be 
considered definitely related to such gross income as a class whether or 
not there is any item of gross income in such class which is received or

[[Page 159]]

accrued during the taxable year and whether or not the amount of 
deductions exceeds the amount of the gross income in such class. See 
paragraph (d)(1) of this section and example 17 of paragraph (g) of this 
section with respect to cases in which there is an excess of deductions. 
In some cases, it will be found that this subparagraph can most readily 
be applied by determining, with respect to a deduction, the categories 
of gross income to which it is not related and concluding that it is 
definitely related to a class consisting of all other gross income.
    (3) Supportive functions. Deductions which are supportive in nature 
(such as overhead, general and administrative, and supervisory expenses) 
may relate to other deductions which can more readily be allocated to 
gross income. In such instance, such supportive deductions may be 
allocated and apportioned along with the deductions to which they 
relate. On the other hand, it would be equally acceptable to attribute 
supportive deductions on some reasonable basis directly to activities or 
property which generate, have generated or could reasonably be expected 
to generate gross income. This would ordinarily be accomplished by 
allocating the supportive expenses to all gross income or to another 
broad class of gross income and apportioning the expenses in accordance 
with paragraph (c)(1) of this section. For this purpose, reasonable 
departmental overhead rates may be utilized. For examples of the 
application of the principles of this paragraph (b)(3) to expenses other 
than expenses attributable to stewardship activities, see Examples 19 
through 21 of paragraph (g) of this section. See paragraph (e)(4)(ii) of 
this section for the allocation and apportionment of deductions 
attributable to stewardship expenses. However, supportive deductions 
that are described in Sec.  1.861-14T(e)(3) shall be allocated and 
apportioned in accordance with the rules of Sec.  1.861-14T and shall 
not be allocated and apportioned by reference only to the gross income 
of a single member of an affiliated group of corporations as defined in 
Sec.  1.861-14T(d).
    (4) Deductions related to a class of gross income. See paragraph (e) 
of this section for rules relating to the allocation and apportionment 
of certain specific deductions definitely related to a class of gross 
income. See paragraph (c)(1) of this section for rules relating to the 
apportionment of deductions.
    (5) Deductions related to all gross income. If a deduction does not 
bear a definite relationship to a class of gross income constituting 
less than all of gross income, it shall ordinarily be treated as 
definitely related and allocable to all of the taxpayer's gross income 
except where provided to the contrary under paragraph (e) of this 
section. Paragraph (e)(9) of this section lists various deductions which 
generally are not definitely related to any gross income and are ratably 
apportioned to all gross income.
    (c) Apportionment of deductions--(1) Deductions definitely related 
to a class of gross income. [Reserved]. For guidance, see Sec.  1.861-
8T(c)(1).
    (2) Apportionment based on assets. [Reserved]. For guidance, see 
Sec.  1.861-8T(c)(2).
    (3) Deductions not definitely related to any gross income. If a 
deduction is not definitely related to any gross income (see paragraph 
(e)(9) of this section), the deduction must be apportioned ratably 
between the statutory grouping (or among the statutory groupings) of 
gross income and the residual grouping. Thus, the amount apportioned to 
each statutory grouping shall be equal to the same proportion of the 
deduction which the amount of gross income in the statutory grouping 
bears to the total amount of gross income. The amount apportioned to the 
residual grouping shall be equal to the same proportion of the deduction 
which the amount of the gross income in the residual grouping bears to 
the total amount of gross income.
    (d) Excess of deductions and excluded and eliminated income--(1) 
Excess of deductions. Each deduction which bears a definite relationship 
to a class of gross income shall be allocated to that class in 
accordance with paragraph (b)(1) of this section even though, for the 
taxable year, no gross income in such class is received or accrued or 
the amount of the deduction exceeds the amount of such class of gross 
income. In apportioning deductions, it may be that, for the taxable 
year, there is no

[[Page 160]]

gross income in the statutory grouping (or residual grouping), or that 
deductions exceed the amount of gross income in the statutory grouping 
(or residual grouping). If there is no gross income in a statutory 
grouping or the amount of deductions allocated and apportioned to a 
statutory grouping exceeds the amount of gross income in the statutory 
grouping, the effects are determined under the operative section. If the 
taxpayer is a member of a group filing a consolidated return, such 
excess of deductions allocated or apportioned to a statutory grouping of 
income of such member is taken into account in determining the 
consolidated taxable income from such statutory grouping, and such 
excess of deductions allocated or apportioned to the residual grouping 
of income is taken into account in determining the consolidated taxable 
income from the residual grouping. See Sec.  1.1502-4(d)(1) and the last 
sentence of Sec.  1.1502-12. For an illustration of the principles of 
this paragraph (d)(1), see example 17 of paragraph (g) of this section.
    (2) Allocation and apportionment to exempt, excluded, or eliminated 
income. [Reserved]. For guidance, see Sec.  1.861-8T(d)(2).
    (e) Allocation and apportionment of certain deductions--(1) In 
general. Paragraphs (e)(2) and (e)(3) of this section contain rules with 
respect to the allocation and apportionment of interest expense and 
research and development expenditures, respectively. Paragraphs (e)(4) 
through (e)(8) of this section contain rules with respect to the 
allocation of certain other deductions. Paragraph (e)(9) of this section 
lists those deductions which are ordinarily considered as not being 
definitely related to any class of gross income. Paragraph (e)(10) of 
this section lists special deductions of corporations which must be 
allocated and apportioned. Paragraph (e)(11) of this section lists 
personal exemptions which are neither allocated nor apportioned. 
Paragraph (e)(12) of this section contains rules with respect to the 
allocation and apportionment of deductions for charitable contributions. 
Examples of allocation and apportionment are contained in paragraph (g) 
of this section.
    (2) Interest. [Reserved]. For guidance, see Sec.  1.861-8T(e)(2).
    (3) Research and experimental expenditures. For rules regarding the 
allocation and apportionment of research and experimental expenditures, 
see Sec.  1.861-17.
    (4) Stewardship and controlled services--(i) Expenses attributable 
to controlled services. If a corporation performs a controlled services 
transaction (as defined in Sec.  1.482-9(l)(3)), which includes any 
activity by one member of a group of controlled taxpayers that results 
in a benefit to a related corporation, and the rendering corporation 
charges the related corporation for such services, section 482 and these 
regulations provide for an allocation where the charge is not consistent 
with an arm's length result as determined. The deductions for expenses 
of the corporation attributable to the controlled services transaction 
are considered definitely related to the amounts so charged and are to 
be allocated to such amounts.
    (ii) Stewardship expenses attributable to dividends received. 
Stewardship expenses, which result from ``overseeing'' functions 
undertaken for a corporation's own benefit as an investor in a related 
corporation, shall be considered definitely related and allocable to 
dividends received, or to be received, from the related corporation. For 
purposes of this section, stewardship expenses of a corporation are 
those expenses resulting from ``duplicative activities'' (as defined in 
Sec.  1.482-9(l)(3)(iii)) or ``shareholder activities'' (as defined in 
Sec.  1.482-9(l)(3)(iv)) of the corporation with respect to the related 
corporation. Thus, for example, stewardship expenses include expenses of 
an activity the sole effect of which is either to protect the 
corporation's capital investment in the related corporation or to 
facilitate compliance by the corporation with reporting, legal, or 
regulatory requirements applicable specifically to the corporation, or 
both. If a corporation has a foreign or international department which 
exercises overseeing functions with respect to related foreign 
corporations and, in addition, the department performs other functions 
that generate other foreign-source income (such as fees for services

[[Page 161]]

rendered outside of the United States for the benefit of foreign related 
corporations, foreign-source royalties, and gross income of foreign 
branches), some part of the deductions with respect to that department 
are considered definitely related to the other foreign-source income. In 
some instances, the operations of a foreign or international department 
will also generate United States source income (such as fees for 
services performed in the United States). Permissible methods of 
apportionment with respect to stewardship expenses include comparisons 
of time spent by employees weighted to take into account differences in 
compensation, or comparisons of each related corporation's gross 
receipts, gross income, or unit sales volume, assuming that stewardship 
activities are not substantially disproportionate to such factors. See 
paragraph (f)(5) of this section for the type of verification that may 
be required in this respect. See Sec.  1.482-9(l)(5) for examples that 
illustrate the principles of Sec.  1.482-9(l)(3). See Example 17 and 
Example 18 of paragraph (g) of this section for the allocation and 
apportionment of stewardship expenses. See paragraph (b)(3) of this 
section for the allocation and apportionment of deductions attributable 
to supportive functions other than stewardship expenses, such as 
expenses in the nature of day-to-day management, and paragraph (e)(5) of 
this section generally for the allocation and apportionment of 
deductions attributable to legal and accounting fees and expenses.
    (5) Legal and accounting fees and expenses. Fees and other expenses 
for legal and accounting services are ordinarily definitely related and 
allocable to specific classes of gross income or to all the taxpayer's 
gross income, depending on the nature of the services rendered (and are 
apportioned as provided in paragraph (c)(1) of this section). For 
example, accounting fees for the preparation of a study of the costs 
involved in manufacturing a specific product will ordinarily be 
definitely related to the class of gross income derived from (or which 
could reasonably have been expected to be derived from) that specific 
product. The taxpayer is not relieved from his responsibility to make a 
proper allocation and apportionment of fees on the grounds that the 
statement of services rendered does not identify the services performed 
beyond a generalized designation such as ``professional,'' or does not 
provide any type of allocation, or does not properly allocate the fees 
involved.
    (6) Income taxes--(i) In general. The deduction for state, local, 
and foreign income, war profits and excess profits taxes (``state income 
taxes'') allowed by section 164 shall be considered definitely related 
and allocable to the gross income with respect to which such state 
income taxes are imposed. For example, if a domestic corporation is 
subject to state income taxation and the state income tax is imposed in 
part on an amount of foreign source income, then that part of the 
taxpayer's deduction for state income tax that is attributable to 
foreign source income is definitely related and allocable to foreign 
source income. In allocating and apportioning the deduction for state 
income tax for purposes including (but not limited to) the computation 
of the foreign tax credit limitation under section 904 of the Code and 
the consolidated foreign tax credit under Sec.  1.1502-4 of the 
regulations, the income upon which the state income tax is imposed is 
determined by reference to the law of the jurisdiction imposing the tax. 
Thus, if a state attributes taxable income to a corporate taxpayer by 
applying an apportionment formula that takes into consideration the 
income and factors of one or more corporations related by ownership to 
the corporate taxpayer and engaging in activities related to the 
business of the corporate taxpayer, then the income so attributed is the 
income upon which the state income tax is imposed. If the income so 
attributed to the corporate taxpayer includes foreign source income, 
then, in computing the taxpayer's foreign tax credit limitation under 
section 904, for example, the taxpayer's deduction for state income tax 
will be considered definitely related and allocable to a class of gross 
income that includes the statutory grouping of foreign source income. 
When the law of the state includes dividends that are treated under 
section 862(a)(2) as income from sources without the United States in 
taxable income apportionable to the state, but

[[Page 162]]

does not include factors of the corporation paying such dividends in the 
apportionment formula used to determine state taxable income, an 
appropriate portion of the deduction for state income tax will be 
considered definitely related and allocable to a class of gross income 
consisting solely of foreign source dividend income. A deduction for 
state income tax will not be considered definitely related to a 
hypothetical amount of income calculated under federal tax principles 
when the jurisdiction imposing the tax computes taxable income under 
different principles. A corporate taxpayer's deduction for a state 
franchise tax that is computed on the basis of income attributable to 
business activities conducted within the state must be allocated and 
apportioned in the same manner as the deduction for state income taxes. 
In determining, for example, both the foreign tax credit under section 
904 of the Code and the consolidated foreign tax credit limitation under 
Sec.  1.1502-4 of the regulations, the deduction for state income tax 
may be allocable and apportionable to foreign source income in a 
statutory grouping described in section 904(d) in a taxable year in 
which the taxpayer has no foreign source income in such statutory 
grouping. Alternatively, such an allocation or apportionment may be 
appropriate if a taxpayer corporation has no foreign source income in a 
statutory grouping, but its deduction is attributable to foreign source 
income in such grouping that is attributed to the taxpayer corporation 
under the law of a state which attributes taxable income to a 
corporation by applying an apportionment formula that takes into 
consideration the income and factors of one or more corporations related 
by ownership to the taxpayer corporation and engaging in activities 
related to the business of the taxpayer corporation. Example 30 of 
paragraph (g) of this section illustrates the application of this last 
rule.
    (ii) Methods of allocation and apportionment--(A) In general. A 
taxpayer's deduction for a state income tax is to be allocated (and then 
apportioned, if necessary, subject to the rules of Sec.  1.861-8(d)) by 
reference to the taxable income that the law of the taxing jurisdiction 
attributes to the taxpayer (``state taxable income'').
    (B) Effect of subsequent recomputations of state income tax. 
[Reserved]
    (C) Illustrations--(1) In general. Examples 25 through 32 of 
paragraph (g) of Sec.  1.861-8 illustrate, in the given factual 
situations, the application of this paragraph (e)(6) and the general 
rule of paragraph (b)(1) of this section that a deduction must be 
allocated to the class of gross income to which the deduction is 
factually related. In general, these examples employ a presumption that 
state income taxes are allocable to a class of gross income that 
includes the statutory grouping of income from sources without the 
United States when the total amount of taxable income determined under 
state law exceeds the amount of taxable income determined under the Code 
(without taking into account the deduction for state income taxes) in 
the residual grouping of income from sources within the United States. A 
taxpayer that allocates and apportions the deduction for state income 
tax in accordance with the methodology of Example 25 of paragraph (g) of 
this section must also apply the modifications illustrated in Examples 
26 and 27 of paragraph (g) of this section, when applicable. The 
modification illustrated in Example 26 is applicable when the deduction 
for state income tax is attributable in part to taxes imposed by a state 
which factually excludes foreign source income (as determined for 
federal income tax purposes) from state taxable income. The modification 
illustrated in Example 27 is applicable when the taxpayer has income-
producing activities in a state which does not impose a corporate income 
tax. The specific allocation of state income tax illustrated in Example 
28 follows the rule in paragraph (e)(6)(i) of this section, and must be 
applied whenever a taxpayer's state taxable income includes dividends 
apportioned to the state under a formula that does not take into account 
the factors of the corporations paying those dividends, regardless of 
whether the taxpayer uses the methodology of Example 25 with respect to 
the remainder of the deduction for state income taxes.

[[Page 163]]

    (2) Modifications. Before applying a method of allocation and 
apportionment illustrated in the examples, the computation of state 
taxable income under state law may be modified, subject to the approval 
of the District Director, to reflect more accurately the income with 
respect to which the state income tax is imposed. Any modification to 
the state law computation of state taxable income must yield an 
allocation and apportionment of the deduction for state income taxes 
that is consistent with the rules contained in this paragraph (e)(6), 
and that accurately reflects the factual relationship between the state 
income tax and the income on which that tax is imposed. For example, a 
modification to the computation of taxable income under state law might 
be appropriate to compensate for differences between the state law 
definition of taxable income and the federal definition of taxable 
income, due to a difference in the rate of allowable depreciation or the 
amount of another deduction that is allowable under both systems. This 
rule is illustrated in Example 31 of paragraph (g) of this section. 
However, a modification to the computation of taxable income under state 
law will not be appropriate, and will not more accurately reflect the 
factual relationship between the state tax and the income on which the 
tax is imposed, to the extent such modification reflects the fact that 
the state does not follow federal tax principles in attributing income 
to the taxpayer's activities in the state. This rule is illustrated in 
Example 32 of paragraph (g) of this section. A taxpayer may not modify 
the methods illustrated in the examples, or use an alternative method of 
allocation and apportionment of the deduction for state income taxes, if 
the modification or alternative method would be inconsistent with the 
rules of paragraph (e)(6)(i) of this section. A taxpayer that uses a 
method of allocation and apportionment other than one illustrated in 
Example 25 (as modified by Examples 26 and 27), or 29 with respect to a 
factual situation similar to those of the examples, must describe the 
alternative method on an attachment to its federal income tax return and 
establish to the satisfaction of the District Director, upon 
examination, that the result of the alternative method more accurately 
reflects the factual relationship between the state income tax and the 
income on which the tax is imposed.
    (D) Elective safe harbor methods--(1) In general. In lieu of 
applying the rules set forth in paragraphs (e)(6)(ii) (A) through (C) of 
this section, a taxpayer may elect to allocate and apportion the 
deduction for state income tax in accordance with one of the two safe 
harbor methods described in paragraph (e)(6)(ii)(D) (2) and (3) of this 
section. A taxpayer shall make this election for a taxable year by 
filing a timely tax return for that year that reflects an allocation and 
apportionment of the deduction for state income tax under one of the 
safe harbor methods and attaching to such return a statement that the 
taxpayer has elected to use the safe harbor method provided in either 
paragraph (e)(6)(ii)(D) (2) or (3) of this section, as appropriate. Once 
made, this election is effective for the taxable year for which made and 
all subsequent taxable years, and may be revoked only with the consent 
of the Commissioner. Example 33 of paragraph (g) of this section 
illustrates the application of these safe harbor methods.
    (2) Method One--(i) Step One--Specific allocation to foreign source 
portfolio dividends and other income. If any portion of the deduction 
for state income tax is attributable to tax imposed by a state which 
includes in a corporate taxpayer's taxable income apportionable to the 
state, portfolio dividends (as defined in paragraph (i) of Example 28 of 
paragraph (g) of this section) that are treated under section 862(a)(2) 
as income from sources without the United States, but does not include 
factors of the corporations paying the portfolio dividends in the 
apportionment formula used to determine state taxable income, the 
taxpayer shall allocate an appropriate portion of the deduction to a 
class of gross income consisting solely of foreign source portfolio 
dividends. The portion of the deduction so allocated, and the amount of 
foreign source portfolio dividends included in such class, shall be 
determined in accordance with the methodology illustrated in paragraph 
(ii) of Example 28

[[Page 164]]

of paragraph (g). If a state income tax is determined based upon 
formulary apportionment of the total taxable income attributable to the 
taxpayer's unitary business, the taxpayer must also apply the 
methodology illustrated in paragraph (ii) (C) through (G) of Example 29 
of paragraph (g) of this section to make specific allocations of 
appropriate portions of the deduction for state income tax on the basis 
of income that, under separate accounting, would have been attributed to 
other members of the unitary group. The taxpayer shall reduce its 
aggregate state taxable income by the amount of foreign source portfolio 
dividends and other income to which a specific allocation is made (the 
reduced amount being referred to hereinafter as ``adjusted state taxable 
income'').
    (ii) Step Two--Adjustment of U.S. source federal taxable income. If 
the taxpayer has significant income-producing activities in a state 
which does not impose a corporate income tax or other state tax measured 
by income derived from business activities in the state, the taxpayer 
shall reduce its U.S. source federal taxable income (solely for purposes 
of this safe harbor method) by the amount of federal taxable income 
attributable to its activities in such state. This amount shall be 
determined in accordance with the methodology illustrated in paragraph 
(ii) of Example 27 of paragraph (g) of this section, provided that the 
taxpayer shall be required to use the rules of the Uniform Division of 
Income for Tax Purposes Act to attribute income to the relevant state. 
The taxpayer's U.S. source federal taxable income, as so reduced, is 
referred to hereinafter as ``adjusted U.S. source federal taxable 
income.''
    (iii) Step Three--Allocation. The taxpayer shall allocate the 
remainder of the deduction for state income tax (after reduction by the 
portion allocated to foreign source portfolio dividends and other income 
under Step One) in accordance with the methodology illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section. However, 
the taxpayer shall substitute for the comparison of aggregate state 
taxable income to U.S. source federal taxable income, illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section, a 
comparison of its adjusted state taxable income to an amount equal to 
110% of its adjusted U.S. source federal taxable income.
    (iv) Step Four--Apportionment. In the event that apportionment of 
the remainder of the deduction for state income tax is required, the 
taxpayer shall apportion that remaining deduction to U.S. source income 
in accordance with the methodology illustrated in paragraph (iii) of 
Example 25 of paragraph (g) of this section, substituting for domestic 
source income in that paragraph an amount equal to 110% of the 
taxpayer's adjusted U.S. source federal taxable income. The remaining 
portion of the deduction shall be apportioned to the statutory groupings 
of foreign source income described in section 904(d) of the Code in 
accordance with the proportion of the income in each statutory grouping 
of foreign source income described in section 904(d) to the taxpayer's 
total foreign source federal taxable income (after reduction by the 
amount of foreign source portfolio dividends to which tax has been 
specifically allocated under Step One, above).
    (3) Method Two--(i) Step One--Specific allocation to foreign source 
portfolio dividends and other income. Step One of this method is the 
same as Step One of Method One (as described in paragraph 
(e)(6)(ii)(D)(2)(i) of this section).
    (ii) Step Two--Adjustment of U.S. source federal taxable income. 
Step Two of this method is the same as Step Two of Method One (as 
described in paragraph (e)(6)(ii)(D)(2)(ii) of this section).
    (iii) Step Three--Allocation. The taxpayer shall allocate the 
remainder of the deduction for state income tax (after reduction by the 
portion allocated to foreign source portfolio dividends and other income 
under Step One) in accordance with the methodology illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section. However, 
the taxpayer shall substitute for the comparison of aggregate state 
taxable income to U.S. source federal taxable income, illustrated in 
paragraph (ii) of Example 25 of paragraph (g) of this section, a 
comparison of its adjusted state taxable income to

[[Page 165]]

its adjusted U.S. source federal taxable income.
    (iv) Step Four--Apportionment. In the event that apportionment of 
the deduction is required, the taxpayer shall apportion to U.S. source 
income that portion of the deduction that is attributable to state 
income taxes imposed upon an amount of state taxable income equal to 
adjusted U.S. source federal taxable income. The taxpayer shall 
apportion the remaining amount of the deduction to U.S. and foreign 
source income in the same proportions that the taxpayer's adjusted U.S. 
source federal taxable income and foreign source federal taxable income 
(after reduction by the amount of foreign source portfolio dividends to 
which tax has been specifically allocated under Step One, above) bear to 
its total federal taxable income (taking into account the adjustment of 
U.S. source federal taxable income under Step Two and after reduction by 
the amount of foreign source portfolio dividends to which tax has been 
specifically allocated under Step One). The portion of the deduction 
apportioned to foreign source income shall be apportioned among the 
statutory groupings described in section 904(d) of the Code in 
accordance with the proportions of the taxpayer's total foreign source 
federal taxable income (after reduction by the amount of foreign source 
portfolio dividends to which tax has been specifically allocated under 
Step One, above) in each grouping.
    (iii) Effective dates. The rules of Sec.  1.861-8(e)(6)(i) and the 
language preceding the examples in Sec.  1.861-8(g) are effective for 
taxable years beginning after December 31, 1976. The rules of Sec.  
1.861-8(e)(6)(ii) (other than Sec.  1.861-8(e)(6)(ii)(D)) and Examples 
25 through 32 of Sec.  1.861-8(g) are effective for taxable years 
beginning on or after January 1, 1988. The rules of Sec.  1.861-
8(e)(6)(ii)(D) and Example 33 of Sec.  1.861-8(g) are effective for 
taxable years ending after March 12, 1991. At the option of the 
taxpayer, however, the rules of Sec.  1.861-8(e)(6)(ii) (other than 
Sec.  1.861-8(e)(6)(ii)(D)) and Examples 25 through 32 of Sec.  1.861-
8(g) may be applied with respect to deductions for state taxes incurred 
in taxable years beginning before January 1, 1988.
    (7) Losses on the sale, exchange, or other disposition of property--
(i) Allocation. The deduction allowed for loss recognized on the sale, 
exchange, or other disposition of a capital asset or property described 
in section 1231(b) shall be considered a deduction which is definitely 
related and allocable to the class of gross income to which such asset 
or property ordinarily gives rise in the hands of the taxpayer. Where 
the nature of gross income generated from the asset or property has 
varied significantly over several taxable years of the taxpayer, such 
class of gross income shall generally be determined by reference to 
gross income generated from the asset or property during the taxable 
year or years immediately preceding the sale, exchange, or other 
dispostion of such asset or property. Thus, for example, where an asset 
generates primarily sales income from domestic sources in the early 
years of its operation and then is leased by the taxpayer to a foreign 
subsidiary in later years, the class of gross income to which the asset 
gives rise will be considered to be the rental income derived from the 
lease and will not include sales income from domestic sources.
    (ii) Apportionment of losses. Where in the unusual circumstances 
that an apportionment of a deduction for losses on the sale, exchange, 
or other disposition of a capital asset or property described in section 
1231(b) is necessary, the amount of such deduction shall be apportioned 
between the statutory grouping (or among the statutory groupings) of 
gross income (within the class of gross income) and the residual 
grouping (within the class of gross income) in the same proportion that 
the amount of gross income within such statutory grouping (or statutory 
groupings) and such residual grouping bear, respectively, to the total 
amount of gross income within the class of gross income. Apportionment 
will be necessary where, for example, the class of gross income to which 
the deduction is allocated consists of gross income (such as royalties) 
attributable to an intangible asset used both within and without the 
United States, or gross income (such as from sales or services) 
attributable to a tangible asset used

[[Page 166]]

both within and without the United States.
    (iii) Allocation of loss recognized in taxable years after 1986. See 
Sec. Sec.  1.865-1 and 1.865-2 for rules regarding the allocation of 
certain loss recognized in taxable years beginning after December 31, 
1986.
    (8) Net operating loss deduction. A net operating loss deduction 
allowed under section 172 shall be allocated and apportioned in the same 
manner as the deductions giving rise to the net operating loss 
deduction.
    (9) Deductions which are not definitely related. Deductions which 
shall generally be considered as not definitely related to any gross 
income, and therefore are ratably apportioned as provided in paragraph 
(c)(3) of this section, are--
    (i) The deduction allowed by section 163 for interest described in 
subparagraph (2)(iii) of this paragraph (e);
    (ii) The deduction allowed by section 164 for real estate taxes on a 
personal residence or for sales tax on the purchase of items for 
personal use;
    (iii) The deduction for medical expenses allowed by section 213; and
    (iv) The deduction for alimony payments allowed by section 215.
    (10) Special deductions. The special deductions allowed in the case 
of a corporation by section 241 (relating to the deductions for 
partially tax exempt interest, dividends received, etc.), section 922 
(relating to Western Hemisphere trade corporations), and section 941 
(relating to China Trade Act corporations) shall be allocated and 
apportioned consistent with the principles of this section.
    (11) Personal exemptions. The deductions for the personal exemptions 
allowed by section 151, 642(b), or 873(b)(3) shall not be taken into 
account for purpose of allocation and apportionment under this section.
    (12) Deductions for certain charitable contributions--(i) In 
general. The deduction for charitable contributions that is allowed 
under sections 170, 873(b)(2), and 882(c)(1)(B) is definitely related 
and allocable to all of the taxpayer's gross income. The deduction 
allocated under this paragraph (e)(12)(i) shall be apportioned between 
the statutory grouping (or among the statutory groupings) of gross 
income and the residual grouping on the basis of the relative amounts of 
gross income from sources in the United States in each grouping.
    (ii) Treaty provisions. If a deduction for charitable contributions 
not otherwise permitted by sections 170, 873(b)(2), and 882(c)(1)(B) is 
allowed under a U.S. income tax treaty, and such treaty limits the 
amount of the deduction based on a percentage of income arising from 
sources within the treaty partner, the deduction is definitely related 
and allocable to all of the taxpayer's gross income. The deduction 
allocated under this paragraph (e)(12)(ii) shall be apportioned between 
the statutory grouping (or among the statutory groupings) of gross 
income and the residual grouping on the basis of the relative amounts of 
gross income from sources within the treaty partner within each 
grouping.
    (iii) Coordination with Sec. Sec.  1.861-14 and 1.861-14T. A 
deduction for a charitable contribution by a member of an affiliated 
group shall be allocated and apportioned under the rules of this 
section, Sec.  1.861-14(e)(6), and Sec.  1.861-14T(c)(1).
    (iv) Effective date. (A) The rules of paragraphs (e)(12)(i) and 
(iii) of this section shall apply to charitable contributions made on or 
after July 28, 2004. Taxpayers may apply the provisions of paragraphs 
(e)(12)(i) and (iii) of this section to charitable contributions made 
before July 28, 2004, but during the taxable year ending on or after 
July 28, 2004.
    (B) The rules of paragraphs (e)(12)(ii) of this section shall apply 
to charitable contributions made on or after July 14, 2005. Taxpayers 
may apply the provisions of paragraph (e)(12)(ii) of this section to 
charitable contributions made before July 14, 2005, but during the 
taxable year ending on or after July 14, 2005.
    (f) Miscellaneous matters--(1) Operative sections. The operative 
sections of the Code which require the determination of taxable income 
of the taxpayer from specific sources or activities and which give rise 
to statutory groupings to which this section is applicable include the 
sections described below.
    (i) Overall limitation to the foreign tax credit. Under the overall 
limitation to

[[Page 167]]

the foreign tax credit, as provided in section 904(a)(2) (as in effect 
before enactment of the Tax Reform Act of 1976, or section 904(a) after 
such enactment) the amount of the foreign tax credit may not exceed the 
tentative U.S. tax (i.e., the U.S. tax before application of the foreign 
tax credit) multiplied by a fraction, the numerator of which is the 
taxable income from sources without the United States and the 
denominator of which is the entire taxable income. Accordingly, in this 
case, the statutory grouping is foreign source income (including, for 
example, interest received from a domestic corporation which meets the 
tests of section 861(a)(1)(B), dividends received from a domestic 
corporation which has an election in effect under section 936, and other 
types of income specified in section 862). Pursuant to sections 862(b) 
and 863(a) and Sec. Sec.  1.862-1 and 1.863-1, this section provides 
rules for identifying the deductions to be taken into account in 
determining taxable income from sources without the United States. See 
section 904(d) (as in effect after enactment of the Tax Reform Act of 
1976) and the regulations thereunder which require separate treatment of 
certain types of income. See example 3 of paragraph (g) of this section 
for one example of the application of this section to the overall 
limitation.
    (ii) [Reserved]
    (iii) DISC and FSC taxable income. Sections 925 and 994 provide 
rules for determining the taxable income of a FSC and DISC, 
respectively, with respect to qualified sales and leases of export 
property and qualified services. The combined taxable income method 
available for determining a DISC's taxable income provides, without 
consideration of export promotion expenses, that the taxable income of 
the DISC shall be 50 percent of the combined taxable income of the DISC 
and the related supplier derived from sales and leases of export 
property and from services. In the FSC context, the taxable income of 
the FSC equals 23 percent of the combined taxable income of the FSC and 
the related supplier. Pursuant to regulations under section 925 and 994, 
this section provides rules for determining the deductions to be taken 
into account in determining combined taxable income, except to the 
extent modified by the marginal costing rules set forth in the 
regulations under sections 925(b)(2) and 994(b)(2) if used by the 
taxpayer. See Examples (22) and (23) of paragraph (g) of this section. 
In addition, the computation of combined taxable income is necessary to 
determine the applicability of the section 925(d) limitation and the 
``no loss'' rules of the regulations under sections 925 and 994.
    (iv) Effectively connected taxable income. Nonresident alien 
individuals and foreign corporations engaged in trade or business within 
the United States, under sections 871(b)(1) and 882(a)(1), on taxable 
income which is effectively connected with the conduct of a trade or 
business within the United States. Such taxable income is determined in 
most instances by initially determining, under section 864(c), the 
amount of gross income which is effectively connected with the conduct 
of a trade or business within the United States. Pursuant to sections 
873 and 882(c), this section is applicable for purposes of determining 
the deductions from such gross income (other than the deduction for 
interest expense allowed to foreign corporations (see Sec.  1.882-5)) 
which are to be taken into account in determining taxable income. See 
example 21 of paragraph (g) of this section.
    (v) Foreign base company income. Section 954 defines the term 
``foreign base company income'' with respect to controlled foreign 
corporations. Section 954(b)(5) provides that in determining foreign 
base company income the gross income shall be reduced by the deductions 
of the controlled foreign corporation ``properly allocable to such 
income''. This section provides rules for identifying which deductions 
are properly allocable to foreign base company income.
    (vi) Other operative sections. The rules provided in this section 
also apply in determining--
    (A) The amount of foreign source items of tax preference under 
section 58(g) determined for purposes of the minimum tax;
    (B) The amount of foreign mineral income under section 901(e);
    (C) [Reserved]

[[Page 168]]

    (D) The amount of foreign oil and gas extraction income and the 
amount of foreign oil related income under section 907;
    (E) The tax base for individuals entitled to the benefits of section 
931 and the section 936 tax credit of a domestic corporation that has an 
election in effect under section 936;
    (F) The exclusion for income from Puerto Rico for bona fide 
residents of Puerto Rico under section 933;
    (G) The limitation under section 934 on the maximum reduction in 
income tax liability incurred to the Virgin Islands;
    (H) The income derived from the U.S. Virgin Islands or from a 
section 935 possession (as defined in Sec.  1.935-1(a)(3)(i)).
    (I) The special deduction granted to China Trade Act corporations 
under section 941;
    (J) The amount of certain U.S. source income excluded from the 
subpart F income of a controlled foreign corporation under section 
952(b);
    (K) The amount of income from the insurance of U.S. risks under 
section 953(b)(5);
    (L) The international boycott factor and the specifically 
attributable taxes and income under section 999; and
    (M) The taxable income attributable to the operation of an agreement 
vessel under section 607 of the Merchant Marine Act of 1936, as amended, 
and the Capital Construction Fund Regulations thereunder (26 CFR, part 
3). See 26 CFR 3.2(b)(3).
    (2) Application to more than one operative section. (i) Where more 
than one operative section applies, it may be necessary for the taxpayer 
to apply this section separately for each applicable operative section. 
In such a case, the taxpayer is required to use the same method of 
allocation and the same principles of apportionment for all operative 
sections.
    (ii) When expenses, losses, and other deductions that have been 
properly allocated and apportioned between combined gross income of a 
related supplier and a DISC or former DISC and residual gross income, 
regardless of which of the administrative pricing methods of section 994 
has been applied, such deductions are not also allocated and apportioned 
to gross income consisting of distributions from the DISC or former DISC 
attributable to income of the DISC or former DISC as determined under 
the administrative pricing methods with respect to DISC or former DISC 
taxable years beginning after December 31, 1986. Accordingly, Example 
(22) of paragraph (g) of this section does not apply to distributions 
from a DISC or former DISC with respect to DISC or former DISC taxable 
years beginning after December 31, 1986. This rule does not apply to the 
extent that the taxable income of the DISC or former DISC is determined 
under the section 994(a)(3) transfer pricing method. In addition, for 
taxable years beginning after December 31, 1986, in the case of 
expenses, losses, and other deductions that have been properly allocated 
and apportioned between combined gross income of a related supplier and 
a FSC and residual gross income, regardless of which of the 
administrative pricing methods of section 925 has been applied, such 
deductions are not also allocated and apportioned to gross income 
consisting of distributions from the FSC or former FSC which are 
attributable to the foreign trade income of the FSC or former FSC as 
determined under the administrative pricing methods. This rule does not 
apply to the extent that the foreign trade income of the FSC or former 
FSC is determined under the section 925(a)(3) transfer pricing method. 
See Example (23) of paragraph (g) of this section.
    (3) Special rules of section 863(b)--(i) In general. Special rules 
under section 863(b) provide for the application of rules of general 
apportionment provided in Sec. Sec.  1.863-3 to 1.863-5, to worldwide 
taxable income in order to attribute part of such worldwide taxable 
income to U.S. sources and the remainder of such worldwide taxable 
income to foreign sources. The activities specified in section 863(b) 
are--
    (A) Transportation or other services rendered partly within and 
partly without the United States,
    (B) Sales of personal property produced by the taxpayer within and 
sold without the United States, or produced by the taxpayer without and 
sold within the United States, and

[[Page 169]]

    (C) Sales within the United States of personal property purchased 
within a possession of the United States.


In the instances provided in Sec. Sec.  1.863-3 and 1.863-4 with respect 
to the activities described in (A), (B), and (C) of this subdivision, 
this section is applicable only in determining worldwide taxable income 
attributable to these activities.
    (ii) Relationship of sections 861, 862, 863(a), and 863(b). Sections 
861, 862, 863(a), and 863(b) are the four provisions applicable in 
determining taxable income from specific sources. Each of these four 
provisions applies independently. Where a deduction has been allocated 
and apportioned to income under one of these four provisions, the 
deduction shall not again be allocated and apportioned to gross income 
under any of the other three provisions. However, two or more of these 
provisions may have to be applied at the same time to determine the 
proper allocation and apportionment of a deduction. The special rules 
under section 863(b) take precedence over the general rules of Code 
sections 861, 862 and 863(a). For example, where a deduction is 
allocable in whole or in part to gross income to which section 863(b) 
applies, such deduction or part thereof shall not otherwise be allocated 
under section 861, 862, or 863(a). However, where the gross income to 
which the deduction is allocable includes both gross income to which 
section 863(b) applies and gross income to which section 861, 862, or 
863(a) applies, more than one section must be applied at the same time 
in order to determine the proper allocation and apportionment of the 
deduction.
    (4) Adjustments made under other provisions of the Code--(i) In 
general. If an adjustment which affects the taxpayer is made under 
section 482 or any other provision of the Code, it may be necessary to 
recompute the allocations and apportionments required by this section in 
order to reflect changes resulting from the adjustment. The 
recomputation made by the Commissioner shall be made using the same 
method of allocation and apportionment as was originally used by the 
taxpayer, provided such method as originally used conformed with 
paragraph (a)(2) of this section and, in light of the adjustment, such 
method does not result in a material distortion. In addition to 
adjustments which would be made aside from this section, adjustments to 
the taxpayer's income and deductions which would not otherwise be made 
may be required before applying this section in order to prevent a 
distortion in determining taxable income from a particular source of 
activity. For example, if an item included as a part of the cost of 
goods sold has been improperly attributed to specific sales, and, as a 
result, gross income under one of the operative sections referred to in 
paragraph (f)(1) of this section is improperly determined, it may be 
necessary for the Commissioner to make an adjustment to the cost of 
goods sold, consistent with the principles of this section, before 
applying this section. Similarly, if a domestic corporation transfers 
the stock in its foreign subsidiaries to a domestic subsidiary and the 
parent corporation continues to incur expenses in connection with 
protecting its capital investment in the foreign subsidiaries (see 
paragraph (e)(4) of this section), it may be necessary for the 
Commissioner to make an allocation under section 482 with respect to 
such expenses before making allocations and apportionments required by 
this section, even though the section 482 allocation might not otherwise 
be made.
    (ii) Example. X, a domestic corporation, purchases and sells 
consumer items in the United States and foreign markets. Its sales in 
foreign markets are made to related foreign subsidiaries. X reported 
$1,500,000 as sales during the taxable year of which $1,000,000 was 
domestic sales and $500,000 was foreign sales. X took a deduction for 
expenses incurred by its marketing department during the taxable year in 
the amount of $150,000. These expenses were determined to be allocable 
to both domestic and foreign sales and are apportionable between such 
sales. Thus, X allocated and apportioned the marketing department 
deduction as follows:

To gross income from domestic sales: $150,000 x ($1,000,000/    $100,000
 $1,500,000).................................................
To gross income from foreign sales: $150,000 x ($500,000/         50,000
 $1,500,000).................................................
                                                              ----------
 Total.......................................................    150,000
 


[[Page 170]]

    On audit of X's return for the taxable year, the District Director 
adjusted, under section 482, X's sales to related foreign subsidiaries 
by increasing the sales price by a total of $100,000, thereby increasing 
X's foreign sales and total sales by the same amount. As a result of the 
section 482 adjustment, the apportionment of the deduction for the 
marketing department expenses is redetermined as follows:

To gross income from domestic sales: $150,000 x ($1,000,000/     $93,750
 $1,600,000)..................................................
To gross income from foreign sales: $150,000 x ($600,000/         56,250
 $1,600,000)
                                                               ---------
 Total........................................................   150,000
 

    (5) Verification of allocations and apportionments. Since, under 
this section, allocations and apportionments are made on the basis of 
the factual relationship between deductions and gross income, the 
taxpayer is required to furnish, at the request of the District 
Director, information from which such factual relationships can be 
determined. In reviewing the overall limitation to the foreign tax 
credit of a domestic corporation, for example, the District Director 
should consider information which would enable him to determine the 
extent to which deductions attributable to functions performed in the 
United States are related to earning foreign source income, United 
States source income, or income from both sources. In addition to 
functions with a specific international purpose, consideration should be 
given to the functions of management, the direction and results of an 
acquisition program, the functions of operating units and personnel 
located at the head office, the functions of support units (including 
but not limited to engineering, legal, budget, accounting, and 
industrial relations), the functions of selling and advertising units 
and personnel, the direction and uses of research and development and 
the direction and uses of services furnished by independent contractors. 
Thus, for example when requested by the District Director, the taxpayer 
shall make available any of its organization charts, manuals, and other 
writings which relate to the manner in which its gross income arises and 
to the functions of organizational units, employees, and assets of the 
taxpayer and arrange for the interview of such of its employees as the 
District Director deems desirable in order to determine the gross income 
to which deductions relate. See section 7602 and the regulations 
thereunder which generally provide for the examination of books and 
witnesses. See also section 905(b) and the regulations thereunder which 
require proof of foreign tax credits to the satisfaction of the 
Secretary or his delegate.
    (g) General examples. The following examples illustrate the 
principles of this section. In each example, unless otherwise specified, 
the operative section which is applied and gives rise to the statutory 
grouping of gross income is the overall limitation to the foreign tax 
credit under section 904(a). In addition, in each example, where a 
method of allocation or apportionment is illustrated as an acceptable 
method, it is assumed that such method is used by the taxpayer on a 
consistent basis from year to year (except in the case of the optional 
method for apportioning research and development expense under paragraph 
(e)(3)(iii) of Sec.  1.861-8). Further, it is assumed that each party 
named in each example operates on a calendar year accounting basis and, 
where the party is a U.S. taxpayer, files returns on a calendar year 
basis.

    Examples 1-16 [Reserved]
    Example 17. Stewardship expenses (consolidation). (i) (A) Facts. X, 
a domestic corporation, wholly owns M, N, and O, also domestic 
corporations. X, M, N, and O file a consolidated income tax return. All 
the income of X and O is from sources within the United States, all of 
M's income is general category income from sources within South America, 
and all of N's income is general category income from sources within 
Africa. X receives no dividends from M, N, or O. During the taxable 
year, the consolidated group of corporations earned consolidated gross 
income of $550,000 and incurred total deductions of $370,000 as follows:

------------------------------------------------------------------------
                                                   Gross
                                                   income     Deductions
------------------------------------------------------------------------
Corporations:
    X.........................................     $100,000      $50,000
    M.........................................      250,000      100,000
    N.........................................      150,000      200,000
    O.........................................       50,000       20,000
                                               -------------------------
        Total.................................      550,000      370,000
------------------------------------------------------------------------

    (B) Of the $50,000 of deductions incurred by X, $15,000 relates to 
X's ownership of M; $10,000 relates to X's ownership of N; $5,000 
relates to X's ownership of O; and the sole effect of the entire $30,000 
of deductions is to

[[Page 171]]

protect X's capital investment in M, N, and O. X properly categorizes 
the $30,000 of deductions as stewardship expenses. The remainder of X's 
deductions ($20,000) relates to production of United States source 
income from its plant in the United States.
    (ii) (A) Allocation. X's deductions of $50,000 are definitely 
related and thus allocable to the types of gross income to which they 
give rise, namely $25,000 wholly to general category income from sources 
outside the United States ($15,000 for stewardship of M and $10,000 for 
stewardship of N) and the remainder ($25,000) wholly to gross income 
from sources within the United States. Expenses incurred by M and N are 
entirely related and thus wholly allocable to general category income 
earned from sources without the United States, and expenses incurred by 
O are entirely related and thus wholly allocable to income earned within 
the United States. Hence, no apportionment of expenses of X, M, N, or O 
is necessary. For purposes of applying the foreign tax credit 
limitation, the statutory grouping is general category gross income from 
sources without the United States and the residual grouping is gross 
income from sources with in the United States. As a result of the 
allocation of deductions, the X consolidated group has taxable income 
from sources without the United States in the amount of $75,000, 
computed as follows:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Foreign source general category gross income ($250,000 from     $400,000
 M + $150,000 from N).......................................
Less: Deductions allocable to foreign source general           (325,000)
 category gross income ($25,000 from X, $100,000 from M, and
 $200,000 from N)...........................................
                                                             -----------
    Total foreign-source taxable income.....................      75,000
------------------------------------------------------------------------

    (B) Thus, in the combined computation of the general category 
limitation, the numerator of the limiting fraction (taxable income from 
sources outside the United States) is $75,000.
    Example 18. Stewardship and supportive expenses. (i) (A) Facts. X, a 
domestic corporation, manufactures and sells pharmaceuticals in the 
United States. X's domestic subsidiary S, and X's foreign subsidiaries 
T, U, and V perform similar functions in the United States and foreign 
countries T, U, and V, respectively. Each corporation derives 
substantial net income during the taxable year that is general category 
income described in section 904(d)(1). X's gross income for the taxable 
year consists of:

Domestic sales income.....................................   $32,000,000
Dividends from S (before dividends received deduction)....     3,000,000
Dividends from T..........................................     2,000,000
Dividends from U..........................................     1,000,000
Dividends from V..........................................             0
Royalties from T and U....................................     1,000,000
Fees from U for services performed by X...................     1,000,000
                                                           -------------
    Total gross income....................................    40,000,000
 

    (B) In addition, X incurs expenses of its supervision department of 
$1,500,000.
    (C) X's supervision department (the Department) is responsible for 
the supervision of its four subsidiaries and for rendering certain 
services to the subsidiaries, and this Department provides all the 
supportive functions necessary for X's foreign activities. The 
Department performs three principal types of activities. The first type 
consists of services for the direct benefit of U for which a fee is paid 
by U to X. The cost of the services for U is $900,000 (which results in 
a total charge to U of $1,000,000). The second type consists of 
activities described in Sec.  1.482-9(l)(3)(iii) that are in the nature 
of shareholder oversight that duplicate functions performed by the 
subsidiaries' own employees and that do not provide an additional 
benefit to the subsidiaries. For example, a team of auditors from X's 
accounting department periodically audits the subsidiaries' books and 
prepares internal reports for use by X's management. Similarly, X's 
treasurer periodically reviews for the board of directors of X the 
subsidiaries' financial policies. These activities do not provide an 
additional benefit to the related corporations. The cost of the 
duplicative services and related supportive expenses is $540,000. The 
third type of activity consists of providing services which are 
ancillary to the license agreements which X maintains with subsidiaries 
T and U. The cost of the ancillary services is $60,000.
    (ii) Allocation. The Department's outlay of $900,000 for services 
rendered for the benefit of U is allocated to the $1,000,000 in fees 
paid by U. The remaining $600,000 in the Department's deductions are 
definitely related to the types of gross income to which they give rise, 
namely dividends from subsidiaries S, T, U, and V and royalties from T 
and U. However, $60,000 of the $600,000 in deductions are found to be 
attributable to the ancillary services and are definitely related (and 
therefore allocable) solely to royalties received from T and U, while 
the remaining $540,000 in deductions are definitely related (and 
therefore allocable) to dividends received from all the subsidiaries.
    (iii) (A) Apportionment. For purposes of applying the foreign tax 
credit limitation, the statutory grouping is general category gross

[[Page 172]]

income from sources outside the United States and the residual grouping 
is gross income from sources within the United States. X's deduction of 
$540,000 for the Department's expenses and related supportive expenses 
which are allocable to dividends received from the subsidiaries must be 
apportioned between the statutory and residual groupings before the 
foreign tax credit limitation may be applied. In determining an 
appropriate method for apportioning the $540,000, a basis other than X's 
gross income must be used since the dividend payment policies of the 
subsidiaries bear no relationship either to the activities of the 
Department or to the amount of income earned by each subsidiary. This is 
evidenced by the fact that V paid no dividends during the year, whereas 
S, T, and U paid dividends of $1 million or more each. In the absence of 
facts that would indicate a material distortion resulting from the use 
of such method, the stewardship expenses ($540,000) may be apportioned 
on the basis of the gross receipts of each subsidiary.
    (B) The gross receipts of the subsidiaries were as follows:

S.........................................................    $4,000,000
T.........................................................     3,000,000
U.........................................................       500,000
V.........................................................     1,500,000
                                                           -------------
    Total.................................................     9,000,000
 

    (C) Thus, the expenses of the Department are apportioned for 
purposes of the foreign tax credit limitation as follows:

Apportionment of stewardship expenses to the statutory          $300,000
 grouping of gross income: $540,000 x [($3,000,000 +
 $500,000 + $1,500,000)/$9,000,000].......................
Apportionment of supervisory expenses to the residual            240,000
 grouping of gross income: $540,000 x [$4,000,000/
 9,000,000]...............................................
                                                           -------------
    Total: Apportioned stewardship expense................       540,000
 

    Example 19. Supportive Expense. (i) Facts. X, a domestic 
corporation, purchases and sells products both in the United States and 
in foreign countries. X has no foreign subsidiary and no international 
department. During the taxable year, X incurs the following expenses 
with respect to its worldwide activities:

Personnel department expenses...............................     $50,000
Training department expenses................................      35,000
General and administrative expenses.........................      55,000
President's salary..........................................      40,000
Sales manager's salary......................................      20,000
                                                             -----------
   Total....................................................     200,000
                                                             ===========
 


X has domestic gross receipts from sales of $750,000 and foreign gross 
receipts from sales of $500,000 and has gross income from such sales in 
the same ratio, namely $300,000 from domestic sources and $200,000 from 
foreign sources.
    (ii) Allocation. The above expenses are definitely related and 
allocable to all of X's gross income derived from both domestic and 
foreign markets.
    (iii) Apportionment. For purposes of applying the overall 
limitation, the statutory grouping is gross income from sources outside 
the United States and the residual grouping is gross income from sources 
within the United States. X's deductions for its worldwide sales 
activities must be apportioned between these groupings. Company X in 
this example (unlike Company X in example 18) does not have a separate 
international division which performs essentially all of the functions 
required to manage and oversee its foreign activities. The president and 
sales manager do not maintain time records. The division of their time 
between domestic and foreign activities varies from day to day and 
cannot be estimated on an annual basis with any reasonable degree of 
accuracy. Similarly, there are no facts which would justify a method of 
apportionment of their salaries or of one of the other listed deductions 
based on more specific factors than gross receipts or gross income. An 
acceptable method of apportionment would be on the basis of gross 
receipts. The apportionment of the $200,000 deduction is as follows:

Apportionment of the $200,000 expense to the statutory           $80,000
 grouping of gross income: $200,000 x [$500,000/($500,000 +
 $750,000)].................................................
Apportionment of the $200,000 expense to the residual            120,000
 grouping of gross income: $200,000 x [$750,000/($500,000 +
 $750,000)].................................................
                                                             -----------
  Total apportioned supportive expense......................     200,000
 

    Example 20. Supportive Expense. (i) Facts. Assume the same facts as 
above except that X's president devotes only 5 percent of his time to 
the foreign operations and 95 percent of his time to the domestic 
operations and that X's sales manager devotes approximately 10 percent 
of his time to foreign sales and 90 percent of his time to domestic 
sales.
    (ii) Allocation. The expenses incurred by X with respect to its 
worldwide activities are definitely related, and therefore allocable to 
X's gross income from both its foreign and domestic markets.
    (iii) Apportionment. On the basis of the additional facts it is not 
acceptable to apportion the salaries of the president and the

[[Page 173]]

sales manager on the basis of gross receipts. It is acceptable to 
apportion such salaries between the statutory grouping (gross income 
from sources without the United States) and residual grouping (gross 
income from sources within the United States) on the basis of time 
devoted to each sales activity. Remaining expenses may still be 
apportioned on the basis of gross receipts. The apportionment is as 
follows:

Apportionment of the $200,000 expense to the statutory
 grouping of gross income:
  President's salary: $40,000 x 5 pct.......................      $2,000
  Sales manager's salary: $20,000 x 10 pct..................       2,000
  Remaining expenses: $140,000 x [$500,000/($500,000 +            56,000
   $750,000)]...............................................
                                                             -----------
    Subtotal: Apportionment of expense to statutory grouping      60,000
                                                             ===========
Apportionment of the $200,000 expense to the residual
 grouping of gross income:
  President's salary: $40,000 x 95 pct......................      38,000
  Sales manager's salary: $20,000 x 90 pct..................      18,000
  Remaining expenses: $140,000 x [$750,000/($500,000 +            84,000
   $750,000)]...............................................
                                                             -----------
    Subtotal: Apportionment of expense to residual grouping.     140,000
                                                             ===========
    Total: Apportioned general and administrative expense...     200,000
 

    Example 21. Supportive Expense. (i) Facts. X, a foreign corporation 
doing business in the United States, is a manufacturer of metal stamping 
machines. X has no United States subsidiaries and no separate division 
to manage and oversee its business in the United States. X manufactures 
and sells these machines in the United States and in foreign countries A 
and B and has a separate manufacturing facility in each country. Sales 
of these machines are X's only source of income. In 1977, X incurs 
general and administrative expenses related to both its U.S. and foreign 
operations of $100,000. It has machine sales of $500,000, $1,000,000 and 
$1,000,000 on which it earns gross income of $200,000, $400,000 and 
$400,000 in the United States, country A, and country B, respectively. 
The income from the manufacture and sale of the machines in countries A 
and B is not effectively connected with X's business in the United 
States.
    (ii) Allocation. The $100,000 of general and administrative expense 
is definitely related to the income to which it gives rise, namely a 
part of the gross income from sales of machines in the United States, in 
country A, and in country B. The expenses are allocable to this class of 
income, even though X's gross income from sources outside the United 
States is excluded income since it is not effectively connected with a 
U.S. trade or business.
    (iii) Apportionment Since X is a foreign corporation, the statutory 
grouping is gross income effectively connected with X's trade of 
business in the United States, namely gross income from sources within 
the United States, and the residual grouping is gross income not 
effectively connected with a trade or business in the United States, 
namely gross income from countries A and B. Since there are no facts 
which would require a method of apportionment other than on the basis of 
sales or gross income, the amount may be apportioned between the two 
groupings on the basis of amounts of gross income as follows:

Apportionment of general and administrative expense to the       $20,000
 statutory grouping, gross income from sources within the
 United States: $100,000 x [$200,000/($200,000 + $400,000 +
 $400,000)].................................................
Apportionment of general and administrative expense to the        80,000
 residual grouping, gross income from sources without the
 United States: $100,000 x [($400,000 + $400,000)/($200,000
 + $400,000 + $400,000)]....................................
                                                             -----------
    Total apportioned general and administrative expense....     100,000
 

    Example 22. Domestic International Sales Corporations. (i) Facts. X, 
a domestic corporation, manufactures a line of kitchenware and sells it 
to retailers in the United States, France, and the United Kingdom. After 
the Domestic International Sales Corporation (DISC) legislation was 
passed in 1971, X established, as of January 1, 1972, a DISC and 
thereafter did all of its foreign marketing through sales by the DISC. 
In 1977 the DISC has total sales of $7,700,000 for which X's cost of 
goods sold is $6,000,000. Thus, the gross income attributable to exports 
through the DISC is $1,700,000 ($7,700,000-$6,000,000). Moreover, X has 
U.S. domestic sales of kitchenware of $12,000,000 on which it earned 
gross income of $900,000, and X receives royalty income from the foreign 
license of its kitchenware technology in the amount of $800,000. The 
DISC's expenses attributable to the resale of export property are 
$400,000 of which $300,000 qualify as export promotion expenses. X also 
incurs $125,000 of general and administrative expenses in connection 
with its domestic and foreign sales activities, and its foreign 
licensing activities. X and the DISC determine transfer prices charged 
on the basis of a single product grouping and the ``50-50'' combined 
taxable income method (without marginal costing) which permits the DISC 
to have a taxable income equal to 50 percent of the combined taxable 
income attributable to the production and sales of the export property, 
plus 10 percent of the DISC's export promotion expenses.
    (ii) Allocation. For purposes of determining combined taxable income 
of X and the DISC from export sales, general and administrative expenses 
of $125,000 must be allocated to and apportioned between gross income 
resulting from the production and sale of

[[Page 174]]

kitchenware for export, and from the production and sale of kitchenware 
for the domestic market. The deduction of $400,000 for expenses 
attributable to the resale of export property is allocated solely to 
gross income from the production and sale of kitchenware in foreign 
markets.
    (iii) Apportionment. Apportionment of expense takes place in two 
stages. In the first stage, for computing conbined taxable income from 
the production and sale of export property, the general and 
administrative expense should be apportioned between the statutory 
grouping of gross income from the export of kitchenware and the residual 
grouping of gross income from domestic sales and foreign licenses. In 
the second stage, since the limitation on the foreign tax credit 
requires the use of a separate limitation with respect to dividends from 
a DISC (section 904(d)), the general and administrative expense should 
be apportioned between two statutory groupings, DISC dividends and 
foreign royalty income (for which the overall limitation is used), and 
the residual grouping of gross income from sales within the United 
States. In the first stage, in the absence of more specific or contrary 
information, the general and administrative expense may be apportioned 
on the basis of gross income in the respective groupings, as follows:

Apportionment of general and administrative expense to the       $62,500
 statutory grouping, gross income from exports of
 kitchenware: $125,000 x [$1,700,000/($1,700,000 + $900,000
 + $800,000)]...............................................
Apportionment of general and administrative expense to the        62,500
 residual grouping, gross income from domestic sales of
 kitchenware and foreign royalty income from licensing
 kitchenware technology: $125,000 x [($900,000 + $800,000)/
 ($1,700,000 + $900,000 + $800,000)]........................
                                                             -----------
  Total apportionment of general and administrative expense.     125,000
 


On the basis of this apportionment, the combined taxable income, and the 
DISC portion of taxable income may be calculated as follows:

Gross income from exports....................   $1,700,000
Less:
  DISC expense for resale of export property.      400,000
  Apportioned general and administrative            62,500
   expense...................................
                                              -------------
                                                                $462,500
                                                           -------------
Combined taxable income from production and export of          1,237,500
 kitchenware..............................................
                                              ==============
DISC income:
  50 pct of combined taxable income.......................       618,750
  10 pct of export promotion expense of $300,000..........        30,000
                                              --------------
   Total DISC income......................................       648,750
DISC income as a percentage of combined taxable income....          52.4
 

In the second stage, in the absence of more specific or contrary 
information, the general and administrative expense may also be 
apportioned on the basis of gross income in the respective groupings. 
Since DISC taxable income is 52.4 percent of combined taxable income, 
DISC gross income is treated as 52.4 percent of the gross income from 
exports $1,700,000. The apportionment follows:

Apportionment of general and administrative expense to the       $32,750
 statutory grouping, DISC dividends: $125,000 x [(0.524 x
 $1,700,000)/($1,700,000 + $900,000 + $800,000)]............
Apportionment of general and administrative expense to the        29,412
 statutory grouping, foreign royalty income: $125,000 x
 [$800,000/($1,700,000 + 900,000 + $800,000)]...............
Apportionment of general and administrative expense to the        62,838
 residual grouping, gross income from sources within the
 United States: $125,000 x [($900,000 + (0.476 x
 $1,700,000))/($1,700,000 + $900,000 + $800,000)]...........
                                                             -----------
    Total apportioned general and administrative expense....     125,000
 

    (iv) This Example 22 applies only to DISC taxable years ending 
before January 1, 1987, and to distributions from a DISC or former DISC 
with respect to DISC or former DISC taxable years ending before January 
1, 1987.
    Example 23. [Reserved]
    Example 24. [Reserved]. For guidance, see Sec.  1.861-8T(g) Example 
24.
    Example 25. Income Taxes. (i) Facts. X, a domestic corporation, is a 
manufacturer and distributor of electronic equipment with operations in 
states A, B, and C. X also has a branch in country Y which manufactures 
and distributes the same type of electronic equipment. In 1988, X has 
taxable income from these activities, as described under the Code 
(without taking into account the deduction for state income taxes), of 
$1,000,000, of which $200,000 is foreign source general limitation 
income subject to a separate limitation under section 904(d)(1)(I) 
(``general limitation income'') and $800,000 is domestic source income. 
States A, B, and C each determine X's income subject to tax within their 
state by making adjustments to X's taxable income as determined under 
the Code, and then apportioning the adjusted taxable income on the basis 
of the relative amounts of X's payroll, property, and sales within each 
state as compared to X's worldwide payroll, property, and sales. The 
adjustments made by states A, B, and C all involve adding and 
subtracting enumerated items from taxable income as determined under the 
Code. However, in making these adjustments to taxable income, none of 
the states specifically exempts foreign source income as determined 
under the Code. On this basis, it is determined that X has taxable 
income of $550,000, $200,000, and $200,000 in states A, B, and C, 
respectively. The corporate tax rates in states A, B, and C are 10 
percent, 5

[[Page 175]]

percent, and 2 percent, respectively, and X has total state income tax 
liabilities of $69,000 ($55,000 + $10,000 + $4,000), which it deducts as 
an expense for federal income tax purposes.
    (ii) Allocation. X's deduction of $69,000 for state income taxes is 
definitely related and thus allocable to the gross income with respect 
to which the taxes are imposed. Since the statutes of states A, B, and C 
do not specifically exempt foreign source income (as determined under 
the Code) from taxation and since, in the aggregate, states A, B, and C 
tax $950,000 of X's income while only $800,000 is domestic source income 
under the Code, it is presumed that state income taxes are imposed on 
$150,000 of foreign source income. The deduction for state income taxes 
is therefore related and allocable to both X's foreign source and 
domestic source income.
    (iii) Apportionment. For purposes of computing the foreign tax 
credit limitation, X's income is comprised of one statutory grouping, 
foreign source general limitation gross income, and one residual 
grouping, gross income from sources within the United States. The state 
income tax deduction of $69,000 must be apportioned between these two 
groupings. Corporation X calculates the apportionment on the basis of 
the relative amounts of foreign source general limitation taxable income 
and U.S. source taxable income subject to state taxation. In this case, 
state income taxes are presumed to be imposed on $800,000 of domestic 
source income and $150,000 of foreign source general limitation income.

State income tax deduction apportioned to foreign source         $10,895
 general limitation income (statutory grouping): $69,000 x
 ($150,000/$950,000)..........................................
State income tax deduction apportioned to income from sources     58,105
 within the United States (residual grouping): $69,000 x
 ($800,000/$950,000)..........................................
                                                               ---------
      Total apportioned state income tax deduction............   $69,000
 

    Example 26. Income Taxes. (i) Facts. Assume the same facts as in 
Example 25 except that the language of state A's statute and the 
statute's operation exempt from taxation all foreign source income, as 
determined under the Code, so that foreign source income is not included 
in adjusted taxable income subject to apportionment in state A (and 
factors relating to X's country Y branch are not taken into account in 
computing the state A apportionment fraction).
    (ii) Allocation. X's deduction of $69,000 for state income taxes is 
definitely related and thus allocable to the gross income with respect 
to which the taxes are imposed. Since state A exempts all foreign source 
income by statute, state A is presumed to impose tax on $550,000 of X's 
$800,000 of domestic source income. X's state A tax of $55,000 is 
allocable, therefore, solely to domestic source income. Since the 
statutes of states B and C do not specifically exclude all foreign 
source income as determined under the Code, and since states B and C 
impose tax on $400,000 ($200,000 + $200,000) of X's income of which only 
$250,000 ($800,000 - $550,000) is presumed to be domestic source, the 
deduction for the $14,000 of income taxes imposed by states B and C is 
related and allocable to both foreign source and domestic source income.
    (iii) Apportionment. (A) For purposes of computing the foreign tax 
credit limitation, X's income is comprised of one statutory grouping, 
foreign source general limitation gross income, and one residual 
grouping, gross income from sources within the United States. The 
deduction of $14,000 for income taxes of states B and C must be 
apportioned between these two groupings.
    (B) Corporation X calculates the apportionment on the basis of the 
relative amounts of foreign source general limitation income and U.S. 
source income subject to state taxation.

States B and C income tax deduction apportioned to foreign        $5,250
 source general limitation income (statutory grouping):
 $14,000 x ($150,000/$400,000)................................
States B and C income tax deduction apportioned to income from     8,750
 sources within the United States (residual grouping): $14,000
 x ($250,000/$400,000)........................................
                                                               ---------
      Total apportioned state income tax deduction............   $14,000
 

    (C) Of X's total income taxes of $69,000, the amount allocated and 
apportioned to foreign source general limitation income equals $5,250. 
The total amount of state income taxes allocated and apportioned to U.S. 
source income equals $63,750 ($55,000 + $8,750).
    Example 27. Income Tax. (i) Facts. Assume the same facts as in 
Example 25 except that state A, in which X has significant income-
producing activities, does not impose a corporate income tax or other 
state tax computed on the basis of income derived from business 
activities conducted in state A. X therefore has a total state income 
tax liability in 1988 of $14,000 ($10,000 paid to state B plus $4,000 
paid to state C), all of which is subject to allocation and 
apportionment under paragraph (b) of this section.
    (ii) Allocation. (A) X's deduction of $14,000 for state income taxes 
is definitely related

[[Page 176]]

and allocable to the gross income with respect to which the taxes are 
imposed. However, in these facts, an adjustment is necessary before the 
aggregate state taxable incomes can be compared with U.S. source income 
on the federal income tax return in the manner described in Examples 25 
and 26. Unlike the facts in Examples 25 and 26, state A imposes no 
income tax and does not define taxable income attributable to activities 
in state A. The total amount of X's income subject to state taxation is, 
therefore, $400,000 ($200,000 in state B and $200,000 in state C). This 
total presumptively does not include any income attributable to 
activities performed in state A and therefore can not properly be 
compared to total U.S. source taxable income reported by X for federal 
income tax purposes, which does include income attributable to state A 
activities.
    (B)(1) Accordingly, before applying the method used in Examples 25 
and 26 to the facts of this example, it is necessary first to estimate 
the amount of taxable income that state A could reasonably attribute to 
X's activities in state A, and then to reduce federal taxable income by 
that amount.
    (2) Any reasonable method may be used to attribute taxable income to 
X's activities in state A. For example, the rules of the Uniform 
Division of Income for Tax Purposes Act (``UDITPA'') attribute income to 
a state on the basis of the average of three ratios that are based upon 
the taxpayer's facts--property within the state over total property, 
payroll within the state over total payroll, and sales within the state 
over total sales--and, with adjustments, provide a reasonable method for 
this purpose. When applying the rules of UDITPA to estimate U.S. source 
income derived from state A activities, the taxpayer's UDITPA factors 
must be adjusted to eliminate both taxable income and factors 
attributable to a foreign branch. Therefore, in this example all taxable 
income as well as UDITPA apportionment factors (property, payroll, and 
sales) attributable to X's country Y branch must be eliminated.
    (C)(1) Since it is presumed that, if state A had had an income tax, 
state A would not attempt to tax the income derived by X's country Y 
branch, any reasonable estimate of the income that would be taxed by 
state A must exclude any foreign source income.
    (2) When using the rules of UDITPA to estimate the income that would 
have been taxable by state A in these facts, foreign source income is 
excluded by starting with federally defined taxable income (before 
deduction for state income taxes) and subtracting any income derived by 
X's country Y branch. The hypothetical state A taxable income is then 
determined by multiplying the resulting difference by the average of X's 
state A property, payroll, and sales ratios, determined using the 
principles of UDITPA (after adjustment by eliminating the country Y 
branch factors). The resulting product is presumed to be exclusively 
U.S. source income, and the allocation and apportionment method 
described in Example 26 must then be applied.
    (3) If, for example, state A taxable income were determined to equal 
$550,000, then $550,000 of U.S. source income for federal income tax 
purposes would be presumed to constitute state A taxable income. Under 
Example 26, the remaining $250,000 ($800,000 - $550,000) of U.S. source 
income for federal income tax purposes would be presumed to be subject 
to tax in states B and C. Since states B and C impose tax on $400,000, 
the application of Example 25 would result in a presumption that 
$150,000 is foreign source income and $250,000 is domestic source 
income. The deduction for the $14,000 of income taxes of states B and C 
would therefore be related and allocable to both foreign source and 
domestic source income and would be subject to apportionment.
    (iii) Apportionment. The deduction of $14,000 for income taxes of 
states B and C is apportioned in the same manner as in Example 26. As a 
result, $5,250 of the $14,000 of state B and state C income taxes is 
apportioned to foreign source general limitation income ($14,000 x 
$150,000/$400,000), and $8,750 ($14,000 x $250,000/$400,000) of the 
$14,000 of state B and state C income taxes is apportioned to U.S. 
source income.
    Example 28. Income Tax. (i) Facts. (A) Assume the same facts as in 
Example 25 (X has $1,000,000 of taxable income for federal income tax 
purposes, $800,000 of which is U.S. source income and $200,000 of which 
is foreign source general limitation income), except that $100,000 of 
X's $200,000 of foreign source general limitation income consists of 
dividends from first-tier controlled foreign corporations (``CFCs'') (as 
defined in section 957(a) of the Code) which derive exclusively foreign 
source general limitation income. X owns stock representing 10 to 50 
percent of the vote and value in such CFCs.
    (B) State A taxable income is computed by first making adjustments 
to X's federal taxable income. These adjustments result in X having a 
total of $1,100,000 of apportionable taxable income for state A tax 
purposes. None of the $100,000 of adjustments made by state A relate to 
the dividends paid by the CFCs. As in Example 25, the amount of 
apportionable taxable income attributable to business activities 
conducted in state A is determined by multiplying apportionable taxable 
income by a fraction (the ``state apportionment fraction'') that 
compares the relative amounts of X's payroll, property, and sales within 
state A with X's worldwide payroll, property and sales. An analysis of 
state A law indicates that state A law includes in its definition of the 
taxable business income of X which is apportionable to X's state A 
activities, dividends paid to X by

[[Page 177]]

its subsidiaries that are in the same business as X, but are less than 
50 percent owned by X (``portfolio dividends''). The dividends received 
by X from the 10 to 50 percent owned first-tier CFCs, therefore, are 
considered to be portfolio dividends includable in apportionable 
business income for state A tax purposes. However, the factors of these 
CFCs are not included in the state A apportionment fraction for purposes 
of apportioning income to X's activities in the state. The comparison of 
X's state A factors with X's worldwide factors results in a state 
apportionment fraction of 50 percent. Applying this fraction to 
apportionable taxable income of $1,100,000, as determined under state 
law, results in attributing 50 percent of apportionable taxable income 
to state A, and produces total state A taxable income of $550,000. State 
A imposes an income tax at a rate of 10 percent on the amount of income 
that is attributed to state A, which results in $55,000 of tax imposed 
by state A.
    (ii) Allocation. (A) States A, B, and C impose income taxes of 
$69,000 which must be allocated to the classes of gross income upon 
which the taxes are imposed. A portion of X's federal income tax 
dedution of $55,000 for state A income tax is definitely related and 
thus allocable to the class of gross income consisting of foreign source 
portfolio dividends. A definite relationship exists between a deduction 
for state income tax and portfolio dividends when a state includes 
portfolio dividends in state taxable income apportionable to the state, 
but determines state taxable income by applying an apportionment 
fraction that excludes the factors of the corporations paying those 
dividends. By applying a state apportionment fraction that excludes 
factors of the corporations paying portfolio dividends to apportionable 
taxable income that includes the $100,000 of foreign source portfolio 
dividends, $50,000 (50 percent of the $100,000) of the portfolio 
dividends is attributed to X's activities in state A and subjected to 
state A income tax. Applying the state A income tax rate of 10 percent 
to the $50,000 of foreign source portfolio dividends subjected to state 
A income tax, $5,000 of X's $55,000 total state A income tax liability 
is definitely related and allocable to a class of gross income 
consisting of the foreign source portfolio dividends. Since under the 
look-through rules of section 904(d)(3) the foreign source portfolio 
dividends from the first-tier CFCs are included within the general 
limitation described in section 904(d)(1)(I), the $5,000 of state A tax 
on foreign source portfolio dividends is allocated entirely to foreign 
source general limitation income and, therefore, is not apportioned. (If 
the total amount of state A tax imposed on foreign source portfolio 
dividends were to exceed the actual amount of X's state A income tax 
liability (for example, due to net operating losses), the actual amount 
of state A tax would be allocated entirely to those foreign source 
portfolio dividends.) After allocation of a portion of the state A tax 
to portfolio dividends, $50,000 ($55,000-$5,000) of state A tax remains 
to be allocated.
    (B) A total of $64,000 (the aggregate of the $50,000 remaining state 
A tax, and the $10,000 and $4,000 of taxes imposed by states B and C, 
respectively) is to be allocated (as provided in Example 25) by 
comparing U.S. source taxable income (as determined under the Code) with 
the aggregate of the state taxable incomes determined by states A, B, 
and C (after reducing state apportionable taxable incomes by the amount 
of any portfolio dividends included in apportionable taxable income to 
which tax has been specifically allocated). X's state A taxable income, 
after reduction by the $50,000 of portfolio dividends taxed by state A, 
equals $500,000. X also has taxable income of $200,000 and $200,000 in 
states B and C, respectively. In the aggregate, therefore, states A, B, 
and C tax $900,000 of X's income, after excluding state taxable income 
attributable to portfolio dividends. Since X has only $800,000 of U.S. 
source taxable income for federal income tax purposes, it is presumed 
that state income taxes are imposed on $100,000 of foreign source 
income. The remaining deduction of $64,000 for state income taxes is 
therefore related and allocable to both foreign source and domestic 
source income and is subject to apportionment.
    (iii) Apportionment. For purposes of computing the foreign tax 
credit limitation, X's income is comprised of one statutory grouping, 
foreign source general limitation income, and one residual grouping, 
gross income from sources within the United States. The remaining state 
income tax deduction of $64,000 must be apportioned between these two 
groupings on the basis of relative amounts of foreign source general 
limitation taxable income and U.S. source taxable income subject to 
state taxation. In this case, the $64,000 of state income taxes is 
considered to be imposed on $800,000 of domestic source income and 
$100,000 of foreign source general limitation income and is apportioned 
as follows:

State income tax deduction apportioned to foreign source          $7,111
 general limitation income (statutory grouping): $64,000 x
 ($100,000/$900,000).......................................
State income tax deduction apportioned to income from             56,889
 sources within the United States (residual grouping):
 $64,000 x ($800,000/$900,000).............................
                                                            ------------
      Total apportioned state income tax deduction.........      $64,000
 


[[Page 178]]

    Of the total state income taxes of $69,000, the amount allocated and 
apportioned to foreign source general limitation income equals $12,111 
($5,000 + $7,111). The total amount of state income taxes allocated and 
apportioned to U.S. source income equals $56,889.
    Example 29. Income Taxes. (i) Facts. (A) P, a domestic corporation, 
is a manufacturer and distributor of electronic equipment with 
operations in states F, G, and H. P also has a branch in country Y which 
manufactures and distributes the same type of electronic equipment. In 
addition, P has three wholly owned subsidiaries, US1, US2, and FS, the 
latter a controlled foreign corporation (``CFC'') as defined in section 
957(a) of the Code. P also owns stock representing 10 to 50 percent of 
the vote and value of various other first-tier CFCs that derive 
exclusively foreign source general limitation income.
    (B) In 1988, P derives $1,000,000 of federal taxable income (without 
taking into account the deduction for state income taxes), which 
consists of $250,000 of foreign source general limitation income and 
$750,000 of U.S. source income. The foreign source general limitation 
income consists of a $25,000 subpart F inclusion with respect to FS, 
$150,000 of dividends from the other first-tier CFCs deriving 
exclusively foreign source general limitation income, in which P owns 
stock representing 10 to 50 percent of the vote and value, and $75,000 
of manufacturing and sales income derived by P's U.S. operations and 
country Y branch. The $750,000 of U.S. source income consists of 
manufacturing and sales income derived by P's U.S. operations.
    (C) For federal income tax purposes, US1 derives $75,000 of taxable 
income, before deduction for state income taxes, which consists entirely 
of U.S. source income. US2, a so-called ``80/20'' corporation described 
in section 861(c)(1), derives $250,000 of federal taxable income before 
deduction for state or foreign income taxes, all of which is derived 
from foreign operations and consists entirely of foreign source general 
limitation income. FS is not engaged in a U.S. trade or business and 
derives $550,000 of foreign source general limitation income before 
deduction for foreign income taxes.
    (D) State F imposes a corporate income tax of 10 percent of P's 
state F taxable income, which is determined by formulary apportionment 
of the total taxable income attributable to P's worldwide unitary 
business. State F determines P's taxable income for state F tax purposes 
by first making adjustments to the taxable income, as determined for 
federal income tax purposes, of the members of the unitary business 
group to determine the total taxable income of the group. State F then 
computes P's state taxable income by attributing a portion of that 
unitary business taxable income to activities of P that are conducted in 
state F. State F does this by multiplying the unitary business taxable 
income (federal taxable income with state adjustments) by a fraction 
(the ``state apportionment fraction'') that compares the relative 
amounts of the unitary business group's payroll, property, and sales 
(the ``factors'') in state F with the payroll, property, and sales of 
the unitary business group. P is the only member of its unitary business 
group that has state F factors and that is thereby subject to state F 
income tax and filing requirements. State F defines the unitary business 
group to include any corporation more than 50 percent of which is 
directly or indirectly owned by a state F taxpayer and is engaged in the 
same unitary business. P's unitary business group, therefore, includes 
P, US1, US2, and FS, but does not include the 10 to 50 percent owned 
CFCs. The income of the unitary business group excludes intercompany 
dividends between members of the unitary business group and subpart F 
inclusions with respect to a member of the unitary business group. 
Dividends paid from nonmembers of the unitary group (the 10 to 50 
percent owned CFCs) for state F tax purposes are referred to as 
``portfolio dividends'' and are included in taxable income of the 
unitary business. None of the factors (in state F or worldwide) of the 
corporations paying portfolio dividends are included in the state F 
apportionment fraction for purposes of apportioning total taxable income 
of the unitary business to P's state F activities.
    (E) After state adjustments to the taxable income of the unitary 
business group, as determined under federal tax principles, the total 
taxable income of P's unitary business group equals $2,000,000, 
consisting of $1,050,000 of P's income ($100,000 of foreign source 
manufacturing and sales income, $150,000 of foreign source portfolio 
dividends, and $800,000 of U.S. source manufacturing and sales income, 
but excluding the $25,000 subpart F inclusion attributable to FS since 
FS is a member of the unitary business group), $100,000 of US1's income 
(from sales made in the United States), $275,000 of US2's income (from 
an active business outside the United States), and $575,000 of FS's 
income. The differences between taxable income under federal tax 
principles and state F apportionable taxable income for P, US1, US2, and 
FS represent adjustments to taxable income under federal tax principles 
that are made pursuant to the tax laws of state F.
    (F) The taxable income for each member of the unitary business group 
under federal tax principles and state law principles is summarized in 
the following table. (The items of income listed in the ``Federal'' 
column of the table refer to taxable income before deduction for state 
income tax.)

[[Page 179]]



------------------------------------------------------------------------
                                                    Federal     State F
------------------------------------------------------------------------
                        P
 
U.S. source income..............................    $750,000    $800,000
Foreign source general limitation income:
    Portfolio dividends.........................     150,000     150,000
    Subpart F income............................      25,000           0
    Manufacturing and sales income..............      75,000     100,000
                                                 -----------------------
      Total taxable income......................   1,000,000   1,050,000
 
                       US1
 
U.S. source income..............................      75,000     100,000
 
                       US2
 
Foreign source general limitation income........     250,000     275,000
 
                       FS
 
Foreign source general limitation income........     550,000     575,000
                                                 -----------------------
Taxable income of the unitary business group....  ..........   2,000,000
                                                 =======================
------------------------------------------------------------------------

    (G) State F deems P to have state F taxable income of $500,000, 
which is determined by multiplying the total taxable income of the 
unitary business group ($2,000,000) by the group's state F apportionment 
fraction, which is assumed to be 25 percent in these facts. P's state F 
taxable income is then multiplied by the state F tax rate of 10 percent, 
resulting in a state F tax liability of $50,000. State G and state H, 
unlike state F, do not tax portfolio dividends. Although state G and 
state H apportion taxable income, respectively, on the basis of an 
apportionment fraction that compares state factors to total factors, 
state G and state H, unlike state F, do not apply a unitary business 
theory and consider only P's taxable income and factors in computing P's 
taxable income. P's taxable income under state G law equals $300,000, 
which is subject to a 5 percent tax rate resulting in a state G tax 
liability of $15,000. P's taxable income under state H law is $300,000, 
which is subject to a tax rate of 2 percent resulting in a state H tax 
liability of $6,000. P has a total federal income tax deduction for 
state income taxes of $71,000 ($50,000 + 15,000 + 6,000).
    (ii) Allocation. (A) P's deduction of $71,000 for state income taxes 
is definitely related and allocable to the gross income with respect to 
which the taxes are imposed. Adjustments may be necessary, however, 
before aggregate state taxable incomes can be compared with U.S. source 
taxable income on the federal income tax return in the manner described 
in Examples 25 and 26. In allocating P's deduction for state income 
taxes, it is necessary first to determine the portion, if any, of the 
deduction that is definitely related and allocable to a particular class 
of gross income. A definite relationship exists between a deduction for 
state income tax and dividend income when a state includes portfolio 
dividends in state taxable income apportionable to the taxpayer's 
activities in the state, but determines state taxable income by applying 
an apportionment formula that excludes the factors of the corporations 
paying portfolio dividends.
    (B) In this case, $150,000 of foreign source portfolio dividends are 
subject to a state F apportionment fraction of 25 percent, which results 
in a total of $37,500 of state F taxable income attributable to such 
dividends. As illustrated in Example 28, $3,750 ($150,000 x 25 percent 
state F apportionment percentage x 10 percent state F tax rate) of P's 
state F income tax is definitely related and allocable to a class of 
gross income consisting entirely of the foreign source portfolio 
dividends. Since under the look-through rules of section 904(d)(3) the 
foreign source portfolio dividends paid by first-tier CFCs are included 
within the general limitation described in section 904(d)(1)(I), the 
$3,750 of state F tax on foreign source portfolio dividends is allocated 
entirely to foreign source general limitation income and, therefore, is 
not apportioned.
    (C) After reducing state F taxable income of the unitary business 
group by the taxable income attributable to portfolio dividends, P's 
remaining state F taxable income equals $462,500 ($500,000 - $37,500), 
the portion of the taxable income of the unitary business that state F 
attributes to P's activities in state F. Accordingly, in order to 
allocate and apportion the remaining $46,250 of state F tax ($50,000 of 
state F tax minus the $3,750 of state F tax allocated to foreign source 
portfolio dividends), it is necessary first to determine if state F is 
taxing only P's non-unitary taxable income (as defined below) or is 
imposing its tax partly on other unitary business income that is 
attributed under state F law to P's activities in state F. P's state F 
non-unitary taxable income is computed by applying the state F 
apportionment formula, solely on the basis of P's income (excluding 
portfolio dividends) and state F apportionment factors. If the state F 
taxable income (after reduction by the portfolio dividends attributed to 
state F) attributed to P under state F law exceeds P's non-unitary 
taxable income, a portion of the state F tax must be allocated and 
apportioned on the basis of the other unitary business income that is 
attributed to and taxable to P under state F law. If P's non-unitary 
taxable income equals or exceeds the $462,500 of remaining state F 
taxable income, it is presumed that state F is only taxing P's non-
unitary taxable income, so that the entire amount of the remaining state 
F tax should be allocated and apportioned in the manner described in 
Example 25.
    (D) If P's non-unitary taxable income is less than the $462,500 of 
remaining state F taxable income (after reduction for the

[[Page 180]]

$37,500 of state F taxable income attributable to portfolio dividends), 
it is presumed that state F is attributing to P, and taxing P upon, 
other unitary business income. In such a case, it is necessary to 
determine if state F is attributing to P, and imposing its income tax 
on, a part of the foreign source income that would be generally presumed 
under separate accounting to be the income of foreign affiliates and 80/
20 companies included in the unitary group, or whether state F is 
limiting the income it attributes to P, and its taxation of P, to the 
U.S. source income that would be generally presumed under separate 
accounting to be the income of domestic members of the unitary group.
    (E) Assume for purposes of this example that the non-unitary taxable 
income attributable to P equals $396,000, computed by multiplying P's 
state F taxable income of $900,000 (P's state F taxable income (before 
state F apportionment) of $1,050,000 less the $150,000 of foreign source 
portfolio dividends) by P's non-unitary state F apportionment fraction, 
which is assumed to be 44 percent. Because P's non-unitary taxable 
income of $396,000 is less than the $462,500 of remaining state F 
taxable income, state F is presumed to be attributing to P and taxing 
the income that would have been generally attributed under separate 
accounting to P's affiliates in the unitary group. To determine if state 
F tax is being imposed on members of the unitary group (other that P) 
that produce foreign source income, it is necessary to compute a 
hypothetical state F taxable income for all companies in the unitary 
group with significant U.S. operations. (For this purpose, the 
hypothetical group of companies with significant domestic operations is 
referred to as the ``water's edge group.'') State F is presumed to be 
attributing to P and taxing income that would have been generally 
attributable under separate accounting to foreign corporations and 80/20 
companies to the extent that the remaining state F taxable income 
($462,500) of P exceeds the hypothetical state F taxable income that 
would have been attributed under state F law to P if state F had defined 
the unitary group to be the water's edge group.
    (F) The members of the water's edge group would have been P and US1. 
The unitary business income of this water's edge group is $1,000,000, 
the sum of $900,000 (P's state F taxable income (before state F 
apportionment) of $1,050,000 less the $150,000 of foreign source 
portfolio dividends) and $100,000 (US1's state F taxable income). For 
purposes of this example, the state F apportionment fraction determined 
on a unitary basis for this water's edge group is assumed to equal 40 
percent, the average of P and US1's state F payroll, property, and sales 
factor ratios (the water's edge group's state F factors over its 
worldwide factors). Applying this apportionment fraction to the 
$1,000,000 of unitary business income of the water's edge group yields 
state F water's edge taxable income of $400,000. The excess of the 
remaining $462,500 of P's state F taxable income over the $400,000 of 
P's state F water's edge taxable income equals $62,500, and is 
attributable to the inclusion of US2 and FS in the unitary group. The 
state F tax attributable to the $62,500 of taxable income attributed to 
P under state F law, and that would have generally been attributed to 
US2 and FS under non-unitary accounting, equals $6,250 and is allocated 
entirely to a class of gross income consisting of foreign source general 
limitation income, because the income of FS and US2 consists entirely of 
such income. After the $6,250 of state F tax attributable to US2 and FS 
is subtracted from the remaining $46,250 of net state F tax, P has 
$40,000 of state F tax remaining to be allocated and apportioned.
    (G) To the extent that the remainder of P's state F taxable income 
($400,000) exceeds P's non-unitary state F taxable income ($396,000), it 
is presumed that state F is attributing to and imposing on P a tax on 
U.S. source income that would have been attributed under separate 
accounting to members of the water's edge group other than P. In these 
facts, the $4,000 difference in P's state F taxable income results from 
the inclusion of US1 in the unitary group. The $400 of P's state F tax 
attributable to this $4,000 is allocated entirely to P's U.S. source 
income. P's remaining $39,600 of state F tax ($40,000 of P's state F tax 
resulting from the attribution of P of income that would have been 
attributed under non-unitary accounting to other members of the water's 
edge group, minus $400 of state F tax attributable to US1 and allocated 
to P's U.S. source income) is the state F tax attributable to P's non-
unitary state F taxable income that is to be allocated and apportioned 
together with P's state G tax of $15,000 and state H tax of $6,000 as 
illustrated in Example 25.
    (H) In allocating the $60,600 of state tax liabilities ($39,600 
state F tax attributable to P's non-unitary state F income + $15,000 
state G tax + $6,000 state H tax) under Example 25, P's state taxable 
income in state G and state H ($300,000 + $300,000) must be added to P's 
non-unitary state F taxable income ($396,000). The resulting $996,000 of 
combined state taxable incomes is compared with $750,000 of U.S. source 
income on P's federal income tax return. Because P's combined state 
taxable incomes exceeds P's federal U.S. source taxable income, it is 
presumed that the remaining $60,600 of P's total state income taxes is 
imposed in part on foreign source income. Accordingly, P's remaining 
deduction of $60,600 ($39,600 + $15,000 + $6,000) for state income taxes 
is related and allocable to both P's foreign source and domestic source 
income and is subject to apportionment.

[[Page 181]]

    (iii) Apportionment. The $60,600 of state taxes (the remaining 
$39,600 of state F tax + $15,000 of state G tax + $6,000 of state H tax) 
must be apportioned between foreign source general limitation income and 
U.S. source income for federal income tax purposes. This apportionment 
is based upon the relative amounts of foreign source general limitation 
taxable income and U.S. source taxable income comprising the $996,000 of 
income subject to tax by the states, after reducing the total amount of 
income subject to tax by the portfolio dividends and the income 
attributed to P under state F law that would have been attributed under 
arm's length principles to other members of P's state F unitary business 
group. The deduction for the $60,600 of state income taxes is 
apportioned as follows:

State income tax deduction apportioned to foreign source         $14,967
 general limitation income (statutory grouping): $60,600 x
 ($246,000/$996,000)..........................................
State income tax deduction apportioned to income from sources     45,633
 within the United States (residual grouping): $60,600 x
 ($750,000/$996,000)..........................................
                                                               ---------
    Total apportioned state income tax deduction..............    60,600
 
 


Of the total state income taxes of $71,000, the amount allocated and 
apportioned to foreign source general limitation income is $24,967--the 
sum of $14,967 of state F, state G, and state H taxes apportioned to 
foreign source general limitation income, $3,750 of state F tax 
allocated to foreign source apportionable dividend income, and the 
$6,250 of state F tax allocated to foreign source general limitation 
income as the result of state F's worldwide unitary business theory of 
taxation. The total amount of state income taxes allocated and 
apportioned to U.S. source income equals $46,033--the sum of the $400 of 
state F tax attributable to the inclusion of US1 in the state F unitary 
business group and $45,633 of combined state F, G, and H tax apportioned 
under the method provided in Example 25.
    Example 30. Income taxes. (i)(A) Facts. As in Example 17 of this 
paragraph (g), X is a domestic corporation that wholly owns M, N, and O, 
also domestic corporations. X, M, N, and O file a consolidated income 
tax return. All the income of X and O is from sources within the United 
States, all of M's income is general category income from sources within 
South America, and all of N's income is general category income from 
sources within Africa. X receives no dividends from M, N, or O. During 
the taxable year, the consolidated group of corporations earned 
consolidated gross income of $550,000 and incurred total deductions of 
$370,000. X has gross income of $100,000 and deductions of $50,000, 
without regard to its deduction for state income tax. Of the $50,000 of 
deductions incurred by X, $15,000 relates to X's ownership of M; $10,000 
relates to X's ownership of N; $5,000 relates to X's ownership of O; and 
the entire $30,000 constitutes stewardship expenses. The remainder of 
X's $20,000 of deductions (which is assumed not to include state income 
tax) relates to production of U.S. source income from its plant in the 
United States. M has gross income of $250,000 and deductions of 
$100,000, which yield foreign-source general category taxable income of 
$150,000. N has gross income of $150,000 and deductions of $200,000, 
which yield a foreign-source general category loss of $50,000. O has 
gross income of $50,000 and deductions of $20,000, which yield U.S. 
source taxable income of $30,000.
    (B) Unlike Example 17 of this paragraph (g), however, X also has a 
deduction of $1,800 for state A income taxes. X's state A taxable income 
is computed by first making adjustments to the Federal taxable income of 
X to derive apportionable taxable income for state A tax purposes. An 
analysis of state A law indicates that state A law also includes in its 
definition of the taxable business income of X which is apportionable to 
X's state A activities, the taxable income of M, N, and O, which is 
related to X's business. As in Example 25 of this paragraph (g), the 
amount of apportionable taxable income attributable to business 
activities conducted in state A is determined by multiplying 
apportionable taxable income by a fraction (the ``state apportionment 
fraction'') that compares the relative amounts of payroll, property, and 
sales within state A with worldwide payroll, property, and sales. 
Assuming that X's apportionable taxable income equals $180,000, $100,000 
of which is from sources without the United States, and $80,000 is from 
sources within the United States, and that the state apportionment 
fraction is equal to 10 percent, X has state A taxable income of 
$18,000. The state A income tax of $1,800 is then derived by applying 
the state A income tax rate of 10 percent to the $18,000 of state A 
taxable income.
    (ii) Allocation and apportionment. Assume that under Example 29 of 
this paragraph (g), it is determined that X's deduction for state A 
income tax is definitely related to a class of gross income consisting 
of income from sources both within and without the United States, and 
that the state A tax is apportioned $1,000 to sources without the United 
States, and $800 to sources within the United States. Under Example 17 
of this paragraph (g), without regard to the deduction for X's state A 
income tax, X has a separate loss of ($25,000) from sources without the 
United States. After taking into account the deduction for state A 
income tax, X's separate loss from sources without the United States is 
increased by the $1,000 state A tax apportioned to sources without the 
United States, and equals a loss of ($26,000), for purposes of computing 
the numerator of the consolidated

[[Page 182]]

general category foreign tax credit limitation.
    Example 31. Income Taxes. (i) Facts. Assume that the facts are the 
same as in Example 29, except that state G requires P to adjust its 
federal taxable income by depreciating an asset at a different rate than 
is allowed P under the Internal Revenue Code for the same asset. Before 
using the methodology of Example 25 to determine whether a portion of 
its deduction for state income taxes is allocable to a class of gross 
income that includes foreign source income, P recomputes its taxable 
income under state G law by using the rate of depreciation that it is 
entitled to use under the Code, and uses this recomputed amount in 
applying the methodology of Example 25.
    (ii) Allocation. P's modification of its state G taxable income is 
permissible. Under the methdology of Example 25, this modification of 
state G taxable income will produce a reasonable determination of the 
portion (if any) of P's state income taxes that is allocable to a class 
of gross income that includes foreign sources income.
    Example 32. Income Taxes. (i) Facts. Assume the facts are the same 
as Example 29, except that P's state F taxable income differs from the 
amount of its U.S. source income under federal income tax principles 
solely because state F determines P's state taxable income under a 
worldwide unitary business theory instead of the arm's length principles 
applied in the Code. Before using the methodology of Example 25 to 
determine whether a portion of its deduction for state income taxes is 
allocable to a class of gross income that includes foreign source 
income, P recomputes state F taxable income under the arm's length 
principles applied in the Code. P substitutes that recomputed amount for 
the amount of taxable income actually determined under state F law in 
applying the methodology of Example 25.
    (ii) Allocation. P's modification of state F taxable income does not 
accurately reflect the factual relationship between the deduction for 
state F income tax and the income on which the tax is imposed, because 
there is no factual relationship between the state F income tax and the 
state F taxable income as recomputed under Code principles. State F does 
not impose its income tax upon P's income as it might have been defined 
under the Internal Revenue Code. Consequently, P's modification of state 
F taxable income is impermissible because it will not produce a 
reasonable determination of the portion (if any) of P's state income 
taxes that is allocable to a class of gross income that includes foreign 
source income.
    Example 33. Income Taxes. (i) Facts. Assume the same facts as in 
Example 29, except that state G does not impose an income tax on 
corporations, and P's non-unitary state F taxable income equals 
$462,500. Thus only $56,000 of state income taxes ($50,000 of state F 
income tax and $6,000 of state H income tax) are deductible and required 
to be allocated and (if necessary) apportioned. As in Example 29, P has 
$800,000 of aggregate state taxable income ($500,000 of state F taxable 
income and $300,000 of state H taxable income).
    (ii) Method One. Assume that P has elected to allocate and apportion 
its deduction for state income tax under the safe harbor method provided 
in Sec.  1.861-8 (e)(6)(ii)(D)(2) (``Method One'').
    (A) Step One--Specific allocation to foreign source portfolio 
dividends. P applies the methodology of paragraph (ii) of Example 28 to 
determine the portion of the deduction that must be allocated to a class 
of gross income consisting solely of foreign source portfolio dividends. 
As illustrated in paragraphs (ii) (A) and (B) of Example 29, $3,750 of 
the deduction for state F income tax is attributable to the $37,500 of 
foreign source portfolio dividends attributed under state F law to P's 
activities in state F. Thus $3,750 of P's deduction for state income tax 
must be specifically allocated to a class of gross income consisting 
solely of $37,500 of foreign source portfolio dividends. No 
apportionment of the $3,750 is necessary. P's adjusted state taxable 
income is $762,500 (aggregate state taxable income of $800,000 reduced 
by $37,500 of foreign source portfolio dividends). Because the remaining 
amount of state F taxable income ($462,500) equals P's non-unitary state 
F taxable income, no further specific allocation of state tax is 
required.
    (B) Step Two--Adjustment of U.S. source federal taxable income. P 
applies the methodology illustrated in paragraph (ii) of Example 27 
(including the rules of UDITPA described therein) to determine the 
amount of its federal taxable income attributable to its activities in 
state G. Assume that P determines under this methodology that $300,000 
of its federal taxable income is attributable to activities in state G. 
P's adjusted U.S. source federal taxable income equals $450,000 
($750,000 minus the $300,000 attributed to P's activities in state G).
    (C) Step Three--Allocation. The portion of P's deduction for state 
income tax remaining to be allocated equals $52,250 ($56,000 minus the 
$3,750 specifically allocated to foreign source portfolio dividends). P 
allocates this portion by applying the methodology illustrated in 
paragraph (ii) of Example 25, as modified by paragraph 
(e)(6)(ii)(D)(2)(iii) of this section. Thus, P compares its adjusted 
state taxable inocme (as determined under Step One in paragraph (A) 
above) with an amount equal to 110% of its adjusted U.S. source federal 
taxable income (as determined under Step Two in paragraph (B) above). 
Because P's adjusted state taxable income ($762,500) exceeds 110% of P's 
adjusted U.S. source federal taxable income ($495,000, or

[[Page 183]]

110% of $450,000), the remaining portion of P's deduction for state 
income tax ($52,500) must be allocated to a class of gross income that 
includes both U.S. and foreign source income.
    (D) Step Four--Apportionment. P must apportion to U.S. source income 
the portion of the deduction that is attributable to state income tax 
imposed upon state taxable income in an amount equal to 110% of P's 
adjusted U.S. source federal taxable income. The remainder of the 
deduction must be apportioned to foreign source general limitation 
income.

Amount of deduction to be apportioned.....................    $52,250.00
Less portion of deduction to be apportioned to income from    $33,919.67
 sources within the United States (residual grouping):
 ($52,250 x ($495,000/$762,500)...........................
                                                           -------------
Equals Portion of deduction to be apportioned to foreign      $18,330.33
 source general limitation income (statutory grouping):...
 

    (iii) Method Two. Assume that P has elected to allocate and 
apportion its deduction for state income tax under the safe harbor 
method provided in Sec.  1.861-8(e)(6)(ii)(D)(3) (``Method Two'').
    (A) Step One--Specific allocation. Step One of Method Two is the 
same as Step One of Method One. Therefore, as described in paragraph (A) 
of paragraph (ii) above, $3,750 of P's deduction for state income tax 
must be specifically allocated to a class of gross income consisting 
solely of $37,500 of foreign source portfolio dividends. No 
apportionment of the $3,750 is necessary. P's adjusted state taxable 
income is $762,500 (aggregate state taxable income of $800,000 reduced 
by $37,500 of foreign source portfolio dividends).
    (B) Step Two--Adjustment of U.S. source federal taxable income. Step 
Two of Method Two is the same as Step Two of Method One. Therefore, as 
described in paragraph (B) of paragraph (ii) above, assume that P 
determines that $300,000 of its federal taxable income is attributable 
to activities in state G. P's adjusted U.S. source federal taxable 
income equals $450,000 ($750,000 minus the $300,000 attributed to P's 
activities in state G).
    (C) Step Three--Allocation. The portion of P's deduction for state 
income tax remaining to be allocated equals $52,250 ($56,000 minus the 
$3,750 of state F income tax specifically allocated to foreign source 
portfolio dividends). P allocates this portion by applying the 
methodology illustrated in paragraph (ii) of Example 25, as modified by 
paragraph (e)(6)(ii)(D)(3)(iii) of this section. Thus, P compares its 
adjusted state taxable income (as determined under Step One in paragraph 
(A) above) with its adjusted U.S. source federal taxable income (as 
determined under Step Two in paragraph (B) above). Because P's adjusted 
state taxable income ($762,500) exceeds P's adjusted U.S. source federal 
taxable income ($450,000), the remaining portion of P's deduction for 
state income tax ($52,500) must be allocated to a class of gross income 
that includes both U.S. and foreign source income.
    (D) Step Four--Apportionment. P must apportion to U.S. source income 
the portion of the deduction that is attributable to state income tax 
imposed upon state taxable income in an amount equal to P's adjusted 
U.S. source federal taxable income.

Amount of deduction to be apportioned.....................    $52,250.00
Less portion of deduction initially apportioned to income      30,836.07
 from sources within the United States (residual
 grouping): $52,250 x ($450,000/$762,500).................
                                                           -------------
Remainder requiring further apportionment: $52,250 x           21,413.93
 ($312,500/$762,500)......................................
 


The remainder of $21,413.93 must be further apportioned between foreign 
source general limitation income and U.S. source federal taxable income 
in the same proportions that P's adjusted U.S. source federal taxable 
income and foreign source general limitation income bear to P's total 
federal taxable income (taking into account the adjustment of U.S. 
source federal taxable income and reduced by the amount of foreign 
source portfolio dividends to which the tax has been specifically 
allocated).

Portion of remainder apportioned to foreign source general     $6,868.62
 limitation income (statutory grouping): $21,413.93 x
 ($212,500/$662,500)......................................
Remaining state income tax deduction to be apportioned to     $14,545.31
 income from sources within the United States (residual
 grouping): $21,413.93 x ($450,000/$662,500)..............
 

    Of P's total deduction of $56,000 for state income tax, the portion 
allocated and apportioned to foreign source general limitation income 
equals $10,618.62--the sum of $6,868.62 apportioned under Step Four and 
the $3,750.00 specifically allocated to foreign source portfolio 
dividend income under Step One. The portion of the deduction allocated 
and apportioned to U.S. source income equals $45,381.38--the sum of the 
$30,836.07 and the $14,545.31 apportioned under Step Four.

[T.D. 7456, 42 FR 1195, Jan. 6, 1977]

    Editorial Note: For Federal Register citations affecting Sec.  
1.861-8, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.861-8T  Computation of taxable income from sources 
within the United States and from other sources and activities (temporary).

    (a) In general. (1) [Reserved]
    (2) Allocation and apportionment of deductions in general. If an 
affiliated

[[Page 184]]

group of corporations joins in filing a consolidated return under 
section 1501, the provisions of this section are to be applied 
separately to each member in that affiliated group for purposes of 
determining such member's taxable income, except to the extent that 
expenses, losses, and other deductions are allocated and apportioned as 
if all domestic members of an affiliated group were a single corporation 
under section 864(e) and the regulations thereunder. See Sec.  1.861-9T 
through Sec.  1.861-11T for rules regarding the affiliated group 
allocation and apportionment of interest expense, and Sec.  1.861-14T 
for rules regarding the affiliated group allocation and apportionment of 
expenses other than interest.
    (a)(3) through (b) [Reserved] For further guidance, see Sec.  1.861-
8(a)(3) through (b).
    (c) Apportionment of deductions--(1) Deductions definitely related 
to a class of gross income. Where a deduction has been allocated in 
accordance with paragraph (b) of this section to a class of gross income 
which is included in one statutory grouping and the residual grouping, 
the deduction must be apportioned between the statutory grouping and the 
residual grouping. Where a deduction has been allocated to a class of 
gross income which is included in more than one statutory grouping, such 
deduction must be apportioned among the statutory groupings and, where 
necessary, the residual grouping. Thus, in determining the separate 
limitations on the foreign tax credit imposed by section 904(d)(1) or by 
section 907, the income within a separate limitation category 
constitutes a statutory grouping of income and all other income not 
within that separate limitation category (whether domestic or within a 
different separate limitation category) constitutes the residual 
grouping. In this regard, the same method of apportionment must be used 
in apportioning a deduction to each separate limitation category. Also, 
see paragraph (f)(1)(iii) of this section with respect to the 
apportionment of deductions among the statutory groupings designated in 
section 904(d)(1). If the class of gross income to which a deduction has 
been allocated consists entirely of a single statutory grouping or the 
residual grouping, there is no need to apportion that deduction. If a 
deduction is not definitely related to any gross income, it must be 
apportioned ratably as provided in paragraph (c)(3) of this section. A 
deduction is apportioned by attributing the deduction to gross income 
(within the class to which the deduction has been allocated) which is in 
one or more statutory groupings and to gross income (within the class) 
which is in the residual grouping. Such attribution must be accomplished 
in a manner which reflects to a reasonably close extent the factual 
relationship between the deduction and the grouping of gross income. In 
apportioning deductions, it may be that for the taxable year there is no 
gross income in the statutory grouping or that deductions will exceed 
the amount of gross income in the statutory grouping. See paragraph 
(d)(1) of this section with respect to cases in which deductions exceed 
gross income. In determining the method of apportionment for a specific 
deduction, examples of bases and factors which should be considered 
include, but are not limited to--
    (i) Comparison of units sold,
    (ii) Comparison of the amount of gross sales or receipts,
    (iii) Comparison of costs of goods sold,
    (iv) Comparison of profit contribution,
    (v) Comparison of expenses incurred, assets used, salaries paid, 
space utilized, and time spent which are attributable to the activities 
or properties giving rise to the class of gross income, and
    (iv) Comparison of the amount of gross income.


Paragraph (e) (2) through (8) of this section provides the applicable 
rules for allocation and apportionment of deductions for interest, 
research and development expenses, and certain other deductions. The 
effects on tax liability of the apportionment of deductions and the 
burden of maintaining records not otherwise maintained and making 
computations not otherwise made shall

[[Page 185]]

be taken into consideration in determining whether a method of 
apportionment and its application are sufficiently precise. A method of 
apportionment described in this paragraph (c)(1) may not be used when it 
does not reflect, to a reasonably close extent, the factual relationship 
between the deduction and the groupings of income. Furthermore, certain 
methods of apportionment described in this paragraph (c)(1) may not be 
used in connection with any deduction for which another method is 
prescribed. The principles set forth above are applicable in 
apportioning both deductions definitely related to a class which 
constitutes less than all of the taxpayer's gross income and to 
deductions related to all of the taxpayer's gross income. If a deduction 
is not related to any class of gross income, it must be apportioned 
ratably as provided in paragraph (c)(3) of this section.
    (2) Apportionment based on assets. Certain taxpayers are required by 
paragraph (e)(2) of this section and Sec.  1.861-9T to apportion 
interest expense on the basis of assets. A taxpayer may apportion other 
deductions based on the comparative value of assets that generate income 
within each grouping, provided that such method reflects the factual 
relationship between the deduction and the groupings of income and is 
applied in accordance with the rules of Sec.  1.861-9T(g). In general, 
such apportionments must be made either on the basis of the tax book 
value of those assets or on their fair market value. However, once the 
taxpayer uses fair market value, the taxpayer and all related persons 
must continue to use such method unless expressly authorized by the 
Commissioner to change methods. For purposes of this paragraph (c)(2) 
the term related persons means two or more persons in a relationship 
described in section 267(b). In determining whether two or more 
corporations are members of 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 by the application of section 267(c). In determining 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). In the case of any corporate taxpayer that--
    (i) Uses tax book value, and
    (ii) Owns directly or indirectly (within the meaning of Sec.  1.861-
11T(b)(2)(ii)) 10 percent or more of the total combined voting power of 
all classes of stock entitled to vote in any other corporation (domestic 
or foreign) that is not a member of the affiliated group (as defined in 
section 864(e)(5)), such taxpayer shall adjust its basis in that stock 
in the manner described in Sec.  1.861-11T(b).
    (3) [Reserved]
    (d) Excess of deductions and excluded and eliminated items of 
income. (1) [Reserved]
    (2) Allocation and apportionment to exempt, excluded or eliminated 
income--(i) In general. In the case of taxable years beginning after 
December 31, 1986, except to the extent otherwise permitted by Sec.  
1.861-13T, the following rules shall apply to take account of income 
that is exempt or excluded, or assets generating such income, with 
respect to allocation and apportionment of deductions.
    (A) Allocation of deductions. In allocating deductions that are 
definitely related to one or more classes of gross income, exempt income 
(as defined in paragraph (d)(2)(ii) of this section) shall be taken into 
account.
    (B) Apportionment of deductions. In apportioning deductions that are 
definitely related either to a class of gross income consisting of 
multiple groupings of income (whether statutory or residual) or to all 
gross income, exempt income and exempt assets (as defined in paragraph 
(d)(2)(ii) of this section) shall not be taken into account.


For purposes of apportioning deductions which are not taken into account 
under Sec.  1.1502-13 in determining gain or loss from intercompany 
transactions, as defined in Sec.  1.1502-13, income from such 
transactions shall be taken into account in the year such income is 
ultimately included in gross income.
    (ii) Exempt income and exempt asset defined--(A) In general. For 
purposes of

[[Page 186]]

this section, the term exempt income means any income that is, in whole 
or in part, exempt, excluded, or eliminated for federal income tax 
purposes. The term exempt asset means any asset the income from which 
is, in whole or in part, exempt, excluded, or eliminated for federal tax 
purposes.
    (B) Certain stock and dividends. The term ``exempt income'' includes 
the portion of the dividends that are deductible under--
    (1) Section 243(a) (1) or (2) (relating to the dividends received 
deduction),
    (2) Section 245(a) (relating to the dividends received deduction for 
dividends from certain foreign corporations).


Thus, for purposes of apportioning deductions using a gross income 
method, gross income would not include a dividend to the extent that it 
gives rise to a dividend received deduction under either section 
243(a)(1), section 243(a)(2), or section 245(a). In the case of a life 
insurance company taxable under section 801, the amount of such stock 
that is treated as tax exempt shall not be reduced because a portion of 
the dividends received deduction is disallowed as attributable to the 
policyholder's share of such dividends. See Sec.  1.861-14T(h) for a 
special rule concerning the allocation of reserve expenses of a life 
insurance company. In addition, for purposes of apportioning deductions 
using an asset method, assets would not include that portion of stock 
equal to the portion of dividends paid thereon that would be deductible 
under either section 243(a)(1), section 243(a)(2), or section 245(a). In 
the case of stock which generates, has generated, or can reasonably be 
expected to generate qualifying dividends deductible under section 
243(a)(3), such stock shall not constitute a tax exempt asset. Such 
stock and the dividends thereon will, however, be eliminated from 
consideration in the apportionment of interest expense under the 
consolidation rule set forth in Sec.  1.861-10T(c), and in the 
apportionment of other expenses under the consolidation rules set forth 
in Sec.  1.861-14T.
    (iii) Income that is not considered tax exempt. The following items 
are not considered to be exempt, eliminated, or excluded income and, 
thus, may have expenses, losses, or other deductions allocated and 
apportioned to them:
    (A) In the case of a foreign taxpayer (including a foreign sales 
corporation (FSC)) computing its effectively connected income, gross 
income (whether domestic or foreign source) which is not effectively 
connected to the conduct of a United States trade or business;
    (B) In computing the combined taxable income of a DISC or FSC and 
its related supplier, the gross income of a DISC or a FSC;
    (C) For all purposes under subchapter N of the Code, including the 
computation of combined taxable income of a possessions corporation and 
its affiliates under section 936(h), the gross income of a possessions 
corporation for which a credit is allowed under section 936(a); and
    (D) Foreign earned income as defined in section 911 and the 
regulations thereunder (however, the rules of Sec.  1.911-6 do not 
require the allocation and apportionment of certain deductions, 
including home mortgage interest, to foreign earned income for purposes 
of determining the deductions disallowed under section 911(d)(6)).
    (iv) Prior years. For expense allocation and apportionment rules 
applicable to taxable years beginning before January 1, 1987, and for 
later years to the extent permitted by Sec.  1.861-13T, see Sec.  1.861-
8(d)(2) (Revised as of April 1, 1986).
    (e) Allocation and apportionment of certain deductions. (1) 
[Reserved]. For further guidance, see Sec.  1.861-8(e)(1).
    (2) Interest. The rules concerning the allocation and apportionment 
of interest expense and certain interest equivalents are set forth in 
Sec. Sec.  1.861-9T through Sec.  1.861-13T.
    (3) through (f)(1)(i) [Reserved] For further guidance, see Sec.  
1.861-8(e)(3) through (f)(1)(i).
    (ii) Separate limitations to the foreign tax credit. Section 
904(d)(1) requires that the foreign tax credit limitation be determined 
separately in the case of the types of income specified therein. 
Accordingly, the income within each separate limitation category 
constitutes a statutory grouping of income and all other income not 
within that separate limitation category (whether

[[Page 187]]

domestic or within a different separate limitation category) constitutes 
the residual groups.
    (f)(1)(iii) through (g) Examples 1 through 23 [Reserved] For further 
guidance, see Sec.  1.861-8(f)(1)(iii) through (g) Examples 1 through 
23.
    Example 24. Exempt, excluded, or eliminated income. (i) Income 
method--(A) Facts. X, a domestic corporation organized on January 1, 
1987, is engaged in a number of businesses worldwide. X owns a 25-
percent voting interest in each of five corporations engaged in the 
business A, two of which are domestic and three of which are foreign. X 
incurs stewardship expenses in connection with these five stock 
investments in the amount of $100. X apportions its stewardship expenses 
using a gross income method. Each of the five companies pays a dividend 
in the amount of $100. X is entitled to claim the 80-percent dividends 
received deduction on dividends paid by the two domestic companies. 
Because tax exempt income is considered in the allocation of deductions, 
X's $100 stewardship expense is allocated to the class of income 
consisting of dividends from business A companies. However, because tax 
exempt income is not considered in the apportionment of deductions 
within a class of gross income, the gross income of the two domestic 
companies must be reduced to reflect the availability of the dividends 
received deduction. Thus, for purposes of apportionment, the gross 
income paid by the three foreign companies is considered to be $100 
each, while the gross income paid by the domestic companies is 
considered to be $20 each. Accordingly, X has total gross income from 
business A companies, for purposes of apportionment, of $340. As a 
result, $29.41 of X's stewardship expense is apportioned to each of the 
foreign companies and $5.88 of X's stewardship expense is apportioned to 
each of the domestic companies.
    (ii) Asset method--(A) Facts. X, a domestic corporation organized on 
January 1, 1987, carries on a trade or business in the United States. X 
has deductible interest expense incurred in 1987 of $60,000. X owns all 
the stock of Y, a foreign corporation. X also owns 49 percent of the 
voting stock of Z, a domestic corporation. Neither Y nor Z has retained 
earnings and profits at the end of 1987. X apportions its interest 
expense on the basis of the fair market value of its assets. X has 
assets worth $1,500,000 that generate domestic source income, among 
which are tax exempt municipal bonds worth $100,000, and the stock of Z, 
which has a value of $500,000. The Y stock owned by X has a fair market 
value of $2,000,000 and generates solely foreign source general 
limitation income.
    (B) Allocation. No portion of X's interest expense is directly 
allocable solely to identified property within the meaning of Sec.  
1.861-1OT. Thus, X's deduction for interest is definitely related to all 
its gross income as a class.
    (C) Apportionment. For purposes of apportioning expenses, assets 
that generate exempt, eliminated, or excluded income are not taken into 
account. Because X's municipal bonds are tax exempt, they are not taken 
into account in apportioning interest expense. Since X is entitled to 
claim under section 243 to 80-percent dividends received deduction with 
respect to the dividend it received from Z, 80 percent of the value of 
that stock is not taken into account as an asset for purposes of 
apportionment under the asset method. X apportions its interest 
deduction between the statutory grouping of foreign source general 
limitation income and the residual grouping of domestic source income as 
follows:
    To foreign source general limitation income:

[[Page 188]]

[GRAPHIC] [TIFF OMITTED] TC07OC91.000

[GRAPHIC] [TIFF OMITTED] TC07OC91.001

    Examples 25-29. [Reserved]
    Example 30. [Reserved] For further guidance, see Sec.  1.861-8(g) 
Example 30.

    (h) Effective/applicability date. (1) Paragraphs (f)(1)(vi)(E), 
(f)(1)(vi)(F), and (f)(1)(vi)(G) of this section apply to taxable years 
ending after April 9, 2008.
    (2) Paragraph (e)(4), the last sentence of paragraph (f)(4)(i), and 
paragraph (g), Examples 17, 18, and 30 of this section apply to taxable 
years beginning after July 31, 2009.
    (3) Also, see paragraph (e)(12)(iv) of this section and 1.861-
14(e)(6) for rules concerning the allocation and apportionment of 
deductions for charitable contributions.

[T.D. 8228, 53 FR 35474, Sept. 14, 1988]

    Editorial Note: For Federal Register citations affecting Sec.  
1.861-8T, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.861-9  Allocation and apportionment of interest expense.

    (a) through (e)(1) [Reserved]. For further guidance, see Sec.  
1.861-9T(a) through (e)(1).
    (2) Corporate partners whose interest in the partnership is 10 
percent or more. A corporate partner shall apportion its interest 
expense, including the partner's distributive share of partnership 
interest expense, by reference to the partner's assets, including the 
partner's pro rata share of partnership assets, under the rules of 
paragraph (f) of this section if the corporate partner's direct and 
indirect interest in the partnership (as determined under the 
attribution rules of section 318) is 10 percent or more. A corporation 
using the tax book value method or alternative tax book value method of 
apportionment shall use the partnership's inside basis in its assets, 
including adjustments under sections 734(b) and 743(b), if any, and 
adjusted to the extent required under Sec.  1.861-10T(d)(2). A 
corporation using the fair market value method of apportionment shall 
use the fair market value of the partnership's assets, adjusted to the 
extent required under Sec.  1.861-10T(d)(2).
    (3) Individual partners who are general partners or who are limited 
partners with an interest in the partnership of 10 percent or more. An 
individual partner is subject to the rules of this paragraph (e)(3) if 
either the individual is a general partner or the individual's direct 
and indirect interest (as determined under the attribution rules of 
section

[[Page 189]]

318) in the partnership is 10 percent or more. The individual shall 
first classify his or her distributive share of partnership interest 
expense as interest incurred in the active conduct of a trade or 
business, as passive activity interest, or as investment interest under 
regulations issued under sections 163 and 469. The individual must then 
apportion his or her interest expense, including the partner's 
distributive share of partnership interest expense, under the rules of 
paragraph (d) of this section. Each such individual partner shall take 
into account his or her distributive share of the partnership gross 
income or pro rata share of the partnership assets in applying such 
rules. An individual using the tax book value or alternative tax book 
value method of apportionment shall use the partnership's inside basis 
in its assets, including adjustments under sections 734(b) and 743(b), 
if any, and adjusted to the extent required under Sec.  1.861-10T(d)(2). 
An individual using the fair market value method of apportionment shall 
use the fair market value of the partnership's assets, adjusted to the 
extent required under Sec.  1.861-10(d)(2).
    (e)(4) through (f)(3)(i) [Reserved]. For further guidance, see Sec.  
1.861-9T(e)(4) through (f)(3)(i).
    (f)(3)(ii) Manner of election. The election shall be made by filing 
the statement and providing the written notice described in Sec.  1.964-
1(c)(3)(ii) and (iii), respectively, at the time and in the manner 
described therein. For further guidance, see Sec.  1.861-9T(f)(3)(ii).
    (f)(3)(iii) and (iv) [Reserved] For further guidance, see Sec.  
1.861-9T(f)(3)(iii) and (iv).
    (4) Noncontrolled section 902 corporations--(i) In general. For 
purposes of computing earnings and profits of a noncontrolled section 
902 corporation (as defined in section 904(d)(2)(E)) for Federal tax 
purposes, the interest expense of a noncontrolled section 902 
corporation may be apportioned using either the asset method described 
in Sec.  1.861-9T(g) or the modified gross income method described in 
Sec.  1.861-9T(j). A noncontrolled section 902 corporation that is not a 
controlled foreign corporation may elect to use a different method of 
apportionment than that elected by one or more of its shareholders. A 
noncontrolled section 902 corporation must use the same method of 
apportionment with respect to all its domestic corporate shareholders.
    (ii) Manner of election. The election to use the asset method 
described in Sec.  1.861-9T(g) or the modified gross income method 
described in Sec.  1.861-9T(j) may be made either by the noncontrolled 
section 902 corporation or by the majority domestic corporate 
shareholders (as defined in Sec.  1.964-1(c)(5)(ii)) on behalf of the 
noncontrolled section 902 corporation. The election shall be made by 
filing the statement and providing the written notice described in Sec.  
1.964-1(c)(3)(ii) and (iii), respectively, at the time and in the manner 
described therein. For further guidance, see Sec.  1.861-9T(f)(4)(ii).
    (iii) Stock characterization. In general, the stock of a 
noncontrolled section 902 corporation shall be characterized in the 
hands of any domestic corporation that meets the ownership requirements 
of section 902(a) with respect to the noncontrolled section 902 
corporation, or in the hands of any member of the same qualified group 
as defined in section 902(b)(2), using the same method that the 
noncontrolled section 902 corporation uses to apportion its interest 
expense. Stock in a noncontrolled section 902 corporation shall be 
characterized as a passive category asset in the hands of any such 
shareholder that fails to meet the substantiation requirements of Sec.  
1.904-5(c)(4)(iii), or in the hands of any shareholder that is not 
eligible to compute an amount of foreign taxes deemed paid with respect 
to a dividend from the noncontrolled section 902 corporation for the 
taxable year. See Sec.  1.861-12(c)(4).
    (f)(5) through (h)(3) [Reserved]. For further guidance, see Sec.  
1.861-9T(f)(5) through (h)(3).
    (h)(4) Valuing related party debt and stock in related persons--(i) 
Related party debt. For purposes of this section, the value of a debt 
obligation of a related person held by the taxpayer or another person 
related to the taxpayer equals the amount of the liability of the 
obligor related person.
    (ii) Stock in related persons. The value of stock in a related 
person held by the taxpayer or by another person related

[[Page 190]]

to the taxpayer equals the sum of the following amounts reduced by the 
taxpayer's pro rata share of liabilities of such related person:
    (A) The portion of the value of intangible assets of the taxpayer 
and related persons that is apportioned to such related person under 
Sec.  1.861-9T(h)(2);
    (B) The taxpayer's pro rata share of tangible assets held by the 
related person (as determined under Sec.  1.861-9T(h)(1)(ii));
    (C) The taxpayer's pro rata share of debt obligations of any related 
person held by the related person (as valued under paragraph (h)(4)(i) 
of this section); and
    (D) The total value of stock in all related persons held by the 
related person as determined under this paragraph (h)(4).
    (iii) Example--(A) Facts. USP, a domestic corporation, wholly owns 
CFC1 and owns 80% of CFC2, both foreign corporations. The aggregate 
trading value of USP's stock traded on established securities markets at 
the end of Year 1 is $700 and the amount of USP's liabilities to 
unrelated persons at the end of Year 1 is $400. Neither CFC1 nor CFC2 
has liabilities to unrelated persons at the end of Year 1. USP owns 
plant and equipment valued at $500, CFC1 owns plant and equipmen t 
valued at $400, and CFC2 owns plant and equipment valued at $250. The 
value of these assets has been determined using generally accepted 
valuation techniques, as required by Sec.  1.861-9T(h)(1)(ii). There is 
an outstanding loan from CFC2 to CFC1 in an amount of $100. There is 
also an outstanding loan from USP to CFC1 in an amount of $200.
    (B) Valuation of group assets. Pursuant to Sec.  1.861-9T(h)(1)(i), 
the aggregate value of USP's assets is $1100 (the $700 trading value of 
USP's stock increased by $400 of USP's liabilities to unrelated 
persons).
    (C) Valuation of tangible assets. Pursuant to Sec.  1.861-
9T(h)(1)(ii), the value of USP's tangible assets and pro rata share of 
assets held by CFC1 and CFC2 is $1100 (the plant and equipment held 
directly by USP, valued at $500, plus USP's 100% pro rata share of the 
plant and equipment held by CFC1 valued at $400 and USP's 80% pro rata 
share of the plant and equipment held by CFC 2 valued at $200 (80% of 
$250)).
    (D) Computation of intangible asset value. Pursuant to Sec.  1.861-
9T(h)(1)(iii), the value of the intangible assets of USP, CFC1, and CFC2 
is $0 (total aggregate group asset value ($1100) determined in paragraph 
(B) less total tangible asset value ($1100) determined in paragraph 
(C)). Because the intangible asset value is zero, the provisions of 
Sec.  1.861-9T(h)(2) and (3) relating to the apportionment and 
characterization of intangible assets do not apply.
    (E) Valuing related party debt obligations. Pursuant to Sec.  1.861-
9(h)(4)(i), the value of the debt obligation of CFC1 held by CFC2 is 
equal to the amount of the liability, $100. The value of the debt 
obligation of CFC1 held by USP is equal to the amount of the liability, 
$200.
    (F) Valuing the stock of CFC1 and CFC2. Pursuant to Sec.  1.861-
9(h)(4)(ii), the value of the stock of CFC2 held by USP is $280 (USP's 
80% pro rata share of tangible assets of CFC2 included in paragraph (C) 
($200) plus USP's 80% pro rata share of the debt obligation of CFC1 held 
by CFC2 valued in paragraph (E) ($80). The value of the stock of CFC1 
held by USP is $100 (USP's 100% pro rata share of tangible assets of 
CFC1 included in paragraph (C) ($400) less USP's 100% pro rata share of 
the liabilities of CFC1 to USP and CFC2 ($300)).
    (h)(5) Characterizing stock in related persons--(i) General rule. 
Stock in a related person held by the taxpayer or by another related 
person shall be characterized on the basis of the fair market value of 
the taxpayer's pro rata share of assets held by the related person 
attributed to each statutory grouping and the residual grouping under 
the stock characterization rules of Sec.  1.861-12T(c)(3)(ii), except 
that the portion of the value of intangible assets of the taxpayer and 
related persons that is apportioned to the related person under Sec.  
1.861-9T(h)(2) shall be characterized on the basis of the net income 
before interest expense of the related person within each statutory 
grouping or residual grouping (excluding income that is passive under 
Sec.  1.904-4(b)).
    (ii) Special rule for section 936 corporations regarding alternative 
minimum tax.

[[Page 191]]

For purposes of characterizing stock in a related section 936 
corporation in determining foreign source alternative minimum taxable 
income within each separate category and the alternative minimum tax 
foreign tax credit pursuant to section 59(a), the rules of Sec.  1.861-
9T(g)(3) shall apply and Sec.  1.861-9(h)(5)(i) shall not apply. Thus, 
for taxable years beginning after December 31, 1989, and before January 
1, 1994, stock in a related section 936 corporation is characterized for 
alternative minimum tax purposes as a foreign source passive asset 
because the stock produces foreign source passive dividend income under 
sections 861(a)(2)(A), 862(a)(2), and 904(d)(2)(A) and the regulations 
under those sections. For taxable years beginning after December 31, 
1993, stock in a related section 936 corporation would be characterized 
for alternative minimum tax purposes as an asset subject to the separate 
limitation for section 936 corporation dividends because the stock 
produces foreign source dividend income that, for alternative minimum 
tax purposes, is subject to a separate foreign tax credit limitation 
under section 56(g)(4)(C)(iii)(IV). However, stock in a section 936 
corporation is characterized as a U.S. source asset to the extent 
required by section 904(g). For the definition of the term section 936 
corporation, see Sec.  1.861-11(d)(2)(ii).
    (6) [Reserved]. For further guidance, see Sec.  1.861-9T(h)(6).
    (i) Alternative tax book value method--(1) Alternative value for 
certain tangible property. A taxpayer may elect to determine the tax 
book value of its tangible property that is depreciated under section 
168 (section 168 property) using the rules provided in this paragraph 
(i)(1) (the alternative tax book value method). The alternative tax book 
value method applies solely for purposes of apportioning expenses 
(including the calculation of the alternative minimum tax foreign tax 
credit pursuant to section 59(a)) under the asset method described in 
paragraph (g) of this section.
    (i) The tax book value of section 168 property placed in service 
during or after the first taxable year to which the election to use the 
alternative tax book value method applies shall be determined as though 
such property were subject to the alternative depreciation system set 
forth in section 168(g) (or a successor provision) for the entire period 
that such property has been in service.
    (ii) In the case of section 168 property placed in service prior to 
the first taxable year to which the election to use the alternative tax 
book value method applies, the tax book value of such property shall be 
determined under the depreciation method, convention, and recovery 
period provided for under section 168(g) for the first taxable year to 
which the election applies.
    (iii) If a taxpayer revokes an election to use the alternative tax 
book value method (the prior election) and later makes another election 
to use the alternative tax book value method (the subsequent election) 
that is effective for a taxable year that begins within 3 years of the 
end of the last taxable year to which the prior election applied, the 
taxpayer shall determine the tax book value of its section 168 property 
as though the prior election has remained in effect.
    (iv) The tax book value of section 168 property shall be determined 
without regard to the election to expense certain depreciable assets 
under section 179.
    (v) Examples. The provisions of this paragraph (i)(1) are 
illustrated in the following examples:

    Example 1. In 2000, a taxpayer purchases and places in service 
section 168 property used solely in the United States. In 2005, the 
taxpayer elects to use the alternative tax book value method, effective 
for the current taxable year. For purposes of determining the tax book 
value of its section 168 property, the taxpayer's depreciation deduction 
is determined by applying the method, convention, and recovery period 
rules of the alternative depreciation system under section 168(g)(2) as 
in effect in 2005 to the taxpayer's original cost basis in such 
property. In 2006, the taxpayer acquires and places in service in the 
United States new section 168 property. The tax book value of this 
section 168 property is determined under the rules of section 168(g)(2) 
applicable to property placed in service in 2006.
    Example 2. Assume the same facts as in Example 1, except that the 
taxpayer revokes the alternative tax book value method election 
effective for taxable year 2010. Additionally, in 2011, the taxpayer 
acquires new section 168

[[Page 192]]

property and places it in service in the United States. If the taxpayer 
elects to use the alternative tax book value method effective for 
taxable year 2012, the taxpayer must determine the tax book value of its 
section 168 property as though the prior election still applied. Thus, 
the tax book value of property placed in service prior to 2005 would be 
determined by applying the method, convention, and recovery period rules 
of the alternative depreciation system under section 168(g)(2) 
applicable to property placed in service in 2005. The tax book value of 
section 168 property placed in service during any taxable year after 
2004 would be determined by applying the method, convention, and 
recovery period rules of the alternative depreciation system under 
section 168(g)(2) applicable to property placed in service in such 
taxable year.

    (2) Timing and scope of election. (i) Except as provided in this 
paragraph (i)(2), a taxpayer may elect to use the alternative tax book 
value method with respect to any taxable year beginning on or after 
March 26, 2004. However, pursuant to Sec.  1.861-8T(c)(2), a taxpayer 
that has elected the fair market value method must obtain the consent of 
the Commissioner prior to electing the alternative tax book value 
method. Any election made pursuant to this paragraph (i)(2) shall apply 
to all members of an affiliated group of corporations as defined in 
Sec. Sec.  1.861-11(d) and 1.861-11T(d). Any election made pursuant to 
this paragraph (i)(2) shall apply to all subsequent taxable years of the 
taxpayer unless revoked by the taxpayer. Revocation of such an election, 
other than in conjunction with an election to use the fair market value 
method, for a taxable year prior to the sixth taxable year for which the 
election applies requires the consent of the Commissioner.
    (ii) Example. The provisions of this paragraph (i)(2) are 
illustrated in the following example:

    Example. Corporation X, a calendar year taxpayer, elects on its 
original, timely filed tax return for the taxable year ending December 
31, 2007, to use the alternative tax book value method for its 2007 
year. The alternative tax book value method applies to Corporation X's 
2007 year and all subsequent taxable years. Corporation X may not, 
without the consent of the Commissioner, revoke its election and 
determine tax book value using a method other than the alternative tax 
book value method with respect to any taxable year beginning before 
January 1, 2012. However, Corporation X may automatically elect to 
change from the alternative tax book value method to the fair market 
value method for any open year.

    (3) Certain other adjustments. [Reserved]
    (j) [Reserved]. For further guidance, see Sec.  1.861-9T(j).
    (k) Effective/applicability date. Paragraph (h)(5) of this section 
applies to taxable years beginning after December 31, 1989. Paragraph 
(i) of this section applies to taxable years beginning on or after March 
26, 2004. Paragraphs (f)(3)(ii) and (4) of this section apply to taxable 
years of shareholders ending on or after April 20, 2009. See 26 CFR 
1.861-9T(f)(3)(ii)(last sentence) and (4) (revised as of April 1, 2009) 
for rules applicable to taxable years of shareholders ending after the 
first day of the first taxable year of the noncontrolled section 902 
corporation beginning after December 31, 2002, and ending before April 
20, 2009. Paragraphs (e)(2), (e)(3) and (h)(4) apply to taxable years 
beginning on or after July 16, 2014. See 26 CFR 1.861-9T(e)(2) and (3) 
(revised as of April 1, 2014) for rules applicable to taxable years 
beginning after January 17, 2012, and before July 16, 2014. See 26 CFR 
1.861-9T(e)(2) and (3) (revised as of April 1, 2011) for rules 
applicable to taxable years beginning on or before January 17, 2012. See 
26 CFR 1.861-9T(h)(4) (revised as of April 1, 2014) for rules applicable 
to taxable years ending on or after January 17, 2012, and beginning 
before July 16, 2014. See 26 CFR 1.861-9T(h)(4) (revised as of April 1, 
2011) for rules applicable to taxable years ending before January 17, 
2012.

[T.D. 8916, 66 FR 272, Jan. 3, 2001, as amended by T.D. 9120, 69 FR 
15675, Mar. 26, 2004; T.D. 9247, 71 FR 4814, Jan. 30, 2006; T.D. 9452, 
74 FR 27873, June 11, 2009; T.D. 9456, 74 FR 46346, Sept. 9, 2009; T.D. 
9676, 79 FR 41425, July 16, 2014; T.D. 9676, 79 FR 49683, Aug. 22, 2014]



Sec.  1.861-9T  Allocation and apportionment of interest expense (temporary).

    (a) In general. Any expense that is deductible under section 163 
(including original issue discount) constitutes interest expense for 
purposes of this section, as well as for purposes of Sec. Sec.  1.861-
10T, 1.861-11T, 1.861-12T, and 1.861-13T. The term interest refers to 
the gross

[[Page 193]]

amount of interest expense incurred by a taxpayer in a given tax year. 
The method of allocation and apportionment for interest set forth in 
this section is based on the approach that, in general, money is 
fungible and that interest expense is attributable to all activities and 
property regardless of any specific purpose for incurring an obligation 
on which interest is paid. Exceptions to the fungibility rule are set 
forth in Sec.  1.861-10T. The fungibility approach recognizes that all 
activities and property require funds and that management has a great 
deal of flexibility as to the source and use of funds. When borrowing 
will generally free other funds for other purposes, and it is reasonable 
under this approach to attribute part of the cost of borrowing to such 
other purposes. Consistent with the principles of fungibility, except as 
otherwise provided, the aggregate of deductions for interest in all 
cases shall be considered related to all income producing activities and 
assets of the taxpayer and, thus, allocable to all the gross income 
which the assets of the taxpayer generate, have generated, or could 
reasonably have been expected to generate. In the case of the interest 
expense of members of an affiliated group, interest expense shall be 
considered to be allocable to all gross income of the members of the 
group under Sec.  1.861-11T. That section requires the members of an 
affiliated group to allocate and apportion the interest expense of each 
member of the group as if all members of such group were a single 
corporation. For the method of determining the interest deduction 
allowed to foreign corporations under section 882(c), see Sec.  1.882-5.
    (b) Interest equivalents--(1) Certain expenses and losses--(i) 
General rule. Any expense or loss (to the extent deductible) incurred in 
a transaction or series of integrated or related transactions in which 
the taxpayer secures the use of funds for a period of time shall be 
subject to allocation and apportionment under the rules of this section 
if such expense or loss is substantially incurred in consideration of 
the time value of money. However, the allocation and apportionment of a 
loss under this paragraph (b) shall not affect the characterization of 
such loss as capital or ordinary for other purposes of the Code and the 
regulations thereunder.
    (ii) Examples. The rule of this paragraph (b)(1) may be illustrated 
by the following examples.

    Example 1. W, a domestic corporation, borrows from X two ounces of 
gold at a time when the spot price for gold is $500 per ounce. W agrees 
to return the two ounces of gold in six months. W sells the two ounces 
of gold to Y for $1000. W then enters into a contract with Z to purchase 
two ounces of gold six months in the future for $1,050. In exchange for 
the use of $1,000 in cash, W has sustained a loss of $50 on related 
transactions. This loss is subject to allocation and apportionment under 
the rules of this section in the same manner as interest expense.
    Example 2. X, a domestic corporation with a dollar functional 
currency, borrows 100 pounds on January 1, 1987 for a three-year term at 
an interest rate greater than the applicable federal rate for dollar 
loans. At this time, the interest rate on the pound was approximately 
equal to the interest rate on dollar borrowings and the forward price on 
the pound, vis-a-vis the dollar, was approximately equal to the spot 
price. On January 1, 1987, X converted 100 pounds into dollars and 
entered into a currency swap that substantially hedged X's foreign 
currency exposure on the pound borrowing, both with respect to interest 
and principal. The borrowing, coupled with the swap, represents a series 
of related transactions in which the taxpayer secures the use of funds 
in its functional currency. Any net foreign currency loss on this series 
of transactions constitutes a loss incurred substantially in 
consideration of the time value of money and shall be apportioned in the 
same manner as interest expense. Thus, if the pound depreciates against 
the dollar, such that when the first payment on the pound borrowing is 
due the taxpayer has a currency loss on the swap payment hedging its 
first interest payment, such loss shall, even if the transaction is not 
integrated under section 988(d), be allocated and apportioned in the 
same manner as interest expense under the authority of this paragraph 
(b)(1).
    Example 3. On January 1, 1987, X, a domestic corporation with a 
dollar functional currency, enters into a dollar interest rate swap 
contract with Y, a domestic counterparty. Under the terms of this 
agreement, X agrees to pay Y floating rate interest with respect to a 
notional principal amount of $100 for five years. In return, Y agrees to 
pay X fixed rate interest at 10 percent with respect to a notional 
principal amount of $100 for five years. On the same day, Y prepays the 
fixed leg of the swap by making a lump sum payment of $37 to X. This 
lump sum payment represents the present value of five $10 swap

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payments. Because X secures the use of $37 in this transaction, any net 
swap expense arising from the transaction represents an expense incurred 
substantially in consideration of the time value of money. Assuming this 
lump sum payment is not otherwise characterized as a loan from Y to X, 
and that X must amortize the $37 lump sum payment under the principles 
of Notice 89-21, any net swap expense incurred by X with respect to this 
transaction (i.e., the excess, if any, of X's annual swap payment to Y 
over the annual amortization of the $37 lump sum payment that is taken 
into income by X) represents an expense equivalent to interest expense. 
The result would be the same if X sold the fixed leg to a third party 
for $37. While this example presents the case of a lump sum payment, the 
rules of paragraph (b)(1) would also apply to any transaction in which 
the swap payments are not substantially contemporaneous if the pricing 
of the transaction is materially affected by the time value of money. 
Thus, expenses and losses will be subject to apportionment under the 
rules of this section to the extent that such expenses or losses were 
incurred in consideration of the time value of money.

    (2) Certain foreign currency borrowings--(i) Rule. If a taxpayer 
borrows in a nonfunctional currency at a rate of interest that is less 
than the applicable federal rate (or its equivalent in functional 
currency if the functional currency is not the dollar), any swap, 
forward, future, option, or similar financial arrangement (or any 
combination thereof) entered into by the taxpayer or by a related person 
(as defined in Sec.  1.861-8T(c)(2)) that exists during the term of the 
borrowing and that substantially diminishes currency risk with respect 
to the borrowing or interest expense thereon will be presumed to 
constitute a hedge of such borrowing, unless the taxpayer can 
demonstrate on the basis of facts and circumstances that the two 
transactions are in fact unrelated. Under this presumption, the currency 
loss incurred on the borrowing during taxable years beginning after 
December 31, 1988, in connection with hedged nonfunctional currency 
borrowings, reduced or increased by the gain or loss on the hedge, will 
be apportioned in the same manner as interest expense. This presumption 
can be rebutted by a showing that the financial arrangement was entered 
into in connection with hedging currency exposure arising in the 
ordinary course of a trade or business (other than with respect to the 
borrowing).
    (ii) Examples. The principles of this paragraph (b)(2) may be 
illustrated by the following examples.

    Example 1. Taxpayer has a dollar functional currency and does not 
have any qualified business units with a functional currency other than 
the dollar. On January 1, 1989, when the unit of foreign currency is 
worth $1, taxpayer borrows 100 units of foreign currency for a three-
year period bearing interest at the annual rate of 3 percent and 
immediately converts the proceeds of the borrowing into dollars for use 
in its business. In the ordinary course of its business, taxpayer has no 
foreign currency exposure in this currency. In March 1989, taxpayer 
enters into a three-year swap agreement that covers most, but not all, 
of the payment of interest and principal. Because the swap substantially 
diminishes currency risk with respect to the borrowing, it is presumed 
to hedge the loan. Since taxpayer cannot demonstrate that it was hedging 
currency exposure arising in the ordinary course of its business (other 
than currency exposure with respect to the borrowing), the net currency 
loss on the borrowing adjusted for any gain or loss on the swap must be 
apportioned in the same manner as interest expense.
    Example 2. Assume the same facts as in Example 1, except that the 
taxpayer borrows in two separate foreign currencies on terms described 
in Example 1 and enters into a swap agreement in a single currency that 
substantially diminishes the taxpayer's aggregate foreign currency risk. 
The net currency loss on the borrowings adjusted for any gain or loss on 
the swap must be apportioned in the same manner as interest expense.

    (3) Losses on sale of certain receivables--(1) General rule. Any 
loss on the sale of a trade receivable (as defined in Sec.  1.954-2(h)) 
shall be allocated and apportioned, solely for purposes of this section 
and Sec. Sec.  1.861-10T, 1.861-11T, 1.861-12T, and 1.861-13T, in the 
same manner as interest expense, unless at the time of sale of the 
receivable, it bears interest at a rate which is at least 120 percent of 
the short term applicable federal rate (as determined under section 
1274(d) of the Code), or its equivalent in foreign currency in the case 
of receivables denominated in foreign currency, determined at the time 
the receivable arises. This treatment shall not affect the 
characterization of such expense as interest for other purposes of the 
Internal Revenue Code.

[[Page 195]]

    (ii)(A) Exceptions. To the extent that a loss on the sale of a trade 
receivable exceeds the discount on the receivable that would be computed 
applying to the amount received on the sale of the receivable 120 
percent of the applicable federal rate (or its equivalent in foreign 
currency in the case of receivables denominated in foreign currency) for 
the period commencing with the date on which the receivable is sold and 
ending with the earlier of the date on which the receivable begins to 
bear interest at such rate or the anticipated payment date of the 
receivable, such excess shall not be allocated and apportioned in the 
same manner as interest expense but rather shall be allocated and 
apportioned to the gross income generated by the receivable. In cases of 
transfers of receivables to a domestic international sales corporation 
described Sec.  1.994-1(c)(6)(v), the rule of this paragraph (b)(3) 
shall not apply for purposes of computing combined taxable income.
    (B) Example. On October 1, X sells a widget to Y for $100 payable in 
30 days, after which the receivable will bear stated interest at 13 
percent. On October 4, X sells Y's obligation to Z for $98. Assume that 
the applicable federal rate for the month of October is 10 percent. 
Applying 120 percent of the applicable federal rate to the $98 received 
on the sale of the receivable, the obligation is discounted at a 12 
percent rate for a period of 27 days. At this discount rate, the 
obligation would have sold for $99.22. Thus, 88 cents of the $2 loss on 
the sale is apportioned in the same manner as interest expense, and 
$1.22 of the $2 loss on the sale is directly allocated to the income 
generated on the widget sale.
    (4) Rent in certain leasing transactions. [Reserved]
    (5) Treatment of bond premium--(i) Treatment by the issuer. If a 
bond or other debt obligation is issued at a premium, an amount of 
interest expense incurred by the issuer on that bond or other debt 
obligation equal to the amortized portion of that premium that is 
included in gross income for the year shall be allocated and apportioned 
solely to the amortized portion of premium derived by the issuer for the 
year.
    (ii) Treatment by the holder. If a bond or debt obligation is 
purchased at a premium, the portion of that premium amortized during the 
year by the holder under section 171 and the regulations thereunder 
shall be allocated and apportioned solely to interest income derived 
from the bond by the holder for the year.
    (6) Financial products that alter effective cost of borrowing--(i) 
In general. Various derivative financial products can be part of 
transactions or series of transactions described in paragraph (b)(1) of 
this section. Such derivative financial products, including interest 
rate swaps, options, forwards, caps, and collars, potentially alter a 
taxpayer's effective cost of borrowing with respect to an actual 
liability of the taxpayer. For example, a taxpayer that is obligated to 
pay interest at a fixed rate may, in effect, pay interest at a floating 
rate by entering into an interest rate swap. Similarly, a taxpayer that 
is obligated to pay interest at a floating rate may, in effect, limit 
its exposure to rising interest rates by purchasing a cap. Such a 
taxpayer may have gains or losses associated with such derivative 
financial products. This paragraph (b)(6) provides rules for the 
treatment of gains and losses from such derivative financial products 
(``financial products'') that are part of transactions described in 
paragraph (b)(1) of this section and that are used by the taxpayer to 
alter its effective cost of borrowing with respect to an actual 
liability. This paragraph (b)(6) shall only apply where the hedge and 
the borrowing are in the same currency and shall not apply to the extent 
otherwise provided in section 988 and the regulations thereunder. The 
allocation and apportionment of a loss under this paragraph (b) shall 
not affect the characterization of such loss as capital or ordinary for 
other purposes of the Code and the regulations thereunder.
    (ii) Definition of gain and loss. For purposes of this paragraph 
(b)(6), the term ``gain'' refers to the excess of the amounts properly 
taken into income under a financial product that alters the effective 
cost of borrowing over the amounts properly allowed as a deduction 
thereunder within a given taxable year. See. e.g., Notice 89-21. The 
term

[[Page 196]]

``loss'' refers to the excess of the amounts properly allowed as a 
deduction under such a financial product over the amounts properly taken 
into income thereunder within a given taxable year.
    (iii) Treatment of gain or loss on the disposition of a financial 
product. [Reserved]
    (iv) Entities that are not financial services entities. An entity 
that does not constitute a financial services entity within the meaning 
of Sec.  1.904-4(e)(3) shall treat gains and losses on financial 
products described in paragraph (b)(6)(i) of this section as follows.
    (A) Losses. Losses on any financial product described in paragraph 
(b)(6)(i) of this section shall be apportioned in the same manner as 
interest expense whether or not such financial product is identified by 
the taxpayer under paragraph (b)(6)(iv)(C) of this section as a 
liability hedge.
    (B) Gains. Gains on any financial product described in paragraph 
(b)(6)(i) of this section shall reduce the taxpayer's total interest 
expense that is subject to apportionment, but only if such financial 
product is identified by the taxpayer under paragraph (b)(6)(iv)(C) of 
this section as a liability hedge. Such reduction is accomplished by 
directly allocating interest expense to the income derived from such a 
financial product.
    (C) Identification of financial products. A taxpayer can identify a 
financial product described in paragraph (b)(6)(i) of this section as 
hedging a particular interest-bearing liability (or any group of such 
liabilities) by clearly identifying on its books and records on the same 
day that it becomes a party to such arrangement that such arrangement 
hedges a given liability (or group of liabilities). In the case of a 
partial hedge, such identification shall apply to only that part of the 
liability that is hedged. If the taxpayer clearly identifies on its 
books and records a financial product as a hedge of an interest-bearing 
asset (or any group of such assets), it will create a rebuttable 
presumption that such financial product is not described in paragraph 
(b)(6)(i) of this section. A taxpayer may identify a hedge as relating 
to an anticipated liability, provided that such liability is in fact 
incurred within 120 days following the date of such identification. 
Gains and losses on such an anticipatory arrangement accruing prior to 
the time at which the liability is incurred shall constitute an 
adjustment to interest expense.
    (v) Financial services entities. [Reserved]
    (vi) Dealers. The rule of paragraph (b)(6)(iv) of this section shall 
not apply to a person acting in its capacity as a regular dealer in the 
financial products described in paragraph (b)(6)(i) of this section. 
Instead, losses sustained by a regular dealer in connection with such 
financial products shall be allocated to the class of gross income from 
such arrangements. Gains of a regular dealer in notional principal 
contracts are governed by the rules of Sec.  1.863-7T(b). Amounts 
received or accrued by any person from any financial product that is 
integrated as specified in Notice 89-90 with an asset shall not be 
treated as amounts received or accrued by a person acting in its 
capacity as a regular dealer in financial products.
    (vii) Examples. The principles of this paragraph (b)(6) may be 
illustrated by the following examples.

    Example 1. X is not a financial services entity or regular dealer in 
the financial products described in paragraph (b)(6)(i) of this section 
and has a dollar functional currency. In 1990, X incurred a total of 
$200 of interest expense. On January 1, 1990, X entered into an interest 
rate swap agreement with Y, in order to hedge its interest rate exposure 
with respect to a pre-existing floating rate liability. On the same day, 
X properly identified the agreement as a hedge of such liability. Under 
the agreement, X is required to pay Y an amount equal to a fixed rate of 
10 percent on a notional principal amount of $1,000. Y is required to 
pay X an amount equal to a floating rate of interest on the same 
notional principal amount. Under the agreement, X received from Y during 
1990 a net payment of $25. Because X identified the swap agreement as a 
liability hedge under the rules of paragraph (b)(6)(iv)(C), X may 
effectively reduce its total allocable interest expense for 1990 to $175 
by directly allocating $25 of interest expense to the swap income. Had X 
not properly identified the swap as a liability hedge, this swap payment 
would have been treated as domestic source income in accordance with the 
rule of Sec.  1.863-7T(b).
    Example 2. Assume the same facts as Example (1), except that X did 
not properly identify the agreement as a liability hedge on

[[Page 197]]

January 1, 1990. In 1990, X made a net payment of $25 to Y under the 
swap agreement. This swap payment is allocated and apportioned in the 
same manner as interest expense under the rules of paragraph 
(b)(6)(iv)(A).

    (7) Foreign currency gain or loss. In addition to the rules of 
paragraph (b)(1), (b)(2), and (b)(6) of this section, any foreign 
currency loss that is treated as an adjustment to interest expense under 
regulations issued under section 988 shall be allocated and apportioned 
in the same manner as interest expense. Any foreign currency gain that 
is treated as an adjustment to interest expense under regulations issued 
under section 988 shall offset apportionable interest expense.
    (c) Allowable deductions. In order for an interest expense to be 
allocated and apportioned, it must first be determined that the interest 
expense is currently deductible. A number of provisions in the Code 
disallow or suspend deductions of interest expense or require the 
capitalization thereof.
    (1) Disallowed deductions. A taxpayer does not allocate and 
apportion interest expense under this section that is permanently 
disallowed as a deduction by operation of section 163(h), section 265, 
or any other provision or rule that permanently disallows the deduction 
of interest expense.
    (2) Section 263A. Section 263A requires the capitalization of 
interest expense that is allocable to designated types of property. Any 
interest expense that is capitalized under section 263A does not 
constitute deductible interest expense for purposes of this section. 
Furthermore, interest expense capitalized in inventory or depreciable 
property is not separately allocated and apportioned when the inventory 
is sold or depreciation is allowed. Capitalized interest expense is 
effectively allocated and apportioned as part of, and in the same manner 
as, the cost of goods sold, amortization, or depreciation deduction.
    (3) Section 163(d). Section 163(d) suspends the deduction for 
interest expense to the extent that it exceeds net investment income. In 
the year that suspended investment interest expense becomes allowable 
under the rules of section 163(d), that interest expense is apportioned 
under rules set forth in paragraph (d)(1) of this section as though it 
were incurred in the taxable year in which the expense is deducted.
    (4) Section 469--(i) General rule. Section 469 suspends the 
deduction of passive activity losses to the extent that they exceed 
passive activity income for the year. Passive activity losses may 
consist in part of interest expense properly allocable to passive 
activity. In the year that suspended interest expense becomes allowable 
as a deduction under the rules of section 469, that interest expense is 
apportioned under rules set forth in paragraph (d)(1) of this section as 
though it were incurred in the taxable year in which the expense is 
deducted.
    (ii) Identification of the interest component of a suspended passive 
loss. A suspended passive loss may consist of a variety of items of 
expense other than interest expense. Suspended interest expense for any 
taxable year is computed by multiplying the total suspended passive loss 
for the year by a fraction, the numerator of which is passive interest 
expense for the year (determined under regulations issued under section 
163) and the denominator of which is total passive expenses for the 
year. The amount of the suspended interest expense that is considered to 
be deductible in a subsequent taxable year is computed by multiplying 
the amount of any cumulative suspended interest expense (reduced by 
suspended interest expense allowed as a deduction in prior taxable 
years) times a fraction, the numerator of which is the portion of 
cumulative suspended passive losses that become deductible in the 
taxable year and the denominator of which is the cumulative suspended 
passive losses for prior taxable years (reduced by suspended passive 
losses allowed as deductions in prior taxable years).
    (iii) Example. The rules of this paragraph (c)(4) may be illustrated 
by the following example.

    Example. On January 1, 1987, A, a United States citizen, invested in 
a passive activity. In 1987, the passive activity generated no passive 
income and $100 in passive losses, all of which were suspended by 
operation of section 469. The suspended loss included $10 of suspended 
interest expense. In 1988, the passive activity generated $50 in passive 
income and $150 in passive expenses which included

[[Page 198]]

$30 of interest expense. The entire $100 passive loss was suspended in 
1988 and included $20 of interest expense ($100 suspended passive loss x 
$30 passive interest expense/$150 total passive expenses). Thus, at the 
end of 1988, A had total suspended passive losses of $200, including $30 
of suspended interest expense. In 1989, the passive activity generated 
$100 in passive income and no passive expenses. Thus, $100 of A's 
cumulative suspended passive loss was therefore allowed in 1989. The 
$100 of deductible passive loss includes $15 of suspended interest 
expense ($30 cumulative suspended interest expense x $100 of cumulative 
suspended passive losses allowable in 1989/$200 of total cumulative 
suspended passive losses). The $15 of interest expense is apportioned 
under the rules of paragraph (d) of this section as though it were 
incurred in 1989.

    (d) Apportionment rules for individuals, estates, and certain 
trusts--(1) United States individuals. In the case of taxable years 
beginning after December 31, 1986, individuals generally shall apportion 
interest expense under different rules according to the type of interest 
expense incurred. The interest expense of individuals shall be 
characterized under the regulations issued under section 163. However, 
in the case of an individual whose foreign source income (including 
income that is excluded under section 911) does not exceed a gross 
amount of $5,000, the apportionment of interest expense under this 
section is not required. Such an individual's interest expense may be 
allocated entirely to domestic source income.
    (i) Interest incurred in the conduct of a trade or business. An 
individual who incurs business interest described in section 
163(h)(2)(A) shall apportion such interest expense using an asset method 
by reference to the individual's business assets.
    (ii) Investment interest. An individual who incurs investment 
interest described in section 163(h)(2)(B) shall apportion that interest 
expense on the basis of the individual's investment assets.
    (iii) Interest incurred in a passive activity. An individual who 
incurs passive activity interest described in section 163(h)(2)(C) shall 
apportion that interest expense on the basis of the individual's passive 
activity assets. Individuals who receive a distributive share of 
interest expense incurred in a partnership are subject to special rules 
set forth in paragraph (e) of this section.
    (iv) Qualified residence and deductible personal interest. 
Individuals who incur qualified residence interest described in section 
163(h)(2)(D) shall apportion that interest expense under a gross income 
method, taking into account all income (including business, passive 
activity, and investment income) but excluding income that is exempt 
under section 911. For purposes of this section, any qualified residence 
that is rented shall be considered to be a business asset for the period 
in which it is rented, with the result that the interest on such a 
residence is not apportioned under this subdivision (iv) but instead 
under subdivisions (i) or (iii) of this paragraph (d)(1). To the extent 
that personal interest described in section 163(h)(2) remains deductible 
under transitional rules, individuals shall apportion such interest 
expense in the same manner as qualified residence interest.
    (v) Example. The following example illustrates the principles of 
this section.

    Example. (i) Facts. A is a resident individual taxpayer engaged in 
the active conduct of a trade or business, which A operates as a sole 
proprietor. A's business generates only domestic source income. A's 
investment portfolio consists of several less than 10 percent stock 
investments. Certain stocks in which A's adjusted basis is $40,000 
generate domestic source income and other stocks in which A's adjusted 
basis is $60,000 generate foreign source passive income. In addition, A 
owns his personal residence, which is subject to a mortgage in the 
amount of $100,000. All interest expense incurred with respect to A's 
mortgage is qualified residence interest for purposes of section 
163(h)(2)(D). A's other indebtedness consists of a bank loan in the 
amount of $40,000. Under the regulations issued under section 163(h), it 
is determined that the proceeds of the $40,000 loan were divided equally 
between A's business and his investment portfolio. In 1987, the gross 
income of A's business, before the apportionment of interest expense, 
was $50,000. A's investment portfolio generated $4,000 in domestic 
source income and $6,000 in foreign source passive income. All of A's 
debt obligations bear interest at the annual rate of 10 percent.
    (ii) Analysis of business interest. Under section 163(h) of the 
Code, $2,000 of A's interest expense is attributable to his business. 
Under the rules of paragraph (d)(1)(i), such

[[Page 199]]

interest must be apportioned on the basis of the business assets. 
Applying the asset method described in paragraph (g) of this section, it 
is determined that all of A's business assets generate domestic income 
and, therefore, constitute domestic assets. Thus, the $2,000 in interest 
expense on the business loan is allocable to domestic source income.
    (iii) Analysis of investment interest. Under section 163(h) of the 
Code, $2,000 of A's interest expense is investment interest. Under the 
rules of paragraph (d)(1)(ii) of this section, such interest must be 
apportioned on the basis of investment assets. Applying the asset 
method, A's investment assets consist of stock generating domestic 
source income with an adjusted basis of $40,000 and stock generating 
foreign source passive income with an adjusted basis of $60,000. Thus, 
40 percent ($800) of A's investment interest is apportioned to domestic 
source income and 60 percent ($1,200) of A's investment interest is 
apportioned to foreign source passive income for purposes of section 
904.
    (iv) Analysis of qualified residence interest. The $10,000 of 
qualified residence interest expense is apportioned under the rules of 
paragraph (d)(1)(iv) of this section on the basis of all of A's gross 
income. A's gross income consists of $60,000, $54,000 of which is 
domestic source and $6,000 of which is foreign source passive income. 
Thus, $9,000 of A's qualified residence interest is apportioned to 
domestic source income and $1,000 of A's qualified residence interest is 
apportioned to foreign source passive income.

    (2) Nonresident aliens--(i) General rule. For taxable years 
beginning on or after January 1, 1988, interest expense incurred by a 
nonresident alien shall be considered to be connected with income 
effectively connected with a United States trade or business only to the 
extent that interest expense is incurred with respect to liabilities 
that--
    (A) Are entered on the books and records of the United States trade 
or business when incurred, or
    (B) Are secured by assets that generate such effectively connected 
income.
    (ii) Limitations--(A) Maximum debt capitalization. Interest expense 
incurred by a nonresident alien is not considered to be connected with 
effectively connected income to the extent that it is incurred with 
respect to liabilities that exceed 80 percent of the gross assets of the 
United States trade or business.
    (B) Collateralization by other assets. Interest expense on 
indebtedness that is secured by specific assets (not including the 
general credit of the nonresident alien) other than the assets of the 
United States trade or business shall not be considered to be connected 
with effectively connected income.
    (3) Estates and trusts. Estates shall be treated in the same manner 
as individuals. In the case of a trust that is beneficially owned by 
individuals and is a complex trust, the trust shall be treated in the 
same manner as individuals under the rules of paragraph (d) of this 
section, except that no de minimis amount shall apply. In the case of a 
trust that is beneficially owned by one or more corporations, the trust 
shall be treated either as a partnership or as a corporation depending 
on how the trust is characterized under the rules of section 7701 and 
the regulations thereunder.
    (e) Partnerships--(1) In general--aggregate rule. A partner's 
distributive share of the interest expense of a partnership that is 
directly allocable under Sec.  1.861-10T to income from specific 
partnership property shall be treated as directly allocable to the 
income generated by such partnership property. Subject to the exceptions 
set forth in paragraph (e)(4), a partner's distributive share of the 
interest expense of a partnership that is not directly allocable under 
Sec.  1.861-10T generally is considered related to all income producing 
activities and assets of the partner and shall be subject to 
apportionment under the rules described in this paragraph. For purposes 
of this section, a partner's percentage interest in a partnership shall 
be determined by reference to the partner's interest in partnership 
income for the year. Similarly, a partner's pro rata share of 
partnership assets shall be determined by reference to the partner's 
interest in partnership income for the year.
    (e)(2) through (e)(3) [Reserved]. For further guidance see Sec.  
1.861-9(e)(2) through (e)(3).
    (4) Less than 10 percent limited partners and less than 10 percent 
corporate general partners--entity rule--(i) Partnership interest 
expense. A limited partner (whether individual or corporate) or 
corporate general partner whose direct and indirect interest (as 
determined under the attribution rules of section 318) in the 
partnership is less than 10

[[Page 200]]

percent shall directly allocate its distributive share of partnership 
interest expense to its distributive share of partnership gross income. 
Under Sec.  1.904-7(i)(2) of the regulations, such a partner's 
distributive share of foreign source income of the partnership is 
treated as passive income (subject to the high taxed income exception of 
section 904(d)(2)(F)), except in the case of high withholding tax 
interest or income from a partnership interest held in the ordinary 
course of the partner's active trade or business, as defined in Sec.  
1.904-7(i)(2). A partner's distributive share of partnership interest 
expense (other than partnership interest expense that is directly 
allocated to identified property under Sec.  1.861-10T) shall be 
apportioned in accordance with the partner's relative distributive share 
of gross foreign source income in each limitation category and of 
domestic source income from the partnership. To the extent that 
partnership interest expense is directly allocated under Sec.  1.861-
10T, a comparable portion of the income to which such interest expense 
is allocated shall be disregarded in determining the partner's relative 
distributive share of gross foreign source income in each limitation 
category and domestic source income. The partner's distributive share of 
the interest expense of the partnership that is directly allocable under 
Sec.  1.861-10T shall be allocated according to the treatment, after 
application of Sec.  1.904-7(i)(2), of the partner's distributive share 
of the income to which the expense is allocated.
    (ii) Other interest expense of the partner. For purposes of 
apportioning other interest expense of the partner on an asset basis, 
the partner's interest in the partnership, and not the partner's pro 
rata share of partnership assets, is considered to be the relevant 
asset. The value of this asset for apportionment purposes is either the 
tax book value or fair market value of the partner's partnership 
interest, depending on the method of apportionment used by the taxpayer. 
This amount of a partner's interest in the partnership is allocated 
among various limitation categories in the same manner as partnership 
interest expense (that is not directly allocable under Sec.  1.861-10T) 
is apportioned in subdivision (i) of this paragraph (e)(4). If the 
partner uses the tax book value method of apportionment, the partner's 
interest in the partnership must be reduced, for this purpose, to the 
extent that the partner's basis consists of liabilities that are taken 
into account under section 752. Under either the tax book value or fair 
market value method of apportionment, for purposes of this section only, 
the value of the partner's interest in the partnership must be reduced 
by the principal amount of any indebtedness of the partner the interest 
on which is directly allocated to its partnership interest under Sec.  
1.861-10T.
    (5) Tiered partnerships. If a partnership is a partner in another 
partnership, the distributive share of interest expense of a lower-tier 
partnership that is subject to the rules of paragraph (e)(4) shall not 
be reapportioned in the hands of any higher-tier partner. However, the 
distributive share of interest expense of lower-tier partnership that is 
subject to the rules of paragraph (e) (2) or (3) shall be apportioned by 
the partner of the higher-tier partnership or by any higher-tier 
partnership to which the rules of paragraph (e)(4) apply, taking into 
account the partner's indirect pro rata share of the lower-tier 
partnership's income or assets.
    (6) Example--(i) Facts. A, B, and C are partners in a limited 
partnership. A is a corporate general partner, owns a 5 percent interest 
in the partnership, and has an adjusted basis in its partnership 
interest, determined without regard to section 752 of the Code, of $5. 
A's investment in the partnership is not held in the ordinary course of 
the taxpayer's active trade or business, as defined in Sec.  1.904-
7(i)(2). B, a corporate limited partner, owns a 70 percent interest in 
the partnership, and has an adjusted basis in its partnership interest, 
determined without regard to section 752 of the Code, of $70. C is an 
individual limited partner, owns a 25 percent interest in the 
partnership, and has an adjusted basis in the partnership interest, 
determined without regard to section 752 of the Code, of $25. The 
partners' interests in the profits and losses of the partnership conform 
to their respective interests. None of

[[Page 201]]

the interest expense incurred directly by any of the partners is 
directly allocable to their partnership interest under Sec.  1.861-10T. 
The ABC partnership's sole assets are two apartment buildings, one 
domestic and the other foreign. The domestic building has an adjusted 
inside basis of $600 and the foreign building has an adjusted inside 
basis of $500. Each of the buildings is subject to a nonrecourse 
liability in the amount of $500. The ABC partnership's total interest 
expense for the taxable year is $120, both nonrecourse liabilities 
bearing interest at the rate of 12 percent. The indebtedness on the 
domestic building qualifies for direct allocation under the rules of 
Sec.  1.861-10T. The indebtedness on the foreign building does not so 
qualify. The partnership incurred no foreign taxes. The partnership's 
gross income for the taxable year is $360, consisting of $100 in foreign 
source income and $260 in domestic source income. Under Sec.  1.752-
1(e), the nonrecourse liabilities of the partnership are allocated among 
the partners according to their share of the partnership profits. 
Accordingly, the adjusted basis of A, B, and C in their respective 
partnership interests (for other than apportionment purposes) is, 
respectively, $55, $770, and $275.
    (ii) Determination of the amount of partnership interest expense 
that is subject to allocation and apportionment. Interest on the 
nonrecourse loan on the domestic building is, under Sec.  1.861-10T, 
directly allocable to income from that investment. The interest expense 
is therefore directly allocable to domestic income. Interest on the 
nonrecourse loan on the foreign building is not directly allocable. The 
interest expense is therefore subject to allocation and apportionment. 
Thus, $60 of interest expense is directly allocable to domestic income 
and $60 of interest expense is subject to allocation and apportionment.
    (iii) Analysis for Partner A. A's distributive share of the 
partnership's gross income is $18, which consists of $5 in foreign 
source income and $13 in domestic source income. A's distributive share 
of the ABC interest expense is $6, $3 of which is directly allocable to 
domestic income and $3 of which is subject to apportionment. After 
direct allocation of qualifying interest expense, A's distributive share 
of the partnership's gross income consists of $5 in foreign source 
income and $10 in domestic source income. Because A is a less than 10 
percent corporate partner, A's distributive share of any foreign source 
partnership income is considered to be passive income. Accordingly, in 
apportioning the $3 of partnership interest expense that is subject to 
apportionment on a gross income method, one-third ($1) is apportioned to 
foreign source passive income and two-thirds ($2) is apportioned to 
domestic source income. In apportioning its other interest expense, A 
uses the tax book value method. A's adjusted basis in A's partnership 
interest ($55) includes A's share of the partnership's liabilities 
($50), which are included in basis under section 752. For purposes of 
apportioning other interest expense, A's adjusted basis in the 
partnership must be reduced to the extent of such liabilities. Thus, A's 
adjusted basis in the partnership, for purposes of apportionment, is $5. 
For the purpose of apportioning A's other interest expense, this $5 in 
basis is characterized one-third as a foreign passive asset and two-
thirds as a domestic asset, which is the ratio determined in paragraph 
(e)(4)(i).
    (iv) Analysis for Partner B. B's distributive share of the ABC 
interest expense is $84, $42 of which is directly allocable to domestic 
income and $42 of which is subject to apportionment. As a corporate 
limited partner whose interest in the partnership is 10 percent or more, 
B is subject to the rules of paragraph (e)(2) and paragraph (f) of this 
section. These rules require that a corporate partner apportion its 
distributive share of partnership interest expense at the partner level 
on the asset method described in paragraph (g) of this section by 
reference to its corporate assets, which include, for this purpose, 70 
percent of the partnership's assets, adjusted in the manner described in 
Sec.  1.861-10T(e) to reflect directly allocable interest expense.
    (v) Analysis for Partner C. C's distributive share of the ABC 
interest expense is $30, $15 of which is directly allocable to domestic 
income and $15 of which is subject to apportionment. As

[[Page 202]]

an individual limited partner whose interest in the partnership is 10 
percent or more, C is subject to the rules of paragraph (e)(3) of this 
section. These rules require that an individual's share of partnership 
interest expense be classified under regulations issued under section 
163(h) and then apportioned under the rules applicable to individuals, 
which are set forth in paragraph (d) of this section.
    (7) Foreign partners. The distributive share of partnership interest 
expense of a nonresident alien who is a partner in a partnership shall 
be considered to be connected with effectively connected income based on 
the percentage of the assets of the partnership that generate 
effectively connected income. No interest expense directly incurred by 
the partner may be allocated and apportioned to effectively connected 
income derived by the partnership.
    (f) Corporations--(1) Domestic corporations. Domestic corporations 
shall apportion interest expense using the asset method described in 
paragraph (g) of this section and the applicable rules of Sec. Sec.  
1.861-10T through 1.861-13T.
    (2) Foreign branches of domestic corporations. In the application of 
the asset method described in paragraph (g) of this section, a domestic 
corporation shall--
    (i) Take into account the assets of any foreign branch, translated 
according to the rules set forth in paragraph (g) of this section, and
    (ii) Combine with its own interest expense any deductible interest 
expense incurred by a branch, translated according to the rules of 
section 987 and the regulations thereunder.


For purposes of computing currency gain or loss on any remittance from a 
branch or other qualified business unit (as defined in Sec.  1.989(a)-
1T) under section 987, the rules of this paragraph (f) shall not apply. 
The branch shall compute its currency gain or loss on remittances by 
taking into account only its separate expenses and its separate income.

    Example. (i) Facts. X is a domestic corporation which operates B, a 
branch doing business in a foreign country. In 1988, without regard to 
branch B, X has gross domestic source income of $1,000 and gross foreign 
source general limitation income of $500 and incurs $200 of interest 
expense. Using the tax book value method of apportionment, X, without 
regard to branch B, determines the value of its assets that generate 
domestic source income to be $6,000 and the value of its assets that 
generate foreign source general limitation income to be $1,000. B 
constitutes a qualified business unit within the meaning of section 989 
with a functional currency other than the U.S. dollar and uses the 
profit and loss method prescribed by section 987. Applying the 
translation rules of section 987, B earned $500 of gross foreign general 
limitation income and incurred $100 of interest expense. B incurred no 
other expenses. For 1988, the average functional currency book value of 
B's assets that generate foreign general limitation income translated at 
the year-end rate for 1988 is $3,000.
    (ii) Computation of net income. The combined assets of X and B for 
1988 (averaged under the rules of Sec.  1.861-9T(g)(3)) consist 60 
percent of assets generating domestic source income and 40 percent of 
assets generating foreign source general limitation income. The combined 
interest expense of both X and B is $300. Thus, $180 of the combined 
interest expense is apportioned to domestic source income and $120 is 
apportioned to the foreign source income, yielding net domestic source 
income of $820 and net foreign source general limitation income of $880.
    (iii) Computation of currency gain or loss. For purposes of 
computing currency gain or loss on branch remittances, B takes into 
account only its gross income and its separate expenses. In 1988, B 
therefore has a net amount of income in foreign currency units equal in 
value to $400. Gain or loss on remittances shall be computed by 
reference to this amount.

    (3) Controlled foreign corporations--(i) In general. For purposes of 
computing subpart F income and computing earnings and profits for all 
other federal tax purposes, the interest expense of a controlled foreign 
corporation may be apportioned either using the asset method described 
in paragraph (g) of this section or using the modified gross income 
method described in paragraph (j) of this section, subject to the rules 
of subdivisions (ii) and (iii) of this paragraph (f)(2). However, the 
gross income method described in paragraph (j) of this section is not 
available to any controlled foreign corporation if a United States 
shareholder and the members of its affiliated group (as defined in Sec.  
1.861-11T(d)) constitute controlling shareholders of such controlled 
foreign corporation and such affiliated group elects the fair market 
value

[[Page 203]]

method of apportionment under paragraph (g) of this section.
    (ii) Manner of election. The election to use the asset method 
described in paragraph (g) of this section or the modified gross income 
method described in paragraph (j) of this section may be made either by 
the controlled foreign corporation or by the controlling United States 
shareholders on behalf of the controlled foreign corporation. The term 
``controlling United States shareholders'' means those United States 
shareholders (as defined in section 951(b)) who, in 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. In the case of a controlled foreign 
corporation in which the United States shareholders own stock 
representing more than 50 percent of the value of the stock in such 
corporation, but less than 50 percent of the combined voting power of 
all classes of stock in such corporation, 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. All United States 
shareholders are bound by the election of either the controlled foreign 
corporation or the controlling United States shareholders. For guidance 
relating to the time and manner of this election, see Sec.  1.861-
9(f)(3)(ii).
    (iii) Consistency requirement. The same method of apportionment must 
be employed by all controlled foreign corporations in which a United 
States taxpayer and the members of its affiliated group (as defined in 
Sec.  1.861-11T(d)) constitute controlling United States shareholders. A 
controlled foreign corporation that is required by this paragraph 
(f)(3)(iii) to utilize a particular method of apportionment must do so 
with respect to all United States shareholders.
    (iv) Stock characterization. Pursuant to Sec.  1.861-12T(c)(2), the 
stock of a controlled foreign corporation shall be characterized in the 
hands of any United States shareholder using the same method that the 
controlled foreign corporation uses to apportion its interest expense.
    (4) Noncontrolled section 902 corporations--(i) In general. For 
purposes of computing earnings and profits of a noncontrolled section 
902 corporation (as defined in section 904(d)(2)(E)) for federal tax 
purposes, the interest expense of a noncontrolled section 902 
corporation may be apportioned using either the asset method described 
in paragraph (g) of this section or the modified gross income method 
described in paragraph (j) of this section. A noncontrolled section 902 
corporation that is not a controlled foreign corporation may elect to 
use a different method of apportionment than that elected by one or more 
of its shareholders. For further guidance, see Sec.  1.861-9(f)(4).
    (ii) Manner of election. The election to use the asset method 
described in paragraph (g) of this section or the modified gross income 
method described in paragraph (j) of this section may be made either by 
the noncontrolled section 902 corporation or by the majority domestic 
corporate shareholders (as defined in Sec.  1.964-1T(c)(5)(ii)) on 
behalf of the noncontrolled section 902 corporation. The election shall 
be made by filing a statement described in Sec.  1.964-1T(c)(3)(ii) at 
the time and in the manner described therein and providing a written 
notice described in Sec.  1.964-1T(c)(3)(iii), except that no such 
statement or notice is required to be filed or sent before July 24, 
2006.
    (iii) Stock characterization. In general, the stock of a 
noncontrolled section 902 corporation shall be characterized in the 
hands of any domestic corporation that meets the ownership requirements 
of section 902(a) with respect to the noncontrolled section 902 
corporation, or in the hands of any member of the same qualified group 
as defined in section 902(b)(2), using the same method that the 
noncontrolled section 902 corporation uses to apportion its interest 
expense. Stock in a noncontrolled section 902 corporation shall be 
characterized as a passive category asset in the hands of any such 
shareholder that fails to meet the substantiation requirements of Sec.  
1.904-5T(c)(4)(iii), or in the hands of any shareholder that is not 
eligible to compute an amount of foreign taxes deemed paid with respect 
to a dividend from the noncontrolled

[[Page 204]]

section 902 corporation for the taxable year. See Sec.  1.861-12T(c)(4).
    (iv) Effective date. This paragraph (f)(4) applies for taxable years 
of shareholders ending after the first day of the first taxable year of 
the noncontrolled section 902 corporation beginning after December 31, 
2002.
    (5) Other relevant provisions. Affiliated groups of corporations are 
subject to special rules set forth in Sec.  1.861-11T. Section 1.861-12T 
sets forth rules relating to basis adjustments for stock in 
nonaffiliated 10 percent owned corporations, special rules relating to 
the consideration and characterization of certain assets in the 
apportionment of interest expense, and to other special rules pertaining 
to the apportionment of interest expense. Section 1.861-13T contains 
transition rules limiting the application of the rules of Sec. Sec.  
1.861-8T through 1.861-12T, which are otherwise applicable to taxable 
years beginning after 1986. In the case of an affiliated group of 
corporations as defined in Sec.  1.861-11T(d), any reference in 
Sec. Sec.  1.861-8T through 1.861-13T to the ``taxpayer'' with respect 
to the allocation and apportionment of interest expense generally 
denotes the entire affiliated group of corporations and not the separate 
members thereof, unless the context otherwise requires.
    (g) Asset method--(1) In general. (i) Under the asset method, the 
taxpayer apportions interest expense to the various statutory groupings 
based on the average total value of assets within each such grouping for 
the taxable year, as determined under the asset valuation rules of this 
paragraph (g)(1) and paragraph (g)(2) of this section and the asset 
characterization rules of paragraph (g)(3) of this section and Sec.  
1.861-12T. Except to the extent otherwise provided (see, e.g., paragraph 
(d)(1)(iv) of this section), taxpayers must apportion interest expense 
only on the basis of asset values and may not apportion any interest 
deduction on the basis of gross income.
    (ii) A taxpayer may elect to determine the value of its assets on 
the basis of either the tax book value or the fair market value of its 
assets. For rules concerning the application of an alternative method of 
valuing assets for purposes of the tax book value method, see Sec.  
1.861-9(i). For rules concerning the application of the fair market 
value method, see paragraph (h) of this section. In the case of an 
affiliated group--
    (A) The parent of which used the fair market value method prior to 
1987, or
    (B) A substantial portion of which used the fair market value method 
prior to 1987, such a taxpayer may use either the fair market value 
method or the tax book value method for its tax year commencing in 1987 
and may use either such method in its tax year commencing in 1988 
without regard to which method was used in its tax year commencing in 
1987 and without securing the Commissioner's consent. The use of the 
fair market value method in 1988, however, shall operate as a binding 
election as described in Sec.  1.861-8T(c)(2). For rules requiring 
consistency in the use of the tax book value or fair market value 
method, see Sec.  1.861-8T(c)(2).
    (iii) A taxpayer electing to apportion its interest expense on the 
basis of the fair market value of its assets must establish the fair 
market value to the satisfaction of the Commissioner. If a taxpayer 
fails to establish the fair market value of an asset to the satisfaction 
of the Commissioner, the Commissioner may determine the appropriate 
asset value. If a taxpayer fails to establish the value of a substantial 
portion of its assets to the satisfaction of the Commissioner, the 
Commissioner may require the taxpayer to use the tax book value method 
of apportionment.
    (iv) For rules relating to earnings and profits adjustments by 
taxpayers using the tax book value method for the stock in certain 
nonaffiliated 10 percent owned corporations, see Sec.  1.861-12T(b).
    (v) The provisions of this paragraph (g)(1) may be illustrated by 
the following examples.

    Example 1. (i) Facts. X, a domestic corporation organized on January 
1, 1987, has deductible interest expense in 1987 in the amount of 
$150,000. X apportions its expenses according to the tax book value 
method. The adjusted basis of X's assets is $3,600,000, $3,000,000 of 
which generate domestic source income and $600,000 of which generate 
foreign source general limitation income.

[[Page 205]]

    (ii) Allocation. No portion of the $150,000 deduction is directly 
allocable solely to identified property within the meaning of Sec.  
1.861-10T. Thus, X's deduction for interest is related to all its 
activities and assets.
    (iii) Apportionment. X apportions its interest expense as follows:
    To foreign source general limitation income:
    [GRAPHIC] [TIFF OMITTED] TC14NO91.113
    
    To domestic source income:
    [GRAPHIC] [TIFF OMITTED] TC14NO91.114
    
    Example 2. (i) Facts. Assume the same facts as in Example 1, except 
that X apportions its interest expense on the basis of the fair market 
value of its assets. X's total assets have a fair market value of 
$4,000,000, $3,200,000 of which generate domestic source income and 
$800,000 of which generate foreign source general limitation income.
    (ii) Allocation. No portion of the $150,000 deduction is directly 
allocable solely to identified property within the meaning of Sec.  
1.861-10T. Thus, X's deduction for interest is related to all its 
activities and properties.
    (iii) Apportionment. If it establishes the fair market value of its 
assets to the satisfaction of the Commissioner, X may apportion its 
interest expense as follows:
    To foreign source general limitation income:
    [GRAPHIC] [TIFF OMITTED] TC14NO91.115
    
    To domestic source income:
    [GRAPHIC] [TIFF OMITTED] TC14NO91.116
    
    (2) Asset values--(i) General rule. For purposes of determining the 
value of assets under this section, an average of values (book or 
market) within each statutory grouping and the residual grouping shall 
be computed for the year on the basis of values of assets at the 
beginning and end of the year. For the first taxable year beginning 
after 1986, a taxpayer may choose to determine asset values solely by 
reference to the year-end value of its assets, provided that all the 
members of an affiliated group as defined in Sec.  1.861-11T(d) make the 
same choice. Thus, no averaging is required for the first taxable year 
beginning after 1986. Where a substantial distortion of asset values 
would result from averaging beginning-of-year and year-end values, as 
might be the case in the event of a major corporate acquisition or 
disposition, the taxpayer must use a different method of asset valuation 
that more clearly reflects the average value of assets weighted to 
reflect the time such assets are held by the taxpayer during the taxable 
year.
    (ii) Special rule for qualified business units of domestic 
corporations with functional currency other than the U.S. dollar--(A) 
Tax book value method. In the case of taxpayers using the tax book value 
method of apportionment, the following rules shall apply to determine 
the value of the assets of a qualified business unit (as defined in 
section 989(a)) of a domestic corporation with a functional currency 
other than the dollar.
    (1) Section 987 QBU. In the case of a section 987 QBU (as defined in 
Sec.  1.987-1(b)(2)), the tax book value shall be determined by applying 
the rules of paragraphs (g)(2)(i) and (g)(3) of this section to the 
beginning-of-year and end-of-year functional currency amount of assets. 
The beginning-of-year functional currency amount of assets shall be 
determined by reference to the functional currency amount of assets 
computed under Sec.  1.987-4(d)(1)(i)(B) and (e) on the last day of the 
preceding taxable year. The end-of-year functional currency amount of 
assets shall be determined by reference to the functional currency 
amount of assets computed under Sec.  1.987-4(d)(1)(i)(A) and (e) on the 
last day of the current taxable year. The beginning-of-year and end-of-
year functional currency amount of assets, as so determined within each 
grouping, must then be averaged as provided in paragraph (g)(2)(i) of 
this section.
    (2) Approximate separate transactions method. In the case of a 
branch for which an election is effective under Sec.  1.985-2T to use 
the dollar approximate separate transactions method to compute currency 
gain or loss, the beginning-of-year dollar amount of the assets shall be 
determined by reference to the end-of-year balance sheet of the branch 
for the immediately preceding taxable year, adjusted for United States 
generally accepted accounting

[[Page 206]]

principles and United States tax accounting principles, and translated 
into U.S. dollars as provided in Sec.  1.985-3T. The year-end dollar 
amount of the assets of the branch shall be determined in the same 
manner by reference to the end-of-year balance sheet for the current 
taxable year. The beginning-of-year and end-of-year dollar tax book 
value of assets, as so determined, within each grouping must then be 
averaged as provided in paragraph (g)(2)(i) of this section.
    (B) Fair market value method. In the case of taxpayers using the 
fair market value method of apportionment, the beginning-of-year and 
end-of-year fair market values of branch assets within each grouping 
shall be computed in dollars and averaged as provided in this paragraph 
(g)(2).
    (iii) Adjustment for directly allocated interest. Prior to 
averaging, the year-end value of any asset to which interest expense is 
directly allocated during the current taxable year under the rules of 
Sec.  1.861-10T (b) or (c) shall be reduced (but not below zero) by the 
percentage of the principal amount of indebtedness outstanding at year-
end equal to the percentage of all interest on the debt for the taxable 
year that is directly allocated.
    (iv) Assets in intercompany transactions. In the application of the 
asset method described in this paragraph (g), the tax book value of 
assets transferred between affiliated corporations in intercompany 
transactions shall be determined without regard to the gain or loss that 
is deferred under the regulations issued under section 1502.
    (v) Example. X is a domestic corporation that uses the fair market 
value method of apportionment. X is a calendar year taxpayer. X owns 25 
percent of the stock of A, a noncontrolled section 902 corporation. At 
the end of 1987, the fair market value of X's assets by income grouping 
are as follows:

Domestic......................................................$1,000,000
Foreign general limitation.......................................500,000
Foreign passive..................................................500,000
Noncontrolled section 902 corporation.............................50,000

    For its 1987 tax year, X apportions its interest expense by 
reference to the 1987 year-end values. In July of 1988, X sells a 
portion of its investment in A and in an asset acquisition purchases a 
shipping business, the assets of which generate exclusively foreign 
shipping income. At the end of 1988, the fair market values of X's 
assets by income grouping are as follows:

Domestic........................................................$800,000
Foreign general limitation.......................................900,000
Foreign passive..................................................300,000
Noncontrolled section 902 corporation.............................40,000
Foreign shipping.................................................100,000

    For its 1988 tax year, X shall apportion its interest expense by 
reference to the average of the 1988 beginning-of-year values (the 1987 
year-end values) and the 1988 year-end values, assuming that the 
averaging of beginning-of-year and end-of-year values does not cause a 
substantial distortion of asset values. These averages are as follows:

Domestic........................................................$900,000
Foreign general limitation.......................................700,000
Foreign passive..................................................400,000
Foreign shipping..................................................50,000
Noncontrolled section 902 corporation.............................45,000

    (vi) Effective/applicability date. Generally, paragraph 
(g)(2)(ii)(A)(1) of this section shall apply to taxable years beginning 
on or after one year after the first day of the first taxable year 
following December 7, 2016. If pursuant to Sec.  1.987-11(b) a taxpayer 
applies Sec. Sec.  1.987-1 through 1.987-11 beginning in a taxable year 
prior to the earliest taxable year described in Sec.  1.987-11(a), then 
paragraph (g)(2)(ii)(A)(1) of this section shall apply to taxable years 
beginning on or after the first day of such prior taxable year.
    (3) Characterization of assets. Assets are charactrized for purposes 
of this section according to the source and type of the income that they 
generate, have generated, or may reasonably be expected to generate. The 
physical location of assets is not relevant to this determination. 
Subject to the special rules of paragraph (h) concerning the application 
of the fair market value method of apportionment, the value of assets 
within each statutory grouping and the residual grouping at the 
beginning and end of each year shall be determined by dividing the 
taxpayer's assets into three types--
    (i) Single category assets. Assets that generate income that is 
exclusively

[[Page 207]]

within a single statutory grouping or the residual grouping;
    (ii) Multiple category assets. Assets that generate income within 
more than one grouping of income (statutory or residual); and
    (iii) Assets without directly identifiable yield. Assets that 
produce no directly identifiable income yield or that contribute equally 
to the generation of all the income of the taxpayer (such as assets used 
in general and administrative functions).


Single category assets are directly attributable to the relevant 
statutory or residual grouping of income. In order to attribute multiple 
category assets to the relevant groupings of income, the income yield of 
each such asset for the taxable year must be analyzed to determine the 
proportion of gross income generated by it within each relevant 
grouping. The value of each asset is then prorated among the relevant 
groupings of income according to their respective proportions of gross 
income. The value of each asset without directly identifiable income 
yield must be identified. However, because prorating the value of such 
assets cannot alter the ratio of assets within the various groupings of 
income (as determined by reference to the single and multiple category 
assets), they are not taken into account in determining that ratio. 
Special asset characterization rules that are set forth in Sec.  1.861-
12T. An example demonstrating the application of the asset method is set 
forth in Sec.  1.861-12T(d).
    (h) The fair market value method. An affiliated group (as defined in 
Sec.  1.861-11T(d)) or other taxpayer (the ``taxpayer'') that elects to 
use the fair market value method of apportionment shall value its assets 
according to the following methodology.
    (1) Determination of values--(i) Valuation of group assets. The 
taxpayer shall first determine the aggregate value of the assets of the 
taxpayer on the last day of its taxable year without excluding the value 
of stock in foreign subsidiaries or any other asset. In the case of a 
publicly traded corporation, this determination shall be equal to the 
aggregate trading value of the taxpayer's stock traded on established 
securities markets at year-end increased by the taxpayer's year-end 
liabilities to unrelated persons and its pro rata share of year-end 
liabilities of all related persons owed to unrelated persons. In 
determining whether persons are related, Sec.  1.861-8T(c)(2) shall 
apply. In the case of a corporation that is not publicly traded, this 
determination shall be made by reference to the capitalization of 
corporate earnings, in accordance with the rules of Rev. Rul. 68-609. In 
either case, control premium shall not be taken into account.
    (ii) Valuation of tangible assets. The taxpayer shall determine the 
value of all assets held by the taxpayer and its pro rata share of 
assets held by other related persons on the last day of its taxable 
year, excluding stock or indebtedness in such persons, any intangible 
property as defined in section 936(h)(3)(B), or goodwill or going 
concern value intangibles. Such valuations shall be made using generally 
accepted valuation techniques. For this purpose, assets may be combined 
into reasonable groupings. Statistical methods of valuation may only be 
used in connection with fungible property, such as commodities. The 
value of stock in any corporation that is not a related person shall be 
determined under the rules of paragraph (h)(1)(i) of this section, 
except that no liabilities shall be taken into account.
    (iii) Computation of intangible asset value. The value of the 
intangible assets of the taxpayer and of intangible assets of all 
related persons attributable to the taxpayer's ownership in related 
persons is equal to the amount obtained by subtracting the amount 
determined under paragraph (h)(1)(ii) of this section from the amount 
determined under paragraph (h)(1)(i) of this section.
    (2) Apportionment of intangible asset value. The value of the 
intangible assets determined under paragraph (h)(1)(iii) of this section 
is apportioned among the taxpayer and all related persons in proportion 
to the net income before interest expense of the taxpayer and the 
taxpayer's pro rata share of the net income before interest expense of 
each ralated person held by the taxpayer, excluding income that is 
passive under Sec.  1.904-4(b). For this purpose, net income is 
determined before

[[Page 208]]

reduction for income taxes. Net income of the taxpayer and of related 
persons shall be computed without regard to dividends or interest 
received from any person that is related to the taxpayer.
    (3) Characterization of affiliated group's portion of intangible 
asset value. The portion of the value of intangible assets of the 
taxpayer and related persons that is apportioned to the taxpayer under 
paragraph (h)(2) of this section is characterized on the basis of net 
income before interest expense, as determined under paragraph (h)(2) of 
this section, of the taxpayer within each statutory or residual grouping 
of income.
    (4) [Reserved]. For further guidance see Sec.  1.861-9(h)(4).
    (5) [Reserved]. For further guidance, see Sec.  1.861-9(h)(5).
    (6) Adjustments for apportioning related person expenses. For 
purposes of apportioning expenses of a related person, the value of 
stock in a second related person as otherwise determined under paragraph 
(h)(4) of this section (which is determined on the basis of the 
taxpayer's percentage ownership interest in the second related person) 
shall be increased to reflect the first related person's percentage 
ownership interest in the second related person to the extent it is 
larger.

    Example. Assume that a taxpayer owns 80 percent of CFC1, which owns 
100 percent of CFC2. The value of CFC1 is determined generally under 
paragraph (h)(4) on the basis of the taxpayer's 80 percent indirect 
interest in CFC2. For purposes of apportioning expenses of CFC1, 100 
percent of the stock of CFC1 must be taken into account. Therefore, the 
value of CFC2 stock in the hands of CFC1 shall equal the value of CFC2 
stock in the hands of CFC1 as determined under paragraph (h)(4) of this 
section, increased by 25 percent of such amount to reflect the fact that 
CFC1 owns 100 percent and not 80 percent of CFC2.

    (i) [Reserved]. For further guidance, see Sec.  1.861-9(i).
    (j) Modified gross income method. Subject to rules set forth in 
paragraph (f)(3) of this section, the interest expense of a controlled 
foreign corporation may be allocated according to the following rules.
    (1) Single-tier controlled foreign corporation. In the case of a 
controlled foreign corporation that does not hold stock in any lower-
tier controlled foreign corporation, the interest expense of the 
controlled foreign corporation shall be apportioned based on its gross 
income.
    (2) Multiple vertically owned controlled foreign corporations. In 
the case of a controlled foreign corporation that holds stock in any 
lower-tier controlled foreign corporation, the interest expense of that 
controlled foreign corporation and such upper-tier controlled foreign 
corporation shall be apportioned based on the following methodology:
    (i) Step 1. Commencing with the lowest-tier controlled foreign 
corporation in the chain, allocate and apportion its interest expense 
based on its gross income as provided in paragraph (j)(1) of this 
section, yielding gross income in each grouping net of interest expense.
    (ii) Step 2. Moving to the next higher-tier controlled foreign 
corporation, combine the gross income of such corporation within each 
grouping with its pro rata share of the gross income net of interest 
expense of all lower-tier controlled foreign corporations held by such 
higher-tier corporation within the same grouping adjusted as follows:
    (A) Exclude from the gross income of the upper-tier corporation any 
dividends or other payments received from the lower-tier corporation 
other than interest subject to look-through under section 904(d)(3); and
    (B) Exclude from the gross income net of interest expense of any 
lower-tier corporation any subpart F income (net of interest expense 
apportioned to such income).


Then apportion the interest expense of the higher-tier controlled 
foreign corporation based on the adjusted combined gross income amounts. 
Repeat this step 2 for each next higher-tier controlled foreign 
corporation in the chain. For purposes of this paragraph (j)(2)(ii), pro 
rata share shall be determined under principles similar to section 
951(a)(2).
    (k) Effective/applicability dates. In general, the rules of this 
section apply for taxable years beginning after December 31, 1986. 
Paragraphs (b)(2) (concerning the treatment of certain foreign currency) 
and (d)(2) (concerning the treatment of interest incurred by

[[Page 209]]

nonresident aliens) of this section are applicable for taxable years 
commencing after December 31, 1988. Taxpayers may also apply paragraph 
(b)(6) of this section to any gain that was realized on any transaction 
described in paragraph (b)(6)(i) of this section that was entered into 
after September 14, 1988, and on or before August 11, 1989, if the 
taxpayer can demonstrate to the satisfaction of the Commissioner that 
substantially all of the arrangements described in paragraph (b)(6)(i) 
of this section to which the taxpayer became a party during that interim 
period were identified on the taxpayer's books and records with the 
liabilities of the taxpayer in a substantially contemporaneous manner 
and that all losses and expenses that are subject to the rules of 
paragraph (b)(6) of this section were treated in the same manner as 
interest expense. For this purpose, arrangements that were identified in 
a substantially contemporaneous manner with the taxpayer's assets shall 
be ignored. For further guidance, see Sec.  1.861-9(k).

[T.D. 8228, 53 FR 35477, Sept. 14, 1988]

    Editorial Note: For Federal Register citations affecting Sec.  
1.861-9T, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.861-10  Special allocations of interest expense.

    (a)-(d) [Reserved]
    (e) Treatment of certain related group indebtedness--(1) In general. 
If, for any taxable year beginning after December 31, 1991, a U.S. 
shareholder (as defined in paragraph (e)(5)(i) of this section) has 
both--
    (i) Excess related group indebtedness (as determined under Step One 
in paragraph (e)(2) of this section) and
    (ii) Excess U.S. shareholder indebtedness (as determined under Step 
Two in paragraph (e)(3) of this section),


the U.S. shareholder shall allocate, to its gross income in the various 
separate limitation categories described in section 904(d)(1), a portion 
of its interest expense paid or accrued to any obligee who is not a 
member of the affiliated group (as defined in Sec.  1.861-11T(d)) of the 
U.S. shareholder (``third party interest expense''), excluding amounts 
allocated under paragraphs (b) and (c) of Sec.  1.861-10T. The amount of 
third party interest expense so allocated shall equal the total amount 
of interest income derived by the U.S. shareholder during the year from 
related group indebtedness, multiplied by the ratio of the lesser of the 
foregoing two amounts of excess indebtedness for the year to related 
group indebtedness for the year. This amount of third party interest 
expense is allocated as described in Step Three in paragraph (e)(4) of 
this section.
    (2) Step One: Excess related group indebtedness. (i) The excess 
related group indebtedness of a U.S. shareholder for the year equals the 
amount by which its related group indebtedness for the year exceeds its 
allowable related group indebtedness for the year.
    (ii) The ``related group indebtedness'' of the U.S. shareholder is 
the average of the aggregate amounts at the beginning and end of the 
year of indebtedness owed to the U.S. shareholder by each controlled 
foreign corporation which is a related person (as defined in paragraph 
(e)(5)(ii) of this section) with respect to the U.S. shareholder.
    (iii) The ``allowable related group indebtedness'' of a U.S. 
shareholder for the year equals--
    (A) The average of the aggregate values at the beginning and end of 
the year of the assets (including stock holdings in and obligations of 
related persons, other than related controlled foreign corporations) of 
each related controlled foreign corporation, multiplied by
    (B) The foreign base period ratio of the U.S. shareholder for the 
year.
    (iv) The ``foreign base period ratio'' of the U.S. shareholder for 
the year is the average of the related group debt-to-asset ratios of the 
U.S. shareholder for each taxable year comprising the foreign base 
period for the current year (each a ``base year''). For this purpose, 
however, the related group debt-to-asset ratio of the U.S. shareholder 
for any base year may not exceed 110 percent of the foreign base period 
ratio for that base year. This limitation shall not apply with respect 
to any of the five taxable years chosen as initial base years by the 
U.S. shareholder

[[Page 210]]

under paragraph (e)(2)(v) of this section or with respect to any base 
year for which the related group debt-to-asset ratio does not exceed 
0.10.
    (v)(A) The foreign base period for any current taxable year (except 
as described in paragraphs (e)(2)(v) (B) and (C) of this section) shall 
consist of the five taxable years immediately preceding the current 
year.
    (B) The U.S. shareholder may choose as foreign base periods for all 
of its first five taxable years for which this paragraph (e) is 
effective the following alternative base periods:
    (1) For the first effective taxable year, the 1982, 1983, 1984, 1985 
and 1986 taxable years;
    (2) For the second effective taxable year, the 1983, 1984, 1985 and 
1986 taxable years and the first effective taxable year;
    (3) For the third effective taxable year, the 1984, 1985 and 1986 
taxable years and the first and second effective taxable years;
    (4) For the fourth effective taxable year, the 1985 and 1986 taxable 
years and the first, second and third effective taxable years; and
    (5) For the fifth effective taxable year, the 1986 taxable year and 
the first, second, third and fourth effective taxable years.
    (C) If, however, the U.S. shareholder does not choose, under 
paragraph (e)(10)(ii) of this section, to apply this paragraph (e) to 
one or more taxable years beginning before January 1, 1992, the U.S. 
shareholder may not include within any foreign base period the taxable 
year immediately preceding the first effective taxable year. Thus, for 
example, a U.S. shareholder for which the first effective taxable year 
is the taxable year beginning on October 1, 1992, may not include the 
taxable year beginning on October 1, 1991, in any foreign base period. 
Assuming that the U.S. shareholder does not elect the alternative base 
periods described in paragraph (e)(2)(v)(B) of this section, the initial 
foreign base period for the U.S. shareholder will consist of the taxable 
years beginning on October 1 of 1986, 1987, 1988, 1989, and 1990. The 
foreign base period for the U.S. shareholder for the following taxable 
year, beginning on October 1, 1993, will consist of the taxable years 
beginning on October 1 of 1987, 1988, 1989, 1990, and 1992.
    (D) If the U.S. shareholder chooses the base periods described in 
paragraph (e)(2)(v)(B) of this section as foreign base periods, it must 
make a similar election under paragraph (e)(3)(v)(B) of this section 
with respect to its U.S. base periods.
    (vi) The ``related group debt-to-asset ratio'' of a U.S. shareholder 
for a year is the ratio between--
    (A) The related group indebtedness of the U.S. shareholder for the 
year (as determined under paragraph (e)(2)(ii) of this section); and
    (B) The average of the aggregate values at the beginning and end of 
the year of the assets (including stock holdings in and obligations of 
related persons, other than related controlled foreign corporations) of 
each related controlled foreign corporation.
    (vii) Notwithstanding paragraph (e)(2)(i) of this section, a U.S. 
shareholder is considered to have no excess related group indebtedness 
for the year if--
    (A) Its related group indebtedness for the year does not exceed its 
allowable related group indebtedness for the immediately preceding year 
(as determined under paragraph (e)(2)(iii) of this section); or
    (B) Its related group debt-to-asset ratio (as determined under 
paragraph (e)(2)(vi) of this section) for the year does not exceed 0.10.
    (3) Step Two: Excess U.S. shareholder indebtedness. (i) The excess 
indebtedness of a U.S. shareholder for the year equals the amount by 
which its unaffiliated indebtedness for the year exceeds its allowable 
indebtedness for the year.
    (ii) The ``unaffiliated indebtedness'' of the U.S. shareholder is 
the average of the aggregate amounts at the beginning and end of the 
year of indebtedness owed by the U.S. shareholder to any obligee, other 
than a member of the affiliated group (as defined in Sec.  1.861-11T(d)) 
of the U.S shareholder.
    (iii) The ``allowable indebtedness'' of a U.S. shareholder for the 
year equals--
    (A) The average of the aggregate values at the beginning and end of 
the

[[Page 211]]

year of the assets of the U.S. shareholder (including stock holdings in 
and obligations of related controlled foreign corporations, but 
excluding stock holdings in and obligations of members of the affiliated 
group (as defined in Sec.  1.861-11T(d)) of the U.S. shareholder), 
reduced by the amount of the excess related group indebtedness of the 
U.S. shareholder for the year (as determined under Step One in paragraph 
(e)(2) of this section), multiplied by
    (B) The U.S. base period ratio of the U.S. shareholder for the year.
    (iv) The ``U.S. base period ratio'' of the U.S. shareholder for the 
year is the average of the debt-to-asset ratios of the U.S. shareholder 
for each taxable year comprising the U.S. base period for the current 
year (each a ``base year''). For this purpose, however, the debt-to-
asset ratio of the U.S. shareholder for any base year may not exceed 110 
percent of the U.S. base period ratio for that base year. This 
limitation shall not apply with respect to any of the five taxable years 
chosen as initial base years by the U.S. shareholder under paragraph 
(e)(3)(v) of this section or with respect to any base year for which of 
the debt-to-asset ratio does not exceed 0.10.
    (v)(A) The U.S. base period for any current taxable year (except as 
described in paragraphs (e)(3)(v) (B) and (C) of this section) shall 
consist of the five taxable years immediately preceding the current 
year.
    (B) The U.S. shareholder may choose as U.S. base periods for all of 
its first five taxable years for which this paragraph (e) is effective 
the following alternative base periods:
    (1) For the first effective taxable year, the 1982, 1983, 1984, 1985 
and 1986 taxable years;
    (2) For the second effective taxable year, the 1983, 1984, 1985 and 
1986 taxable years and the first effective taxable year;
    (3) For the third effective taxable year, the 1984, 1985 and 1986 
taxable years and the first and second effective taxable years;
    (4) For the fourth effective taxable year, the 1985 and 1986 taxable 
years and the first, second and third effective taxable years; and
    (5) For the fifth effective taxable year, the 1986 taxable year and 
the first, second, third and fourth effective taxable years.
    (C) If, however, the U.S. shareholder does not choose, under 
paragraph (e)(10)(ii) of this section, to apply this paragraph (e) to 
one or more taxable years beginning before January 1, 1992, the U.S. 
shareholder may not include within any U.S. base period the taxable year 
immediately preceding the first effective taxable year. Thus, for 
example, a U.S. shareholder for which the first effective taxable year 
is the taxable year beginning on October 1, 1992, may not include the 
taxable year beginning on October 1, 1991, in any U.S. base period. 
Assuming that the U.S. shareholder does not elect the alternative base 
periods described in paragraph (e)(3)(v)(B) of this section, the initial 
U.S. base period for the U.S. shareholder will consist of the taxable 
years beginning on October 1, of 1986, 1987, 1988, 1989, and 1990. The 
U.S. base period for the U.S. shareholder for the following taxable 
year, beginning on October 1, 1993, will consist of the taxable years 
beginning on October 1, 1987, 1988, 1989, 1990, and 1992.
    (D) If the U.S. shareholder chooses the base periods described in 
paragraph (e)(3)(v)(B) of this section as U.S. base periods, it must 
make a similar election under paragraph (e)(2)(v)(B) of this section 
with respect to its foreign base periods.
    (vi) The ``debt-to-asset ratio'' of a U.S. shareholder for a year is 
the ratio between--
    (A) The unaffiliated indebtedness of the U.S. shareholder for the 
year (as determined under paragraph (e)(3)(ii) of this section); and
    (B) The average of the aggregate values at the beginning and end of 
the year of the assets of the U.S. shareholder. For this purpose, the 
assets of the U.S. shareholder include stock holdings in and obligations 
of related controlled foreign corporations but do not include stock 
holdings in and obligations of members of the affiliated group (as 
defined in Sec.  1.861-11T(d)).
    (vii) A U.S. shareholder is considered to have no excess 
indebtedness for the year if its debt-to-asset ratio (as determined 
under paragraph (e)(3)(vi) of this

[[Page 212]]

section) for the year does not exceed 0.10.
    (4) Step Three: Allocation of third party interest expense. (i) A 
U.S. shareholder shall allocate to its gross income in the various 
separate limitation categories described in section 904(d)(1) a portion 
of its third party interest expense incurred during the year equal in 
amount to the interest income derived by the U.S. shareholder during the 
year from allocable related group indebtedness.
    (ii) The ``allocable related group indebtedness'' of a U.S. 
shareholder for any year is an amount of related group indebtedness 
equal to the lesser of--
    (A) The excess related group indebtedness of the U.S. shareholder 
for the year (determined under Step One in paragraph (e)(2) of this 
section); or
    (B) The excess U.S. shareholder indebtedness for the year 
(determined under Step Two in paragraph (e)(3) of this section).
    (iii) The amount of interest income derived by a U.S. shareholder 
from allocable related group indebtedness during the year equals the 
total amount of interest income derived by the U.S. shareholder during 
the year with respect to related group indebtedness, multiplied by the 
ratio of allocable related group indebtedness for the year to the 
aggregate amount of related group indebtedness for the year.
    (iv) The portion of third party interest expense described in 
paragraph (e)(4)(i) of this section shall be allocated in proportion to 
the relative average amounts of related group indebtedness held by the 
U.S. shareholder in each separate limitation category during the year. 
The remaining portion of third party interest expense of the U.S. 
shareholder for the year shall be apportioned as provided in Sec. Sec.  
1.861-8T through 1.861-13T, excluding paragraph (e) of Sec.  1.861-10T 
and this paragraph (e).
    (v) The average amount of related group indebtedness held by the 
U.S. shareholder in each separate limitation category during the year 
equals the average of the aggregate amounts of such indebtedness in each 
separate limitation category at the beginning and end of the year. 
Solely for purposes of this paragraph (e)(4), each debt obligation of a 
related controlled foreign corporation held by the U.S. shareholder at 
the beginning or end of the year is attributed to separate limitation 
categories in the same manner as the stock of the obligor would be 
attributed under the rules of Sec.  1.861-12T(c)(3), whether or not such 
stock is held directly by the U.S. shareholder.
    (vi) The amount of third party interest expense of a U.S. 
shareholder allocated pursuant to this paragraph (e)(4) shall not exceed 
the total amount of the third party interest expense of the U.S. 
shareholder for the year (excluding any third party interest expense 
allocated under paragraphs (b) and (c) of Sec.  1.861-10T).
    (5) Definitions. For purposes of this paragraph (e), the following 
terms shall have the following meanings.
    (i) U.S. shareholder. The term ``U.S. shareholder'' has the same 
meaning as the term ``United States shareholder'' when used in section 
957, except that, in the case of a United States shareholder that is a 
member of an affiliated group (as defined in Sec.  1.861-11T(d)), the 
entire affiliated group is considered to constitute a single U.S. 
shareholder.
    (ii) Related person. For the definition of the term ``related 
person'', see Sec.  1.861-8T(c)(2). A controlled foreign corporation is 
considered ``related'' to a U.S. shareholder if it is a related person 
with respect to the U.S. shareholder.
    (6) Determination of asset values. A U.S. shareholder shall 
determine the values of the assets of each related controlled foreign 
corporation (for purposes of Step One in paragraph (e)(2) of this 
section) and the assets of the U.S. shareholder (for purposes of Step 
Two in paragraph (e)(3) of this section) for any year in accordance with 
the valuation method (tax book value or fair market value) elected for 
that year pursuant to Sec.  1.861-9T(g). However, solely for purposes of 
this paragraph (e), a U.S. shareholder may instead choose to determine 
the values of the assets of all related controlled foreign corporations 
by reference to their values as reflected on Forms 5471 (the annual 
information return with respect to each related controlled foreign 
corporation), subject to the translation rules of paragraph (e)(8)(i) of 
this section. This method of valuation may be used only

[[Page 213]]

if the taxable years of each of the related controlled foreign 
corporations begin with, or no more than one month earlier than, the 
taxable year of the U.S. shareholder. Once chosen for a taxable year, 
this method of valuation must be used in each subsequent taxable year 
and may be changed only with the consent of the Commissioner.
    (7) Adjustments to asset value. For purposes of apportioning 
remaining interest expense under Sec.  1.861-9T, a U.S. shareholder 
shall reduce (but not below zero) the value of its assets for the year 
(as determined under Sec.  1.861-9T (g) (3) or (h)) by an amount equal 
to the allocable related group indebtedness of the U.S. shareholder for 
the year (as determined under Step Three in paragraph (e)(4)(ii) of this 
section). This reduction is allocated among assets in each separate 
limitation category in proportion to the average amount of related group 
indebtedness held by the U.S. shareholder in each separate limitation 
category during the year (as determined under Step Three in paragraph 
(e)(4)(v) of this section).
    (8) Special rules--(i) Exchange rates. All indebtedness amounts and 
asset values (including current year and base year amounts and values) 
denominated in a foreign currency shall be translated into U.S. dollars 
at the exchange rate for the current year. The exchange rate for the 
current year may be determined under any reasonable method (e.g., 
average of month-end exchange rates for each month in the current year) 
if it is consistently applied to the current year and all base years. 
Once chosen for a taxable year, a method for determining an exchange 
rate must be used in each subsequent taxable year and will be treated as 
a method of accounting for purposes of section 446. A taxpayer may apply 
a different translation rule only with the prior consent of the 
Commissioner. In this regard, the Commissioner will be guided by the 
extent to which a different rule would reduce the comparability of 
dollar amounts of indebtedness and dollar asset values for the base 
years and the current year.
    (ii) Exempt assets. Solely for purposes of this paragraph (e), any 
exempt assets otherwise excluded under section 864(e)(3) and Sec.  
1.861-8T(d) shall be included as assets of the U.S. shareholder or 
related controlled foreign corporation.
    (iii) Exclusion of certain directly allocated indebtedness and 
assets. Qualified nonrecourse indebtedness (as defined in Sec.  1.861-
10T(b)(2)) and indebtedness incurred in connection with an integrated 
financial transaction (as defined in Sec.  1.861-10T(c)(2)) shall be 
excluded from U.S. shareholder indebtedness and related group 
indebtedness. In addition, assets which are the subject of qualified 
nonrecourse indebtedness or integrated financial transactions shall be 
excluded from the assets of the U.S. shareholder and each related 
controlled foreign corporation.
    (iv) Exclusion of certain receivables. Receivables between related 
controlled foreign corporations (or between members of the affiliated 
group constituting the U.S. shareholder) shall be excluded from the 
assets of the related controlled foreign corporation (or affiliated 
group member) holding such receivables. See also Sec.  1.861-11T(e)(1).
    (v) Classification of certain loans as related group indebtedness. 
If--
    (A) A U.S. shareholder owns stock in a related controlled foreign 
corporation which is a resident of a country that--
    (1) Does not impose a withholding tax of 5 percent or more upon 
payments of dividends to a U.S. shareholder; and
    (2) Does not, for the taxable year of the controlled foreign 
corporation, subject the income of the controlled foreign corporation to 
an income tax which is greater than that percentage specified under 
Sec.  1.954-1T(d)(1)(i) of the maximum rate of tax specified under 
section 11 of the Code, and
    (B) The controlled foreign corporation has outstanding a loan or 
loans to one or more other related controlled foreign corporations, or 
the controlled foreign corporation has made a direct or indirect capital 
contribution to one or more other related controlled foreign 
corporations which have outstanding a loan or loans to one or more other 
related controlled foreign corporations, then, to the extent of the 
aggregate amount of its capital contributions in taxable years beginning 
after December 31, 1986, to the related controlled foreign corporation 
that

[[Page 214]]

made such loans or additional contributions, the U.S. shareholder itself 
shall be treated as having made the loans decribed in paragraph 
(e)(8)(v)(B) of this section and, thus, such loan amounts shall be 
considered related group indebtedness. However, for purposes of 
paragraph (e)(4) of this section, interest income derived by the U.S. 
shareholder during the year from related group indebtedness shall not 
include any income derived with respect to the U.S. shareholder's 
ownership of stock in the related controlled foreign corporation that 
made such loans or additional contributions.
    (vi) Classification of certain stock as related person indebtedness. 
In determining the amount of its related group indebtedness for any 
taxable year, a U.S. shareholder must treat as related group 
indebtedness its holding of stock in a related controlled foreign 
corporation if, during such taxable year, such related controlled 
foreign corporation claims a deduction for interest under foreign law 
for distributions on such stock. However, for purposes of paragraph 
(e)(4) of this section, interest income derived by the U.S. shareholder 
during the year from related group indebtedness shall not include any 
income derived with respect to the U.S. shareholder's ownership of stock 
in the related controlled foreign corporation.
    (9) Corporate events--(i) Initial acquisition of a controlled 
foreign corporation. If the foreign base period of the U.S. shareholder 
for any year includes a base year in which the U.S. shareholder did not 
hold stock in any related controlled foreign corporation, then, in 
computing the foreign base period ratio, the related group debt-to-asset 
ratio of the U.S. shareholder for any such base year shall be deemed to 
be 0.10.
    (ii) Incorporation of U.S. shareholder--(A) Nonapplication. This 
paragraph (e) does not apply to the first taxable year of the U.S. 
shareholder. However, this paragraph (e) does apply to all following 
years, including years in which later members of the affiliated group 
may be incorporated.
    (B) Foreign and U.S. base period ratios. In computing the foreign 
and U.S. base period ratios, the foreign and U.S. base periods of the 
U.S. shareholder shall be considered to be only the period prior to the 
current year that the U.S. shareholder was in existence if this prior 
period is less than five taxable years.
    (iii) Acquisition of additional corporations. (A) If a U.S. 
shareholder acquires (directly or indirectly) stock of a foreign or 
domestic corporation which, by reason of the acquisition, then becomes a 
related controlled foreign corporation or a member of the affiliated 
group, then in determining excess related group indebtedness or excess 
U.S. shareholder indebtedness, the indebtedness and assets of the 
acquired corporation shall be taken into account only at the end of the 
acquisition year and in following years. Thus, amounts of indebtedness 
and assets and the various debt-to-asset ratios of the U.S. shareholder 
existing at the beginning of the acquisition year or relating to 
preceding years are not recalculated to take account of indebtedness and 
assets of the acquired corporation existing as of dates before the end 
of the year. If, however, a major acquisition is made within the last 
three months of the year and a substantial distortion of values for the 
year would otherwise result, the taxpaper must take into account the 
average values of the acquired indebtedness and assets weighted to 
reflect the time such indebtedness is owed and such assets are held by 
the taxpayer during the year.
    (B) In the case of a reverse acquisition subject to this paragraph 
(e)(9), the rules of Sec.  1.1502-75(d)(3) apply in determining which 
corporations are the acquiring and acquired corporations. For this 
purpose, whether corporations are affiliated is determined under Sec.  
1.861-11T(d).
    (C) If the stock of a U.S. shareholder is acquired by (and, by 
reason of such acquisition, the U.S. shareholder becomes affiliated 
with) a corporation described below, then such U.S. shareholder shall be 
considered to have acquired such corporation for purposes of the 
application of the rules of this paragraph (e). A corporation to which 
this paragraph (e)(9)(iii)(C) applies is--
    (1) A corporation which is not affiliated with any other corporation 
(other than other similarly described corporation); and

[[Page 215]]

    (2) Substantially all of the assets of which consist of cash, 
securities and stock.
    (iv) Election to compute base period ratios by including acquired 
corporations. A U.S. shareholder may choose, solely for purposes of 
paragraph (e)(9) (i) and (iii) of this section, to compute its foreign 
and U.S. base period ratios for the acquisition year and all subsequent 
years by taking into account the indebtedness and asset values of the 
acquired corporation or corporations (including related group 
indebtedness owed to a former U.S. shareholder) at the beginning of the 
acquisition year and in each of the five base years preceding the 
acquisition year. This election, if made for an acquisition, must be 
made for all other acquisitions occurring during the same taxable year 
or initiated in that year and concluded in the following year.
    (v) Dispositions. If a U.S. shareholder disposes of stock of a 
foreign or domestic corporation which, by reason of the disposition, 
then ceases to be a related controlled foreign corporation or a member 
of the affiliated group (unless liquidated or merged into a related 
corporation), in determining excess related group indebtedness or excess 
U.S. shareholder indebtedness, the indebtedness and assets of the 
divested corporation shall be taken into account only at the beginning 
of the disposition year and for the relevant preceding years. Thus, 
amounts of indebtedness and assets and the various debt-to-asset ratios 
of the U.S. shareholder existing at the end of the year or relating to 
following years are not affected by indebtedness and assets of the 
divested corporation existing as of dates after the beginning of the 
year. If, however, a major disposition is made within the first three 
months of the year and a substantial distortion of values for the year 
would otherwise result, the taxpayer must take into account the average 
values of the divested indebtedness and assets weighted to reflect the 
time such indebtedness is owed and such assets are held by the taxpayer 
during the year.
    (vi) Election to compute base period ratios by excluding divested 
corporations. A U.S. shareholder may choose, solely for purposes of 
paragraph (e) (9) (v) and (vii) of this section, to compute its foreign 
and U.S. base period ratios for the disposition year and all subsequent 
years without taking into account the indebtedness and asset values of 
the divested corporation or corporations at the beginning of the 
disposition year and in each of the five base years preceding the 
disposition year. This election, if made for a disposition, must be made 
for all other dispositions occurring during the same taxable year or 
initiated in that year and concluded in the following year.
    (vii) Section 355 transactions. A U.S. corporation which becomes a 
separate U.S. shareholder as a result of a distribution of its stock to 
which section 355 applies shall be considered--
    (A) As disposed of by the U.S. shareholder of the affiliated group 
of which the distributing corporation is a member, with this disposition 
subject to the rules of paragraphs (e) (9) (v) and (vi) of this section; 
and
    (B) As having the same related group debt-to-asset ratio and debt-
to-asset ratio as the distributing U.S. shareholder in each year 
preceding the year of distribution for purposes of applying this 
paragraph (e) to the year of distibution and subsequent years of the 
distributed corporation.
    (10) Effective date--(i) Taxable years beginning after December 31, 
1991. The provisions of this paragraph (e) apply to all taxable years 
beginning after December 31, 1991.
    (ii) Taxable years beginning after December 31, 1987 and before 
January 1, 1992. The provisions of Sec.  1.861-10T (e) apply to taxable 
years beginning after December 31, 1987, and before January 1, 1992. The 
taxpayer may elect to apply the provisions of this paragraph (e) (in 
lieu of the provisions of Sec.  1.861-10T (e)) for any taxable year 
beginning after December 31, 1987, but this paragraph (e) must then be 
applied to all subsequent taxable years.
    (11) The following example illustrates the provisions of this 
paragraph (e):

    Example. (i) Facts. X, a domestic corporation, elects to apply this 
paragraph (e) to its 1990 tax year. X has a calendar taxable year and 
apportions its interest expense on the basis of the tax book value of 
its assets. In 1990, X incurred deductible third-party interest expense 
of $24,960 on an average amount of indebtedness (determined on the basis 
of

[[Page 216]]

beginning-of-year and end-of-year amounts) of $249,600. X manufactures 
widgets, all of which are sold in the United States. X owns all of the 
stock of Y, a controlled foreign corporation that also has a calendar 
taxable year and is also engaged in the manufacture and sale of widgets. 
Y has no earnings and profits or deficit of earnings and profits 
attributable to taxable years prior to 1987. X's total assets and their 
average tax book values (determined on the basis of beginning-of-year 
and end-of-year tax book values) for 1990 are:

------------------------------------------------------------------------
                                                             Average tax
                           Asset                              book value
------------------------------------------------------------------------
Plant and equipment........................................     $315,000
Corporate headquarters.....................................       60,000
Y stock....................................................       75,000
Y note.....................................................       50,000
    Total..................................................      500,000
------------------------------------------------------------------------

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

----------------------------------------------------------------------------------------------------------------
                                                                  1985       1986-88        1989         1990
----------------------------------------------------------------------------------------------------------------
(A) Related group indebtedness..............................      $11,000       24,000       26,000       50,000
(B) Average Value of Assets of Related CFC..................      100,000      200,000      200,000      250,000
(C) Related Group Debt-to-Asset Ratio.......................          .11          .12          .13          .20
----------------------------------------------------------------------------------------------------------------

    (1) X's ``foreign base period ratio'' for 1990, an average of its 
ratios of related group indebtedness to related group assets for 1985 
through 1989, is:

(.11 + .12 + .12 + .12 + .13) / 5 = .12

    (2) X's ``allowable related group indebtedness'' for 1990 is:

$250,000 x .12 = $30,000.

    (3) X's ``excess related group indebtedness'' for 1990 is:

$50,000 - $30,000 = $20,000

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

--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                               1985            1986            1987            1988            1989            1990
--------------------------------------------------------------------------------------------------------------------------------------------------------
(1).....................................................        $231,400         225,000         225,000         225,000         220,800         249,600
(2).....................................................         445,000         450,000         450,000         450,000         460,000         480,000
                                                          ..............  ..............  ..............  ..............  ..............             (a)
(3).....................................................             .52             .50             .50             .50             .48             .52
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (1) U.S. and foreign indebtedness
    (2) Average value of assets of U.S. shareholder
    (3) Debt-to-Asset ratio of U.S. shareholder
    (a) [500,000-20,000 (excess related group indebtedness determined in 
Step 1)]
    X's ``U.S. base period ratio'' for 1990 is:

(.52 + .50 + .50 + .50 + .48) / 5 = .50

    X's ``allowable indebtedness'' for 1990 is:

$480,000 x .50 = $240,000

    X's ``excess U.S. shareholder indebtedness'' for 1990 is:

$249,000 - $240,000 = $9,600

    X's debt-to-asset ratio for 1990 is .52, which is greater than the 
ratio of .10 described in paragraph (e)(3)(vii) of this section. 
Therefore, X's excess U.S. shareholder indebtedness for 1990 remains at 
$9,600.
    (iv) Step 3: (a) Since X's excess U.S. shareholder indebtedness of 
$9,600 is less than its excess related group indebtedness of $20,000, 
X's allocable related group indebtedness for 1990 is $9,600. The amount 
of interest received by X during 1990 on allocable related group 
indebtedness is:

$5,000 x $9,600 / $50,000 = $960


[[Page 217]]


    (b) Therefore, $960 of X's third party interest expense ($24,960) 
shall be allocated among various separate limitation categories in 
proportion to the relative average amounts of Y obligations held by X in 
each such category. The amount of Y obligations in each limitation 
category is determined in the same manner as the stock of Y would be 
attributed under the rules of Sec.  1.861-12T(c)(3). Since Y's interest 
expense is apportioned under the gross income method prescribed in Sec.  
1.861-9T (j), the Y stock must be characterized under the gross income 
method described in Sec.  1.861-12T(c)(3)(iii). Y's gross income net of 
interest expense is determined as follows:

Foreign source high withholding tax interest income
    = $5,000 - [($15,000) multiplied by ($5,000)/($5,000 + $20,000)]
    = $2,000
     and
Foreign source general limitation income
    = $20,000 - [($15,000) multiplied by ($20,000)/($5,000 + $20,000)]
    = $8,000.

    (c) Therefore, $192 [($960 x $2,000/($2,000 + $8,000)] of X's third 
party interest expense is allocated to foreign source high withholding 
tax interest income and $768 [$960 x $8,000/($2,000 + $8,000)] is 
allocated to foreign source general limitation income.
    (v) As a result of these direct allocations, for purposes of 
apportioning X's remaining interest expense under Sec.  1.861-9T, the 
value of X's assets generating foreign source general limitation income 
is reduced by the principal amount of indebtedness the interest on which 
is directly allocated to foreign source general limitation income 
($7,680), and the value of X's assets generating foreign source high 
withholding tax interest income is reduced by the principal amount of 
indebtedness the interest on which is directly allocated to foreign 
source high withholding tax interest income ($1,920), determined as 
follows:
    Reduction of X's assets generating foreign source general limitation 
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.002

    Reduction of X's assets generating foreign source high withholding 
tax interest income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.003


[T.D. 8410, 57 FR 13022, Apr. 15, 1992; 57 FR 28012, June 23, 1992]



Sec.  1.861-10T  Special allocations of interest expense (temporary).

    (a) In general. This section applies to all taxpayers and provides 
three exceptions to the rules of Sec.  1.861-9T that require the 
allocation and apportionment of interest expense on the basis of all 
assets of all members of the affiliated group. Paragraph (b) of this 
section describes the direct allocation of interest expense to the 
income generated by certain assets that are subject to qualified 
nonrecourse indebtedness. Paragraph (c) of this section describes the 
direct allocation of interest expense to income generated by certain 
assets that are acquired in integrated financial transaction. Paragraph 
(d) of this section provides special rules that are applicable to all 
transactions described in paragraphs (b) and (c) of this section. 
Paragraph (e) of this section requires the direct allocation of third 
party interest of an affiliated group to

[[Page 218]]

such group's investment in related controlled foreign corporations in 
cases involving excess related person indebtedness (as defined therein). 
See also Sec.  1.861-9T(b)(5), which requires direct allocation of 
amortizable bond premium.
    (b) Qualified nonrecourse indebtedness--(1) In general. In the case 
of qualified nonrecourse indebtedness (as defined in paragraph (b)(2) of 
this section), the deduction for interest shall be considered directly 
allocable solely to the gross income which the property acquired, 
constructed, or improved with the proceeds of the indebtedness 
generates, has generated, or could reasonably be expected to generate.
    (2) Qualified nonrecourse indebtedness defined. The term ``qualified 
nonrecourse indebtedness'' means any borrowing that is not excluded by 
paragraph (b)(4) of this section if:
    (i) The borrowing is specifically incurred for the purpose of 
purchasing, constructing, or improving identified property that is 
either depreciable tangible personal property or real property with a 
useful life of more than one year or for the purpose of purchasing 
amortizable intangible personal property with a useful life of more than 
one year;
    (ii) The proceeds are actually applied to purchase, construct, or 
improve the identified property;
    (iii) Except as provided in paragraph (b)(7)(ii) (relating to 
certain third party guarantees in leveraged lease transactions), the 
creditor can look only to the identified property (or any lease or other 
interest therein) as security for payment of the principal and interest 
on the loan and, thus, cannot look to any other property, the borrower, 
or any third party with respect to repayment of principal or interest on 
the loan;
    (iv) The cash flow from the property, as defined in paragraph (b)(3) 
of this section, is reasonably expected to be sufficient in the first 
year of ownership as well as in each subsequent year of ownership to 
fulfill the terms and conditions of the loan agreement with respect to 
the amount and timing of payments of interest and original issue 
discount and periodic payments of principal in each such year; and
    (v) There are restrictions in the loan agreement on the disposal or 
use of the property consistent with the assumptions described in 
subdivisions (iii) and (iv) of this paragraph (b)(2).
    (3) Cash flow defined--(i) In general. The term ``cash flow from the 
property'' as used in paragraph (b)(2)(iv) of this section means a 
stream of revenue (as computed under paragraph (b)(3)(ii) of this 
section) substantially all of which derives directly from the property. 
The phrase ``cash flow from the property'' does not include revenue if a 
significant portion thereof is derived from activities such as sales, 
labor, services, or the use of other property. Thus, revenue derived 
from the sale or lease of inventory or of similar property does not 
constitute cash flow from the property, including plant or equipment 
used in the manufacture and sale or lease, or purchase and sale or 
lease, of such inventory or similar property. In addition, revenue 
derived in part from the performance of services that are not ancillary 
and subsidiary to the use of property does not constitute cash flow from 
the property.
    (ii) Self-constructed assets. The activities associated with self-
construction of assets shall be considered to constitute labor or 
services for purposes of paragraph (b)(3)(i) only if the self-
constructed asset--
    (A) Is constructed for the purpose of resale, or
    (B) Without regard to purpose, is sold to an unrelated person within 
one year from the date that the property is placed in service for 
purposes of section 167.
    (iii) Computation of cash flow. Cash flow is computed by subtracting 
cash disbursements excluding debt service from cash receipts.
    (iv) Analysis of operating costs. [Reserved]
    (v) Examples. The principles of this paragraph may be demonstrated 
by the following examples.

    Example 1. In 1987, X borrows $100,000 in order to purchase an 
apartment building, which X then purchases. The loan is secured only by 
the building and the leases thereon. Annual debt service on the loan is 
$12,000. Annual gross rents from the building are $20,000. Annual taxes 
on the building are

[[Page 219]]

$2,000. Other expenses deductible under section 162 are $2,000. Rents 
are reasonably expected to remain stable or increase in subsequent 
years, and taxes and expenses are reasonably expected to remain 
proportional to gross rents in subsequent years. X provides security, 
maintenance, and utilities to the tenants of the building. Based on 
facts and circumstances, it is determined that, although services are 
provided to tenants, these services are ancillary and subsidiary to the 
occupancy of the apartments. Accordingly, the case flow of $16,000 is 
considered to constitute a return from the property. Furthermore, such 
cash flow is sufficient to fulfill the terms and conditions of the loan 
agreement as required by paragraph (b)(2)(iii).
    Example 2. In 1987, X borrows funds in order to purchase a hotel, 
which X then purchases and operates. The loan is secured only by the 
hotel. Based on facts and circumstances, it is determined that the 
operation of the hotel involves services the value of which is 
significant in relation to amounts paid to occupy the rooms. Thus, a 
significant portion of the cash flow is derived from the performance of 
services incidental to the occupancy of hotel rooms. Accordingly, the 
cash flow from the hotel is considered not to constitute a return on or 
from the property.
    Example 3. In 1987, X borrows funds in order to build a factory, 
which X then builds and operates. The loan is secured only by the 
factory and the equipment therein. Based on the facts and circumstances, 
it is determined that the operation of the factory involves significant 
expenditures for labor and raw materials. Thus, a significant portion of 
the cash flow is derived from labor and the processing of raw materials. 
Accordingly, the cash flow from the factory is considered not to 
constitute a return on or from the property.

    (4) Exclusions. The term ``qualified nonrecourse indebtedness'' 
shall not include any transaction that--
    (i) Lacks economic significance within the meaning of paragraph 
(b)(5) of this section;
    (ii) Involves cross collateralization within the meaning of 
paragraph (b)(6) of this section;
    (iii) Except in the case of a leveraged lease described in paragraph 
(b)(7)(ii) of this section, involves credit enhancement within the 
meaning of paragraph (b)(7) of this section or, with respect to loans 
made on or after October 14, 1988, does not under the terms of the loan 
documents, prohibit the acquisition by the holder of bond insurance or 
similar forms of credit enhancement;
    (iv) Involves the purchase of inventory;
    (v) Involves the purchase of any financial asset, including stock in 
a corporation, an interest in a partnership or a trust, or the debt 
obligation of any obligor (although interest incurred in order to 
purchase certain financial instruments may qualify for direct allocation 
under paragraph (c) of this section);
    (vi) Involves interest expense that constitutes qualified residence 
interest as defined in section 163(h)(3); or
    (vii) [Reserved]
    (5) Economic significance. Indebtedness that otherwise qualifies 
under paragraph (b)(2) shall nonetheless be subject to apportionment 
under Sec.  1.861-9T if, taking into account all the facts and 
circumstances, the transaction (including the security arrangement) 
lacks economic significance.
    (6) Cross collateralization. The term ``cross collateralization'' 
refers to the pledge as security for a loan of--
    (i) Any asset of the borrower other than the identified property 
described in paragraph (b)(2) of this section, or
    (ii) Any asset belonging to any related person, as defined in Sec.  
1.861-8T(c)(2).
    (7) Credit enhancement--(i) In general. Except as provided in 
paragraph (b)(7)(ii) of this section, the term ``credit enhancement'' 
refers to any device, including a contract, letter of credit, or 
guaranty, that expands the creditor's rights, directly or indirectly, 
beyond the identified property purchased, constructed, or improved with 
the funds advanced and, thus effectively provides as security for a loan 
the assets of any person other than the borrower. The acquisition of 
bond insurance or any other contract of suretyship by an initial or 
subsequent holder of an obligation shall constitute credit enhancement.
    (ii) Special rule for leveraged leases. For purposes of this 
paragraph (b), the term ``credit enhancement'' shall not include any 
device under which any person that is not a related person within the 
meaning of Sec.  1.861-8T(c)(2) agrees to guarantee, without recourse to 
the lessor or any person related to the lessor, a lessor's payment of 
principal and interest on indebtedness that

[[Page 220]]

was incurred in order to purchase or improve an asset that is 
depreciable tangible personal property or depreciable tangible real 
property (and the land on which such real property is situated) that is 
leased to a lessee that is not a related person in a transaction that 
constitutes a lease for federal income tax purposes.
    (iii) Syndication of credit risk and sale of loan participations. 
The term ``syndication of credit risk'' refers to an arrangement in 
which one primary lender secures the promise of a secondary lender to 
bear a portion of the primary lender's credit risk on a loan. The term 
``sale of loan participations'' refers to an arrangement in which one 
primary lender divides a loan into several portions, sells and assigns 
all rights with respect to one or more portions to participating 
secondary lenders, and does not remain at risk in any manner with 
respect to the portion assigned. For purposes of this paragraph (b), the 
syndication of credit risk shall constitute credit enhancement because 
the primary lender can look to secondary lenders for payment of the 
loan, notwithstanding limitations on the amount of the secondary 
lender's liability. Conversely, the sale of loan participations does not 
constitute credit enhancement, because the holder of each portion of the 
loan can look solely to the asset securing the loan and not to the 
credit or other assets of any person.
    (8) Other arrangements that do not constitute cross 
collateralization or credit enhancement. For purposes of paragraphs (b) 
(6) and (7) of this section, the following arrangements do not 
constitute cross collateralization or credit enhancement:
    (i) Integrated projects. A taxpayer's pledge of multiple assets of 
an integrated project, provided that the integrated project. An 
integrated project consists of functionally related and geographically 
contiguous assets that, as to the taxpayer, are used in the same trade 
or business.
    (ii) Insurance. A taxpayer's purchase of third-party casualty and 
liability insurance on the collateral or, by contract, bearing the risk 
of loss associated with destruction of the collateral or with respect to 
the attachment of third party liability claims.
    (iii) After-acquired property. Extension of a creditor's security 
interest to improvements made to the collateral, provided that the 
extension does not constitute excess collateralization under paragraph 
(b)(6), determined by taking into account the value of improvements at 
the time the improvements are made and the value of the original 
property at the time the loan was made.
    (iv) Warranties of completion and maintenance. A taxpayer's warranty 
to a creditor that it will complete construction or manufacture of the 
collateral or that it will maintain the collateral in good condition.
    (v) Substitution of collateral. A taxpayer's right to substitute 
collateral under any loan contract. However, after the right is 
exercised, the loan shall no longer constitute qualified nonrecourse 
indebtedness.
    (9) Refinancings. If a taxpayer refinances qualified nonrecourse 
indebtedness (as defined in paragraph (b)(2) of this section) with new 
indebtedness, such new indebtedness shall continue to qualify only if--
    (i) The principal amount of the new indebtedness does not exceed by 
more than five percent the remaining principal amount of the original 
indebtedness,
    (ii) The term of the new indebtedness does not exceed by more than 
six months the remaining term of the original indebtedness, and
    (iii) The requirements of this paragraph (other than those of 
paragraph (b)(2) (i) and (ii) of this section) are satisfied at the time 
of the refinancing, and the exclusions contained in this paragraph 
(b)(4) do not apply.
    (10) Post-construction permanent financing. Financing that is 
obtained after the completion of constructed property will be deemed to 
satisfy the requirements of paragraph (b)(2) (i) and (ii) of this 
section if--
    (i) The financing is obtained within one year after the constructed 
property or substantially all of a constructed integrated project (as 
defined in paragraph (b)(9)(i) of this section) is placed in service for 
purposes of section 167; and

[[Page 221]]

    (ii) The financing does not exceed the cost of construction 
(including construction period interest).
    (11) Assumptions of pre-existing qualified nonrecourse indebtedness. 
If a transferee of property that is subject to qualified nonrecourse 
indebtedness assumes such indebtedness, the indebtedness shall continue 
to constitute qualified nonrecourse indebtedness, provided that the 
assumption in no way alters the qualified status of the debt.
    (12) Excess collateralization. [Reserved]
    (c) Direct allocations in the case of certain integrated financial 
transactions--(1) General rule. Interest expense incurred on funds 
borrowed in connection with an integrated financial transaction (as 
defined in paragraph (c)(2) of this section) shall be directly allocated 
to the income generated by the investment funded with the borrowed 
amounts.
    (2) Definition. The term ``integrated financial transaction'' refers 
to any transaction in which--
    (i) The taxpayer--
    (A) Incurs indebtedness for the purpose of making an identified term 
investment,
    (B) Identifies the indebtedness as incurred for such purpose at the 
time the indebtedness is incurred, and
    (C) Makes the identified term investment within ten business days 
after incurring the indebtedness;
    (ii) The return on the investment is reasonably expected to be 
sufficient throughout the term of the investment to fulfill the terms 
and conditions of the loan agreement with respect to the amount and 
timing of payments of principal and interest or original issue discount;
    (iii) The income constitutes interest or original issue discount or 
would constitute income equivalent to interest if earned by a controlled 
foreign corporation (as described in Sec.  1.954-2T(h));
    (iv) The debt incurred and the investment mature within ten business 
days of each other;
    (v) The investment does not relate in any way to the operation of, 
and is not made in the normal course of, the trade or business of the 
taxpayer or any related person, including the financing of the sale of 
goods or the performance of services by the taxpayer or any related 
person, or the compensation of the taxpayer's employees (including any 
contribution or loan to an employee stock ownership plan (as defined in 
section 4975(e)(7)) or other plan that is qualified under section 
401(a)); and
    (vi) The borrower does not constitute a financial services entity 
(as defined in section 904 and the regulations thereunder).
    (3) Rollovers. In the event that a taxpayer sells of otherwise 
liquidates an investment described in paragraph (c)(2) of this section, 
the interest expense incurred on the borrowing shall, subsequent to that 
liquidation, no longer qualify for direct allocation under this 
paragraph (c).
    (4) Examples. The principles of this paragraph (c) may be 
demonstrated by the following examples.

    Example 1. X is a manufacturer and does not constitute a financial 
services entity as defined in the regulations under section 904. On 
January 1, 1988, X borrows $100 for 6 months at an annual interest rate 
of 10 percent. X identifies on its books and records by the close of 
that day that the indebtedness is being incurred for the purpose of 
making an investment that is intended to qualify as an integrated 
financial transaction. On January 5, 1988, X uses the proceeds to 
purchase a portfolio of stock that approximates the composition of the 
Standard & Poor's 500 Index. On that day, X also enters into a forward 
sale contract that requires X to sell the stock on June 1, 1988 for 
$110. X identifies on its books and records by the close of January 5, 
1988, that the portfolio stock purchases and the forward sale contract 
constitute part of the integrated financial transaction with respect to 
which the identified borrowing was incurred. Under Sec.  1.954-2T(h), 
the income derived from the transaction would constitute income 
equivalent to interest. Assuming that the return on the investment to be 
derived on June 1, 1988, will be sufficient to pay the interest due on 
June 1, 1988, the interest on the borrowing is directly allocated to the 
gain from the investment.
    Example 2. X does not constitute a financial services entity as 
defined in the regulations under section 904. X is in the business of, 
among other things, issuing credit cards to consumers and purchasing 
from merchants who accept the X card the receivables of consumers who 
make purchases with the X card. X borrows from Y in order to purchase X 
credit card receivables from Z, a merchant. Assuming that the Y 
borrowing satisfies the other requirements of paragraph


[[Page 222]]

(c)(2) of this section, the transaction nonetheless cannot constitute an 
integrated financial transaction because the purchase relates to the 
operation of X's trade or business.
    Example 3. Assume the same facts as in Example 2, except that X 
borrows in order to purchase the receivables of A, a merchant who does 
not accept the X card and is not otherwise engaged directly or 
indirectly in any business transaction with X. Because the borrowing is 
not related to the operation of X's trade or business, the borrowing may 
qualify as an integrated financial transaction if the other requirements 
of paragraph (c)(2) of this section are satisfied.

    (d) Special rules. In applying paragraphs (b) and (c) of this 
section, the following special rules shall apply.
    (1) Related person transactions. The rules of this section shall not 
apply to the extent that any transaction--
    (i) Involves either indebtedness between related persons (as defined 
in section Sec.  1.861-8T(c)(2)) or indebtedness incurred from unrelated 
persons for the purpose of purchasing property from a related person; or
    (ii) Involves the purchase of property that is leased to a related 
person (as defined in Sec.  1.861-8T(c)(2)) in a transaction described 
in paragraph (b) of this section. If a taxpayer purchases property and 
leases such property in whole or in part to a related person, a portion 
of the interest incurred in connection with such an acquisition, based 
on the ratio that the value of the property leased to the related person 
bears to the total value of the property, shall not qualify for direct 
allocation under this section.
    (2) Consideration of assets or income to which interest is directly 
allocated in apportioning other interest expense. In apportioning 
interest expense under Sec.  1.861-9T, the year-end value of any asset 
to which interest expense is directly allocated under this section 
during the current taxable year shall be reduced to the extent provided 
in Sec.  1.861-9T(g)(2)(iii) to reflect the portion of the principal 
amount of the indebtedness outstanding at year-end relating to the 
interest which is directly allocated. A similar adjustment shall be made 
to the end-of-year value of assets for the prior year for purposes of 
determining the beginning-of-year value of assets for the current year. 
These adjustments shall be made prior to averaging beginning-of-year and 
end-of-year values pursuant to Sec.  1.861-9T(g)(2). In apportioning 
interest expense under the modified gross income method, gross income 
shall be reduced by the amount of income to which interest expense is 
directly allocated under this section.
    (e) Treatment of certain related controlled foreign corporation 
indebtedness--(1) In general. In taxable years beginning after 1987, if 
a United States shareholder has incurred substantially disproportionate 
indebtedness in relation to the indebtedness of its related controlled 
foreign corporations so that such corporations have excess related 
person indebtedness (as determined under step 4 in subdivision (iv) of 
this paragraph (e)(1), the third party interest expense of the related 
United States shareholder (excluding amounts allocated under paragraphs 
(b) and (c)) in an amount equal to the interest income received on such 
excess related person indebtedness shall be allocated to gross income in 
the various separate limitation categories described in section 
904(d)(1) in the manner prescribed in step 6 in subdivision (vi) of this 
paragraph (e)(1). This computation shall be performed as follows.
    (i) Step 1: Compute the debt-to-asset ratio of the related United 
States shareholder. The debt-to-asset ratio of the related United States 
shareholder is the ratio between--
    (A) The average month-end debt level of the related United States 
shareholder taking into account debt owing to any obligee who is not a 
related person as defined in section Sec.  1.861-8T(c)(2), and
    (B) The value of assets (tax book or fair market) of the related 
United States shareholder including stockholdings and obligations of 
related controlled foreign corporations but excluding stockholdings and 
obligations of members of the affiliated group (as defined in Sec.  
1.861-11T(d)).
    (ii) Step 2: Compute aggregate debt-to-asset ratio of all related 
controlled foreign corporations. The aggregate debt-to-asset ratio of 
all related controlled foreign corporations is the ratio between--

[[Page 223]]

    (A) The average aggregate month-end debt level of all related 
controlled foreign corporations for their taxable years ending during 
the related United States shareholder's taxable year taking into account 
only indebtedness owing to persons other than the related United States 
shareholder or the related United States shareholder's other related 
controlled foreign corporations (``third party indebtedness''), and
    (B) The aggregate value (tax book or fair market) of the assets of 
all related controlled foreign corporations for their taxable years 
ending during the related United States shareholder's taxable year 
excluding stockholdings in and obligations of the related United States 
shareholder or the related United States shareholder's other related 
controlled foreign corporations.
    (iii) Step 3: Compute aggregate related person debt of all related 
controlled foreign corporations. This amount equals the average 
aggregate month-end debt level of all related controlled foreign 
corporations for their taxable years ending with or within the related 
United States shareholder's taxable year, taking into account only debt 
which is owned to the related United States shareholder (``related 
person indebtedness'').
    (iv) Step 4: Computation of excess related person indebtedness and 
computation of the income therefrom--(A) General rule. If the ratio 
computed under step 2 is less than applicable percentage of the ratio 
computed under step 1, the taxpayer shall add to the aggregate third 
party indebtedness of all related controlled foreign corporations 
determined under paragraph (e)(1)(ii)(A) of this section that portion of 
the related person indebtedness computed under step 3 that, when 
combined with the aggregate third party indebtedness of all controlled 
foreign corporations, makes the ratio computed under step 2 equal to 
applicable percentage of the ratio computed under step 1. The amount of 
aggregate related person debt that is so added to the aggregate third 
party debt of related controlled foreign corporations is considered to 
constitute excess related person indebtedness. For purposes of this 
paragraph (e)(1)(iv)(A), the term ``applicable percentage'' means the 
designated percentages for taxable years beginning during the following 
calendar years:

------------------------------------------------------------------------
                                                              Applicable
                 Taxable years beginning in                   percentage
------------------------------------------------------------------------
1988........................................................         50
1989........................................................         65
1990 and thereafter.........................................         80
------------------------------------------------------------------------

    (B) Elective quadratic formula. In calculating the amount of excess 
related party indebtedness of related controlled foreign corporations, 
the United States shareholder's debt-to-asset ratio may be adjusted to 
reflect the amount by which its debt and assets would be reduced had the 
related controlled foreign corporations incurred the excess related 
party indebtedness directly to third parties. In such case, the ratio 
computed in Step 1 is adjusted to reflect a reduction of both portions 
of the ratio by the amount of excess related person indebtedness as 
computed under this paragraph (e)(1)(ii)(A). Excess related person 
indebtedness may be computed under the following formula, under which 
excess related person indebtedness equals the smallest positive amount 
(not exceeding the aggregate amount of related controlled foreign 
corporation indebtedness) that is a solution to the following formula 
(with X equalling the amount of excess related person indebtedness):
[GRAPHIC] [TIFF OMITTED] TC14NO91.117


[[Page 224]]



Guidance concerning the solution of this equation is set forth in 
Example (2) of Sec.  1.861-12(k).
    (C) Computation of interest income received on excess related party 
indebtedness. The amount of interest income received on excess related 
person indebtedness equals the total interest income on related person 
indebtedness derived by the related United States shareholder during the 
taxable year multiplied by the ratio of excess related person 
indebtedness over the aggregate related person indebtedness for the 
taxable year.
    (v) Step 5: Determine the aggregate amount of related controlled 
foreign corporation obligations held by the related United States 
shareholder in each limitation category. The aggregate amount of related 
controlled foreign corporation obligations held by the related United 
States shareholder in each limitation category equals the sum of the 
value of all such obligations in each limitation category. Solely for 
purposes of this paragraph (e)(1)(v), each debt obligation in a related 
controlled foreign corporation held by a related United States 
shareholder shall be attributed to separate limitation categories in the 
same manner as the stock of the obligor would be attributed under the 
rules of Sec.  1.861-12T(c)(3), whether or nor such stock is held 
directly by such related United States shareholder.
    (vi) Step 6: Direct allocation of United States shareholder third 
party interest expense. Third party interest expense of the related 
United States shareholder equal to the amount of interest income 
received on excess related person indebtedness as determined in step 4 
shall be allocated among the various separate limitation categories in 
proportion to the relative aggregate amount of related controlled 
foreign corporation obligations held by the related United States 
shareholder in each such category, as determined under step 5. The 
remaining portion of third party interest expense will be apportioned as 
provided in Sec. Sec.  1.861-8T through 1.861-13T, excluding this 
paragraph.
    (2) Definitions--(i) United States shareholder. For purposes of this 
paragraph, the term ``United States shareholder'' has the same meaning 
as defined by section 957, except that, in the case of a United States 
shareholder that is a member an affiliated group (as defined in Sec.  
1.861-11T(d)), the entire affiliated group shall be considered to 
constitute a single United States shareholder. The term ``related United 
States shareholder'' is the United States shareholder (as defined in 
this paragraph (e)(2)(i)) with respect to which related controlled 
foreign corporations (as defined in paragraph (e)(2)(ii) of this 
section) are related within the meaning of that paragraph.
    (ii) Related controlled foreign corporation. For purposes of this 
section, the term ``related controlled foreign corporation'' means any 
controlled foreign corporation which is a related person (as defined in 
Sec.  1.861-8T(c)(2)) to a United States shareholder (as defined 
paragraph (e)(2)(i) of this section).
    (iii) Value of assets and amount of liabilities. For purposes of 
this section, the value of assets is determined under Sec.  1.861-9T(g). 
Thus, in the case of assets that are denominated in foreign currency, 
the average of the beginning-of-year and end-of-year values is 
determined in foreign currency and translated into dollars using 
exchange rates on the last day of the related United States 
shareholder's taxable year. In the case of liabilities that are 
denominated in foreign currency, the average month-end debt level of 
such liabilities is determined in foreign currency and then translated 
into dollars using exchange rates on the last day of the related United 
States shareholder's taxable year.
    (3) Treatment of certain stock. To the extent that there is 
insufficient related person indebtedness of all related controlled 
foreign corporations under step 3 in paragraph (e)(1)(iii) of this 
section to achieve as equal ratio in step 4 of paragraph (e)(1)(iv) of 
this section, certain stock held by the related United States 
shareholder will be treated as related person indebtedness. Such stock 
includes--
    (i) Any stock in the related controlled foreign corporation that is 
treated in the same manner as debt under the law of any foreign country 
that grants a deduction for interest or original issue discount relating 
to such stock, and

[[Page 225]]

    (ii) Any stock in a related controlled foreign corporation that has 
made loans to, or held stock described in this paragraph (e)(3) in, 
another related controlled foreign corporation. However, such stock 
shall be treated as related person indebtedness only to the extent of 
the principal amount of such loans.


For purposes of computing income from excess related person indebtedness 
in step 4 of paragraph (e)(1)(iv) of this section, stock that is treated 
under this paragraph as related person indebtedness shall be considered 
to yield interest in an amount equal to the interest that would be 
computed on an equal amount of indebtedness under section 1274. Only 
dividends actually paid thereon shall be included in gross income for 
other purposes.
    (4) Adjustments to assets in apportioning other interest expense. In 
apportioning interest expense under Sec.  1.861-9T, the value of assets 
in each separate limitation category for the taxable year as determined 
under Sec.  1.861-9T(g)(3) shall be reduced (but not below zero) by the 
principal amount of third party indebtedness of the related United 
States shareholder the interest expense on which is allocated to each 
such category under paragraph (e)(1) of this section.
    (5) Exceptions--(i) Per company rule. If--
    (A) A related controlled foreign corporation with obligations owing 
to a related United States shareholder has a greater proportion of 
passive assets than the proportion of passive assets held by the related 
United States shareholder,
    (B) Such passive assets are held in liquid or short term 
investments, and
    (C) There are frequent cash transfers between the related controlled 
foreign corporation and the related United States shareholder,


the Commissioner, in his discretion, may choose to exclude such a 
corporation from other related controlled foreign corporations in the 
application of the rules of this paragraph (e).
    (ii) Aggregate rule. If it is determined that, in aggregate, the 
application of the rules of this paragraph (e) increases a taxpayer's 
foreign tax credit as determined under section 901(a), the Commissioner, 
in his discretion, may choose not to apply the rules of this paragraph. 
If the Commissioner exercises discretion under this paragraph 
(e)(5)(ii), then paragraph (e) shall not apply to any extent to any 
interest expense of the taxpayer.
    (f) Effective/applicability date. (1) In general, the rules of this 
section apply for taxable years beginning after December 31, 1986.
    (2) Paragraphs (b)(3)(ii) (providing an operating costs test for 
purposes of the nonrecourse indebtedness exception) and (b)(6) 
(concerning excess collaterization of nonrecourse borrowings) of this 
section are applicable for taxable years commencing after December 31, 
1988.
    (3) Paragraph (e) (concerning the treatment of related controlled 
foreign corporation indebtedness) of this section is applicable for 
taxable years commencing after December 31, 1987. For rules for taxable 
years beginning before January 1, 1987, and for later years to the 
extent permitted by Sec.  1.861-13T, see Sec.  1.861-8 (revised as of 
April 1, 1986).

[T.D. 8228, 53 FR 35485, Sept. 14, 1988, as amended by T.D. 9456, 74 FR 
38875, Aug. 4, 2009]



Sec.  1.861-11  Special rules for allocating and apportioning interest expense 
of an affiliated group of corporations.

    (a)-(c) [Reserved]. For further guidance, see Sec.  1.861-11T(a) 
through (c).
    (d) Definition of affiliated group--(1) General rule. For purposes 
of this section, in general, the term affiliated group has the same 
meaning as is given that term by section 1504, except that section 936 
corporations are also included within the affiliated group to the extent 
provided in paragraph (d)(2) of this section. Section 1504(a) defines an 
affiliated group as one or more chains of includible corporations 
connected through 80-percent stock ownership with a common parent 
corporation which is an includible corporation (as defined in section 
1504(b)). In the case of a corporation that either becomes or ceases to 
be a member of the group during the course of the corporation's taxable 
year, only the interest expense

[[Page 226]]

incurred by the group member during the period of membership shall be 
allocated and apportioned as if all members of the group were a single 
corporation. In this regard, assets held during the period of membership 
shall be taken into account. Other interest expense incurred by the 
group member during its taxable year but not during the period of 
membership shall be allocated and apportioned without regard to the 
other members of the group.
    (2) Inclusion of section 936 corporations--(i) Rule--(A) In general. 
Except as otherwise provided in paragraph (d)(2)(i)(B) of this section, 
the exclusion of section 936 corporations from the affiliated group 
under section 1504(b)(4) does not apply for purposes of this section. 
Thus, a section 936 corporation that meets the ownership requirements of 
section 1504(a) is a member of the affiliated group.
    (B) Exception for purposes of alternative minimum tax. The exclusion 
from the affiliated group of section 936 corporations under section 
1504(b)(4) shall be operative for purposes of the application of this 
section solely in determining the amount of foreign source alternative 
minimum taxable income within each separate category and the alternative 
minimum tax foreign tax credit pursuant to section 59(a). Thus, a 
section 936 corporation that meets the ownership requirements of section 
1504(a) is not a member of the affiliated group for purposes of 
determining the amount of foreign source alternative minimum taxable 
income within each separate category and the alternative minimum tax 
foreign tax credit pursuant to section 59(a).
    (ii) Section 936 corporation defined. For purposes of this section, 
Sec.  1.861-9, and Sec.  1.861-14, the term section 936 corporation 
means, for any taxable year, a corporation with an election in effect to 
be eligible for the credit provided under section 936(a)(1) or section 
30A for the taxable year.
    (iii) Example. This example illustrates the provisions of paragraph 
(d)(2)(i) of this section:

    Example. (A) Facts. X owns all of the stock of Y. XY constitutes an 
affiliated group of corporations within the meaning of section 1504(a) 
and uses the tax book value method of apportionment. In 2000, Y owns all 
of the stock of Z, a section 936 corporation. Z manufactures widgets in 
Puerto Rico. Y purchases these widgets and markets them exclusively in 
the United States. Of the three corporations, only Z has foreign source 
income, which includes both qualified possessions source investment 
income and general limitation income. For purposes of section 904, Z's 
qualified possessions source investment income constitutes foreign 
source passive income. In computing the section 30A benefit, Y and Z 
have elected the cost sharing method. Of the three corporations, only X 
has debt and, thus, only X incurs interest expense.
    (B) Analysis for regular tax. Assume first that X has no alternative 
minimum tax liability. Under paragraph (d)(2) of this section, Z is 
treated as a member of the XY affiliated group for purposes of 
allocating and apportioning interest expense for regular tax purposes. 
As provided in Sec.  1.861-11T(b)(2), section 864(e)(1) and (5) do not 
apply in computing the combined taxable income of Y and Z under section 
936, but these rules do apply in computing the foreign source taxable 
income of the XY affiliated group. The effect of including Z in the 
affiliated group is that X, the only debtor corporation in the group, 
must, under the asset method described in Sec.  1.861-9T(g), apportion a 
part of its interest expense to foreign source passive income and 
foreign source general limitation income. This is because the assets of 
Z that generate qualified possessions source investment income and 
general limitation income are included in computing the group 
apportionment fractions. The result is that, under section 904(f), X has 
an overall foreign loss in both the passive and general limitation 
categories, which currently offsets domestic income and must be 
recaptured against any subsequent years' foreign passive income and 
general limitation income, respectively, under the rules of that 
section.
    (C) Analysis for alternative minimum tax. Assume, alternatively, 
that X is liable to pay the alternative minimum tax. Pursuant to section 
59(a), X must compute its alternative minimum tax foreign tax credit as 
if section 904 were applied on the basis of alternative minimum taxable 
income instead of taxable income. Under paragraph (d)(2)(i)(B) of this 
section, for purposes of the apportionment of interest expense in 
determining alternative minimum taxable income within each limitation 
category, Z is not considered a member of the XY affiliated group. Thus, 
the stock (and not the assets) of Z are included in computing the group 
apportionment fractions. Pursuant to sections 59(g)(4)(C)(iii)(IV), 
861(a)(2)(A), and 862(a)(2), dividends paid by a section 936 corporation 
are foreign source income subject to a separate foreign tax credit 
limitation for alternative minimum tax purposes. Thus, under

[[Page 227]]

Sec.  1.861-9T(g)(3), the stock of Z must be considered attributable 
solely to the statutory grouping consisting of foreign source dividends 
from Z. The effect of excluding Z from the affiliated group is that X 
must apportion a part of its interest expense to the separate category 
for foreign source dividends from Z in computing alternative minimum 
taxable income within each separate category. If, as a result, under 
section 904(f), X has a separate limitation loss or an overall foreign 
loss in the category for dividends from Z for alternative minimum tax 
purposes, then that loss must be allocated against X's other income 
(separate limitation or United States source, as the case may be). The 
loss must be recaptured in subsequent years under the rules of section 
904(f) for purposes of the alternative minimum tax foreign tax credit. * 
* *

    (iv) Effective date. This paragraph (d)(2) applies to taxable years 
beginning after December 31, 1989.
    (d)(3) through (6)(i) [Reserved]. For further guidance see Sec.  
1.861-11T(d)(3) through (6)(i).
    (ii) Any foreign corporation if more than 50 percent of the gross 
income of such foreign corporation for the taxable year is effectively 
connected with the conduct of a trade or business within the United 
States and at least 80 percent of either the vote or value of all 
outstanding stock of such foreign corporation is owned directly or 
indirectly by members of the affiliated group (determined with regard to 
this sentence). This paragraph (d)(6)(ii) applies to taxable years 
beginning on or after July 16, 2014. See 26 CFR 1.861-11T(d)(6)(ii) 
(revised as of April 1, 2014) for rules applicable to taxable years 
beginning after August 10, 2010, and before July 16, 2014. See 26 CFR 
1.861-11T(d)(6)(ii) (revised as of April 1, 2010) for rules applicable 
to taxable years beginning on or before August 10, 2010.
    (7) Special rules for the application of Sec.  1.861-11T(d)(6). The 
attribution rules of section 1563(e) and the regulations under that 
section shall apply in determining indirect ownership under Sec.  1.861-
11T(d)(6). The Commissioner shall have the authority to disregard 
trusts, partnerships, and pass-through entities that break affiliated 
status. Corporations described in Sec.  1.861-11T(d)(6) shall be 
considered to constitute members of an affiliated group that does not 
file a consolidated return and shall therefore be subject to the 
limitations imposed under Sec.  1.861-11T(g). The affiliated group 
filing a consolidated return shall be considered to constitute a single 
corporation for purposes of applying the rules of Sec.  1.861-11T(g). 
For taxable years beginning after December 31, 1989, Sec.  1.861-
11T(d)(6)(i) shall not apply in determining foreign source alternative 
minimum taxable income within each separate category and the alternative 
minimum tax foreign tax credit pursuant to section 59(a) to the extent 
that such application would result in the inclusion of a section 936 
corporation within the affiliated group. This paragraph (d)(7) applies 
to taxable years beginning after December 31, 1986.
    (e)-(g) [Reserved]. For further guidance, see Sec.  1.861-11T(e) 
through (g).

[T.D. 8916, 66 FR 273, Jan. 3, 2001, as amended by T.D. 9676, 79 FR 
41426, July 16, 2014]



Sec.  1.861-11T  Special rules for allocating and apportioning 
interest expense of an affiliated group of corporations (temporary).

    (a) In general. Sections 1.861-9T, 1.861-10T, 1.861-12T, and 1.861-
13T provide rules that are generally applicable in apportioning interest 
expense. The rules of this section relate to affiliated groups of 
corporations and implement section 864(e) (1) and (5), which requires 
affiliated group allocation and apportionment of interest expense. The 
rules of this section apply to taxable years beginning after December 
31, 1986, except as otherwise provided in Sec.  1.861-13T. Paragraph (b) 
of this section describes the scope of the application of the rule for 
the allocation and apportionment of interest expense of affiliated 
groups of corporations, which is contained in paragraph (c) of this 
section. Paragraph (d) of this section sets forth the definition of the 
term ``affiliated group'' for purposes of this section. Paragraph (e) 
describes the treatment of loans between members of an affiliated group. 
Paragraph (f) of this section provides rules concerning the affiliated 
group allocation and apportionment of interest expense in computing the 
combined taxable income of a FSC or DISC and its related supplier. 
Paragraph (g) of this section describes the treatment of losses caused 
by apportionment of interest expense in the

[[Page 228]]

case of an affiliated group that does not file a consolidated return.
    (b) Scope of application--(1) Application of section 864(e) (1) and 
(5) (concerning the definition and treatment of affiliated groups). 
Section 864(e) (1) and (5) and the portions of this section implementing 
section 864(e) (1) and (5) apply to the computation of foreign source 
taxable income for purposes of section 904 (relating to various 
limitations on the foreign tax credit). Section 904 imposes separate 
foreign tax credit limitations on passive income, high withholding 
interest income, financial services income, shipping income, income 
consisting of dividends from each noncontrolled section 902 corporation, 
income consisting of dividends from a DISC or former DISC, taxable 
income attributable to foreign trade income within the meaning of 
section 923(b), distributions from a FSC or former FSC, and all other 
forms of foreign source income not enumerated above (``general 
limitation income''). Section 864(e) (1) and (5) and the portions of 
this section implementing section 864(e) (1) and (5) also apply in 
connection with section 907 to determine reductions in the amount 
allowed as a foreign tax credit under section 901. Section 864(e) (1) 
and (5) and the portions of this section implementing section 864(e) (1) 
and (5) also apply to the computation of the combined taxable income of 
the related supplier and a foreign sales corporation (FSC) (under 
sections 921 through 927) as well as the combined taxable income of the 
related supplier and a domestic international sales corporation (DISC) 
(under sections 991 through 997).
    (2) Nonapplication of section 864(e) (1) and (5) (concerning the 
definition and treatment of affiliated groups). Section 864(e) (1) and 
(5) and the portions of this section implementing section 864(e) (1) and 
(5) do not apply to the computation of subpart F income of controlled 
foreign corporations (under sections 951 through 964), the computation 
of combined taxable income of a possessions corporation and its 
affiliates (under section 936), or the computation of effectively 
connected taxable income of foreign corporations. For the rules with 
respect to the allocation and apportionment of interest expenses of 
foreign corporations other than controlled foreign corporations, see 
Sec. Sec.  1.882-4 and 1.882-5.
    (c) General rule for affiliated corporations. Except as otherwise 
provided in this section, the taxable income of each member of an 
affiliated group within each statutory grouping shall be determined by 
allocating and apportioning the interest expense of each member 
according to apportionment fractions which are computed as if all 
members of such group were a single corporation. For purposes of 
determining these apportionment fractions, stock in corporations within 
the affiliated group (as defined in section 864(e)(5) and the rules of 
this section) shall not be taken into account. In the case of an 
affiliated group of corporations that files a consolidated return, 
consolidated foreign tax credit limitations are computed for the group 
in accordance with the rules of Sec.  1.1502-4. Except as otherwise 
provided, all the interest expense of all members of the group will be 
treated as definitely related and therefore allocable to all the gross 
income of the members of the group and all the assets of all the members 
of the group shall be taken into account in apportioning this interest 
expense. For purposes of this section, the term ``taxpayer'' refers to 
the affiliated group (regardless of whether the group files a 
consolidated return), rather than to the separate members thereof.
    (d)(1)-(2) [Reserved]. For further guidance, see Sec.  1.861-
11(d)(1) and (2).
    (3) Treatment of life insurance companies subject to taxation under 
section 801--(i) General rule. A life insurance company that is subject 
to taxation under section 801 shall be considered to constitute a member 
of the affiliated group composed of companies not taxable under section 
801 only if a parent corporation so elects under section 1504(c)(2)(A) 
of the Code. If a parent does not so elect, no adjustments shall be 
required with respect to such an insurance company under paragraph (g) 
of this section.
    (ii) Treatment of stock. Stock of a life insurance company that is 
subject to taxation under section 801 that is not included in an 
affiliated group shall be

[[Page 229]]

disregarded in the allocation and apportionment of the interest expense 
of such affiliated group.
    (4) Treatment of certain financial corporations--(i) In general. In 
the case of an affiliated group (as defined in paragraph (d)(1) of this 
section), any member that constitutes financial corporations as defined 
in paragraph (d)(4)(ii) of this section shall be treated as a separate 
affiliated group consisting of financial corporations (the ``financial 
group''). The members of the group that do not constitute financial 
corporations shall be treated as members of a separate affiliated group 
consisting of nonfinancial corporations (``the nonfinancial group'').
    (ii) Financial corporation defined. The term ``financial 
corporation'' means any corporation which meets all of the following 
conditions:
    (A) It is described in section 581 (relating to the definition of a 
bank) or section 591 (relating to the deduction for dividends paid on 
deposits by mutual savings banks, cooperative banks, domestic building 
and loan associations, and other savings institutions chartered and 
supervised as savings and loan or similar associations);
    (B) Its business is predominantly with persons other than related 
persons (within the meaning of section 864(d)(4) and the regulations 
thereunder) or their customers; and
    (C) It is required by state or Federal law to be operated separately 
from any other entity which is not such an institution.
    (iii) Treatment of bank holding companies. The total aggregate 
interest expense of any member of an affiliated group that constitutes a 
bank holding company subject to regulation under the Bank Holding 
Company Act of 1956 shall be prorated between the financial group and 
the nonfinancial group on the basis of the assets in the financial and 
nonfinancial groups. For purposes of making this proration, the assets 
of each member of each group, and not the stock basis in each member, 
shall be taken into account. Any direct or indirect subsidiary of a bank 
holding company that is predominantly engaged in the active conduct of a 
banking, financing, or similar business shall be considered to be a 
financial corporation for purposes of this paragraph (d)(4). The 
interest expense of the bank holding company must be further apportioned 
in accordance with Sec.  1.861-9T(f) to the various section 904(d) 
categories of income contained in both the financial group and the 
nonfinancial group on the basis of the assets owned by each group. For 
purposes of computing the apportionment fractions for each group, the 
assets owned directly by a bank holding company within each limitation 
category described in section 904(d)(1) (other than stock in affiliates 
or assets described in Sec.  1.861-9T(f)) shall be treated as owned pro 
rata by the nonfinancial group and the financial group based on the 
relative amounts of investments of the bank holding company in the 
nonfinancial group and financial group.
    (iv) Consideration of stock of the members of one group held by 
members of the other group. In apportioning interest expense, the 
nonfinancial group shall not take into account the stock of any lower-
tier corporation that is treated as a member of the financial group 
under paragraph (d)(4)(i) of this section. Conversely, in apportioning 
interest expense, the financial group shall not take into account the 
stock of any lower-tier corporation that is treated as a member of the 
nonfinancial group under paragraph (d)(4)(i) of this section. For the 
treatment of loans between members of the financial group and members of 
the nonfinancial group, see paragraph (e)(1) of this section.
    (5) Example. (i) Facts. X, a domestic corporation which is not a 
bank holding company, is the parent of domestic corporations Y and Z. Z 
owns 100 percent of the stock Z1, which is also a domestic corporation. 
X, Y, Z, and Z1 were organized after January 1, 1987, and constitute an 
affiliated group within the meaning of paragraph (d)(1) of this section. 
Y and Z are financial corporations described in paragraph (d)(4) of this 
section. X also owns 25 percent of the stock of A, a domestic 
corporation. Y owns 25 percent of the voting stock of B, a foreign 
corporation that is not a controlled foreign corporation.

[[Page 230]]

Z owns less than 10 percent of the voting stock of C, another foreign 
corporation. The foreign source income generated by Y's or Z's direct 
assets is exclusively financial services income. The foreign source 
income generated by X's or Z1's direct assets is exclusively general 
limitation income. X and Z1 are not financial corporations described in 
paragraph (d)(4)(ii) of this section. Y and Z, therefore, constitute a 
separate affiliated group apart from X and Z1 for purposes of section 
864(e). The combined interest expense of Y and Z of $100,000 ($50,000 
each) is apportioned separately on the basis of their assets. The 
combined interest expense of X and Z1 of $50,000 ($25,000 each) is 
allocated on the basis of the assets of the XZ1 group.

                     Analysis of the YZ group assets
 
Adjusted basis of assets of the YZ group that generate          $200,000
 foreign source financial services income (excluding stock
 of foreign subsidiaries not included in the YZ affiliated
 group)....................................................
Z's basis in the C stock (not adjusted by the allocable         $100,000
 amount of C's earnings and profits because Z owns less
 than 10 percent of the stock) which would be considered to
 generate passive income in the hands of a nonfinancial
 services entity but is considered to generate financial
 services income when in the hands of Z, a financial
 services entity...........................................
Y's basis in the B stock (adjusted by the allocable amount      $100,000
 of B's earnings and profits) which generates dividends
 subject to a separate limitation for B dividends..........
Adjusted basis of assets of the YZ group that generate U.S.     $600,000
 source income.............................................
                                                            ------------
      Total assets.........................................   $1,000,000
 
                    Analysis of the XZ1 group assets
 
Adjusted basis of assets of the XZ1 group that generate         $500,000
 foreign source general limitation income..................
Adjusted basis of assets of the XZ1 group other than A        $1,900,000
 stock that generate domestic source income................
X's basis in the A stock adjusted by the allocable amount       $100,000
 of A's earnings and profits...............................
                                                            ------------
      Total domestic assets................................   $2,000,000
                                                            ------------
      Total assets.........................................   $2,500,000
 

    (ii) Allocation. No portion of the $50,000 deduction of the YZ group 
is definitely related solely to specific property within the meaning of 
Sec.  1.861-10T. Thus, the YZ group's deduction for interest is related 
to all its activities and properties. Similarly, no portion of the 
$50,000 deduction of the XZ1 group is definitely related solely to 
specific property within the meaning of Sec.  1.861-10T. Thus, the XZ1 
group's deduction for interest is related to all its activities and 
properties.
    (iii) Apportionment. The YZ group would apportion its interest 
expense as follows:

To gross financial services income from sources outside the United 
    States:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.004
    
To gross income subject to a separate limitation for dividends from B:
[GRAPHIC] [TIFF OMITTED] TC07OC91.005

To gross income from sources inside the United States:
[GRAPHIC] [TIFF OMITTED] TC07OC91.006

    The XZ1 group would apportion its interest expense as follows:

To gross general limitation income from sources outside the United 
    States:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.007
    
To gross income from sources inside the United States:
[GRAPHIC] [TIFF OMITTED] TC07OC91.008

    (6) Certain unaffiliated corporations. Certain corporations that are 
not described in paragraph (d)(1) of this section will nonetheless be 
considered to constitute affiliated corporations for purposes of 
Sec. Sec.  1.861-9T through 1.861-13T. These corporations include:

[[Page 231]]

    (i) Any includible corporation (as defined in section 1504(b) 
without regard to section 1504(b)(4)) if 80 percent of either the vote 
or value of all outstanding stock of such corporation is owned directly 
or indirectly by an includible corporation or by members of an 
affiliated group, and
    (ii) [Reserved]. For further guidance see Sec.  1.861-11(d)(6)(ii).
    (7) Special rules for the application of Sec.  1.861-11T(d)(6). 
[Reserved]. For special rules for the application of Sec.  1.861-
11T(d)(6), see Sec.  1.861-11(d)(7).
    (e) Loans between members of an affiliated group--(1) General rule. 
In the case of loans (including any receivable) between members of an 
affiliated group, as defined in paragraph (d) of this section, for 
purposes of apportioning interest expense, the indebtedness of the 
member borrower shall not be considered an asset of the member lender. 
However, in the case of members of separate financial and nonfinancial 
groups under paragraph (d)(4) of this section, the indebtedness of the 
member borrower shall be considered an asset of the member lender and 
such asset shall be characterized by reference to the member lender's 
income from the asset as determined under paragraph (e)(2)(ii) of this 
section. For purposes of this paragraph (e), the terms ``related person 
interest income'' and ``related person interest payment'' refer to 
interest paid and received by members of the same affiliated group as 
defined in paragraph (d) of this section.
    (2) Treatment of interest expense within the affiliated group--(i) 
General rule. A member borrower shall deduct related person interest 
payments in the same manner as unrelated person interest expense using 
group apportionment fractions computed under Sec.  1.861-9T(f). A member 
lender shall include related person interest income in the same class of 
gross income as the class of gross income from which the member borrower 
deducts the related person interest payment.
    (ii) Special rule for loans between financial and nonfinancial 
affiliated corporations. In the case of a loan between two affiliated 
corporations only one of which constitutes a financial corporation under 
paragraph (d)(4) of this section, the member borrower shall allocate and 
apportion related person interest payments in the same manner as 
unrelated person interest expense using group apportionment fractions 
computed under Sec.  1.861-9T(f). The source of the related person 
interest income to the member lender shall be determined under section 
861(a)(1).
    (iii) Special rule for high withholding tax interest. In the case of 
an affiliated corporation that pays interest that is high withholding 
tax interest under Sec.  1.904-5(f)(1) to another affiliated 
corporation, the interest expense of the payor shall be allocated to 
high withholding tax interest.
    (3) Back-to-back loans. If a member of the affiliated group makes a 
loan to a nonmember who makes a loan to a member borrower, the rule of 
paragraphs (e) (1) and (2) of this section shall apply, in the 
Commissioner's discretion, as if the member lender made the loan 
directly to the member borrower, provided that the loans constitute a 
back-to-back loan transaction. Such loans will constitute a back-to-back 
loan for purposes of this paragraph (e) if the loan by the nonmember 
would not have been made or maintained on substantially the same terms 
irrespective of the loan of funds by the lending member to the nonmember 
or other intermediary party.
    (4) Examples. The rules of this paragraph (e) may be illustrated by 
the following examples.

    Example 1. X, a domestic corporation, is the parent of Y, a domestic 
corporation. X and Y were organized after January 1, 1987, and 
constitute an affiliated group within the meaning of paragraph (d)(1) of 
this section. Among X's assets is the note of Y for the amount of 
$100,000. Because X and Y are members of an affiliated group, Y's note 
does not constitute an asset for purposes of apportionment. The 
apportionment fractions for the relevant tax year of the XY group are 50 
percent domestic, 40 percent foreign general, and 10 percent foreign 
passive. Y deducts its related person interest payment using those 
apportionment fractions. Of the $10,000 in related person interest 
income received by X, $5,000 consists of domestic source income, $4,000 
consists of foreign general limitation income, and $1,000 consists of 
foreign passive income.
    Example 2. X is a domestic corporation organized after January 1, 
1987. X owns all the stock of Y, a domestic corporation. On June

[[Page 232]]

1, 1987, X loans $100,000 to Z, an unrelated person. On June 2, 1987, Z 
makes a loan to Y with terms substantially similar to those of the loan 
from X to Z. Based on the facts and circumstances of the transaction, it 
is determined that Z would not have made the loan to Y on the same terms 
if X had not made the loan to Z. Because the transaction constitutes a 
back-to-back loan, as defined in paragraph (e)(3) of this section, the 
Commissioner may require, in his discretion, that neither the note of Y 
nor the note of Z may be considered an asset of X for purposes of this 
section.

    (f) Computations of combined taxable income. In the computation of 
the combined taxable income of any FSC or DISC and its related supplier 
which is a member of an affiliated group under the pricing rules of 
sections 925 or 994, the combined taxable income of such FSC or DISC and 
its related supplier shall be reduced by the portion of the total 
interest expense of the affiliated group that is incurred in connection 
with those assets of the group used in connection with export sales 
involving that FSC or DISC. This amount shall be computed by multiplying 
the total interest expense of the affiliated group and interest expense 
of the FSC or DISC by a fraction the numerator of which is the assets of 
the affiliated group and of the FSC or DISC generating foreign trade 
income or gross income attributable to qualified export receipts, as the 
case may be, and the denominator of which is the total assets of the 
affiliated group and the FSC or DISC. Under this rule, interest of other 
group members may be attributed to the combined taxable income of a FSC 
or DISC and its related supplier without affecting the amount of 
interest otherwise deductible by the FSC or DISC, the related supplier 
or other member of the affiliated group. The FSC or DISC is entitled to 
only the statutory portion of the combined taxable income, net of any 
deemed interest expense, which determines the commission paid to the FSC 
or DISC or the transfer price of qualifying export property sold to the 
FSC or DISC.
    (g) Losses created through apportionment--(1) General rules. In the 
case of an affiliated group that is eligible to file, but does not file, 
a consolidated return and in the case of any corporation described in 
paragraph (d)(6) of this section, the foreign tax credits in any 
separate limitation category are limited to the credits computed under 
the rules of this paragraph (g). As a consequence of the affiliated 
group allocation and apportionment of interest expense required by 
section 864(e)(1) and this section, interest expense of a group member 
may be apportioned for section 904 purposes to a limitation category in 
which that member has no gross income, resulting in a loss in that 
limitation category. The same is true in connection with any expense 
other than interest that is subject to apportionment under the rules of 
section 864(e)(6) of the Code. Any reference to ``interest expense'' in 
this paragraph (g) shall be treated as including such expenses. For 
purposes of this paragraph, the term ``limitation category'' includes 
domestic source income, as well as the types of income described in 
section 904(d)(1) (A) through (I). A loss of one affiliate in a 
limitation category will reduce the income of another member in the same 
limitation category if a consolidated return is filed. (See Sec.  
1.1502-4.) If a consolidated return is not filed, this netting does not 
occur. Accordingly, in such a case, the following adjustments among 
members are required in order to give effect to the group allocation of 
interest expense:
    (i) Losses created through group apportionment of interest expense 
in one or more limitation categories within a given member must be 
eliminated; and
    (ii) A corresponding amount of income of other members in the same 
limitation category must be recharacterized.


Such adjustments shall be accomplished, in accordance with paragraph 
(g)(2) of this section, without changing the total taxable income of any 
member and before the application of section 904(f). Section 904(f) 
(including section 904(f)(5)) does not apply to a loss created through 
the apportionment of interest expense to the extent that the loss is 
eliminated pursuant to paragraph (g)(2)(ii) of this section. For 
purposes of this section, the terms ``limitation adjustment'' and 
``recharacterization'' mean the recharacterization of income in one 
limitation category as income in another limitation category.

[[Page 233]]

    (2) Mechanics of computation--(i) Step 1: Computation of 
consolidated taxable income. The members of an affiliated group must 
first allocate and apportion all other deductible expenses other than 
interest. The members must then deduct from their respective gross 
incomes within each limitation category interest expense apportioned 
under the rules of Sec.  1.861-9T(f). The taxable income of the entire 
affiliated group within each limitation category is then totalled.
    (ii) Step 2: Loss offset adjustments. If, after step 1, a member has 
losses in a given limitation category or limitation categories created 
through apportionment of interest expense, any such loss (i.e., the 
portion of such loss equal to interest expense) shall be eliminated by 
offsetting that loss against taxable income in other limitation 
categories of that member to the extent of the taxable income of other 
members within the same limitation category as the loss. If the member 
has taxable income in more than one limitation category, then the loss 
shall offset taxable income in all such limitation categories on a pro 
rata basis. If there is insufficient domestic income of the member to 
offset the net losses in all foreign limitation categories caused by the 
apportionment of interest expense, the losses in each limitation 
category shall be recharacterized as domestic losses to the extent of 
the taxable income of other members in the same respective limitation 
categories. After these adjustments are made, the income of the entire 
affiliated group within each limitation category is totalled again.
    (iii) Step 3: Determination of amount subject to recharacterization. 
In order to determine the amount of income to be recharacterized in step 
4, the income totals computed under step 1 in each limitation category 
shall be subtracted from the income totals computed under step 2 in each 
limitation category.
    (iv) Step 4: Recharacterization. Because any differences determined 
under step 3 represent deviations from the consolidated totals computed 
under Step 1, such differences (in any limitation category) must be 
eliminated.
    (A) Limitation categories to be reduced. In the case of any 
limitation category in which there is a positive change, the income of 
group members with income in that limitation category must be reduced on 
a pro rata basis (by reference to net income figures as determined under 
Step 2) to the extent of such positive change (``limitation 
reductions''). Each member shall separately compute the sum of the 
limitation reductions.
    (B) Limitation categories to be increased. In any case in which only 
one limitation category has a negative change in Step 3, the sum of the 
limitation reductions within each member is added to that limitation 
category. In the case in which multiple limitation categories have 
negative changes in Step 3, the sum of the limitation reductions within 
each member is prorated among the negative change limitation categories 
based on the ratio that the negative change for the entire group in each 
limitation category bears to the total of all negative changes for the 
entire group in all limitation categories.
    (3) Examples. The following examples illustrate the principles of 
this paragraph.

    Example 1. (i) Facts. X, a domestic corporation, is the parent of 
domestic corporations Y and Z. X, Y, and Z were organized after Janaury 
1, 1987, constitute an affiliated group within the meaning of paragraph 
(d)(1) of this section, but do not file a consolidated return. The XYZ 
group apportions its interest expense on the basis of the fair market 
value of its assets. X, Y, and Z have the following assets, interest 
expense, and taxable income before apportioning interest expense:

------------------------------------------------------------------------
              Assets                   X        Y         Z       Total
------------------------------------------------------------------------
Domestic.........................  2,000.00     0     1,000.00  3,000.00
Foreign Passive..................      0       50.00     50.00    100.00
Foreign General..................      0      700.00    200.00    900.00
Interest expense.................     48.00    12.00     80.00    140.00
Taxable Income (pre-interest):
  Domestic.......................    100.00     0        63.00    163.00
  Foreign Passive................      0        5.00      5.00     10.00
  Foreign General................      0       60.00     35.00     95.00
------------------------------------------------------------------------

    (ii) Step 1: Computation of consolidated taxable income. Each member 
of the XYZ group apportions its interest expense according to group 
apportionment ratios determined under the asset method decribed in Sec.  
1.861-9T(f), yielding the following results:

------------------------------------------------------------------------
     Apportioned interest expense          X       Y       Z      Total
------------------------------------------------------------------------
Domestic..............................   36.00    9.00   60.00    105.00
Foreign Passive.......................    1.20    0.30    2.00      3.50

[[Page 234]]

 
Foreign General.......................   10.80    2.70   18.00     31.50
                                       ---------------------------------
    Total.............................   48.00   12.00   80.00    140.00
------------------------------------------------------------------------

    The members of the group then compute taxable income within each 
category by deducting the apportioned interest expense from the amounts 
of pre-interest taxable income specified in the facts in paragraph (i), 
yielding the following results:

------------------------------------------------------------------------
         Taxable income               X         Y         Z       Total
------------------------------------------------------------------------
Domestic........................     64.00      9.00      3.00     58.00
Foreign Passive.................     -1.20      4.70      3.00      6.50
Foreign General.................    -10.80     57.30     17.00     63.50
                                 ---------------------------------------
    Total.......................     52.00     53.00     23.00    128.00
------------------------------------------------------------------------

    (iii) Step 2: Loss offset adjustments. Because X and Y have losses 
created through apportionment, these losses must be eliminated by 
reducing taxable income of the member in other limitation categories. 
Because X has a total of $12 in apportionment losses and because it has 
only one limitation category with income (i.e., domestic), domestic 
income must be reduced by $12, thus eliminating its apportionment 
losses. Because Y has a total of $9 in apportionment losses and because 
it has two limitation categories with income (i.e., foreign passive and 
foreign general limitation), the income in these two limitation 
categories must be reduced on a pro rata basis in order to eliminate its 
apportionment losses. In summary, the following adjustments are 
required:

------------------------------------------------------------------------
     Loss offset adjustments          X         Y         Z       Total
------------------------------------------------------------------------
Domestic........................    -12.00    + 9.00         0     -3.00
Foreign Passive.................    + 1.20     -0.68         0    + 0.52
Foreign General.................   + 10.80     -8.32         0    + 2.48
------------------------------------------------------------------------

    These adjustments yield the following adjusted taxable income 
figures:

------------------------------------------------------------------------
       Adjusted taxable income           X        Y        Z      Total
------------------------------------------------------------------------
Domestic............................    52.00     0       3.00     55.00
Foreign Passive.....................     0        4.02    3.00      7.02
Foreign General.....................     0       48.98   17.00     65.98
                                     -----------------------------------
    Total...........................    52.00    53.00   23.00    128.00
------------------------------------------------------------------------

    (iv) Step 3: Determination of amount subject to recharacterization. 
The adjustments performed under Step 2 led to a change in the group's 
taxable income within each limitation category. The total loss offset 
adjustments column shown in paragraph (iii) above shows the net 
deviations between Step 1 and 2.
    (v) Step 4: Recharacterization. The loss offset adjustments yield a 
positive change in the foreign passive and the foreign general 
limitation categories. Y and Z both have income in these limitation 
categories. Accordingly, the income of Y and Z in each of these 
limitation categories must be reduced on a pro rata basis (by reference 
to the adjusted taxable income figures) to the extent of the positive 
change in each limitation category. The total positive change in the 
foreign passive limitation category is $0.52. The adjusted taxable 
income of Y in the foreign passive limitation category is $4.02 and the 
adjusted taxable income of Z in the foreign passive limitation category 
is $3. Therefore, $0.30 is drawn from Y and $0.22 is drawn from Z. The 
total positive change in the foreign general limitation category is 
$2.48. The adjusted taxable income of Y in the foreign general 
limitation category is $48.98, and the adjusted taxable income of Z in 
the foreign general limitation category is $17. Therefore, $1.84 is 
drawn from Y and $.64 is drawn from Z.
    The members must then separately compute the sum of the limitation 
reductions. Y has limitation reductions of $0.30 in the foreign passive 
limitation category and $1.84 in the foreign general limitation 
category, yielding total limitation reduction of $2.14. Under these 
facts, domestic income is the only limitation category requiring a 
positive adjustment. Accordingly, Y's domestic income is increased by 
$2.14. Z has limitation reductions of $0.22 in the foreign passive 
limitation category and $0.64 in the foreign general limitation 
category, yielding total limitation reductions of $0.86. Under these 
facts, domestic income is the only limitation category of Z requiring a 
positive adjustment. Accordingly, Z's domestic income is increased by 
$0.86.

------------------------------------------------------------------------
   Recharacterization adjustments        X        Y        Z      Total
------------------------------------------------------------------------
Domestic............................        0   + 2.14   + 0.86   + 3.00
Foreign Passive.....................        0    -0.30    -0.22    -0.52
Foreign General.....................        0    -1.84    -0.64    -2.48
------------------------------------------------------------------------

    These recharacterization adjustments yield the following final 
taxable income figures:

------------------------------------------------------------------------
         Final taxable income             X        Y       Z      Total
------------------------------------------------------------------------
Domestic.............................    52.00    2.14    3.86     58.00
Foreign Passive......................     0       3.72    2.78      6.50
Foreign General......................     0      47.14   16.36     63.50
                                      ----------------------------------
    Total............................    52.00   53.00   23.00    128.00
------------------------------------------------------------------------

    Example 2. (i) Facts. X, a domestic corporation, is the parent of 
domestic corporations Y and Z. X, Y, and Z were organized after January 
1, 1987, constitute an affiliated group within the meaning of paragraph 
(d)(1) of this section, but do not file a consolidated return. Moreover, 
X has served as the sole borrower in the group and, as a result, has

[[Page 235]]

sustained an overall loss. The XYZ group apportions its interest expense 
on the basis of the fair market value of its assets. X, Y, and Z have 
the following assets, interest expense, and taxable income before 
interest expense:

------------------------------------------------------------------------
                Assets                    X        Y       Z      Total
------------------------------------------------------------------------
Domestic.............................    2,000       0   1,000     3,000
Foreign Passive......................        0      50      50       100
Foreign General......................        0     700     200       900
Interest Expense.....................      140       0       0       140
Taxable Income (pre-interest):
Domestic.............................      100       0     100       200
Foreign Passive......................        0       5       5        10
Foreign General......................        0      70      35       105
------------------------------------------------------------------------

    (ii) Step 1: Computation of consolidated taxable income. Each member 
of the XYZ group apportions its interest expense according to group 
apportionment ratios determined under the asset method described in 
Sec.  1.861-9T(g), yielding the following results:

------------------------------------------------------------------------
      Apportioned interest expense          X       Y      Z      Total
------------------------------------------------------------------------
Domestic...............................   105.00      0      0    105.00
Foreign Passive........................     3.50      0      0      3.50
Foreign General........................    31.50      0      0     31.50
                                        --------------------------------
    Total..............................   140.00      0      0    140.00
------------------------------------------------------------------------

    The members of the group then compute taxable income within each 
category by deducting the apportioned interest expense from the amounts 
of pre-interest taxable income specified in the facts in paragraph (i), 
yielding the following results:

------------------------------------------------------------------------
          Taxable income               X        Y         Z       Total
------------------------------------------------------------------------
Domestic.........................     -5.00     0       100.00     95.00
Foreign Passive..................     -3.50     5.00      5.00      6.50
Foreign General..................    -31.50    70.00     35.00     73.50
                                  --------------------------------------
    Total........................    -40.00    75.00    140.00    175.00
------------------------------------------------------------------------

    (iii) Step 2: Loss offset adjustment. Because X has insufficient 
domestic income to offset the sum of the losses in the foreign 
limitation categories caused by apportionment, the amount of 
apportionment losses in each limitation category shall be 
recharacterized as domestic losses to the extent of taxable income of 
other members in the same limitation category. This is accomplished by 
adding to each foreign limitation categories an amount equal to the loss 
therein and by subtracting the sum of such foreign losses from domestic 
income, as follows:

------------------------------------------------------------------------
    Loss offset adjustments          X          Y         Z       Total
------------------------------------------------------------------------
Domestic.......................     -35.00         0         0    -35.00
Foreign Passive................     + 3.50         0         0    + 3.50
Foreign General................    + 31.50         0         0   + 31.50
------------------------------------------------------------------------

    These adjustments yield the following adjusted taxable income 
figures:

------------------------------------------------------------------------
     Adjusted taxable income          X         Y         Z       Total
------------------------------------------------------------------------
Domestic........................       -40         0       100        60
Foreign Passive.................         0         5         5        10
Foreign General.................         0        70        35       105
                                 ---------------------------------------
    Total.......................       -40        75       140       175
------------------------------------------------------------------------

    (iv) Step 3: Determination of amount subject to recharacterization. 
The adjustments performed under Step 2 led to a change in the group's 
taxable income within each limitation category. The total loss offset 
adjustment column shown in paragraph (iii) above shows the net 
deviations between Steps 1 and 2.
    (v) Step 4: Recharacterization. The loss offset adjustments yield a 
positive change in the foreign passive and the foreign general 
limitation categories. Y and Z both have income in these limitation 
categories. Accordingly, the income of Y and Z in each of these 
limitation categories must be reduced on a pro rata basis (by reference 
to the adjusted taxable income figures) to the extent of the positive 
change in each limitation category. The total positive change in the 
foreign passive limitation category is $3.50. The adjusted taxable 
income of Y in the foreign passive limitation category is $5, and the 
adjusted taxable income of Z in the foreign passive limitation category 
is $5. Therefore, $1.75 is drawn from Y and $1.75 is drawn from Z. The 
total positive change in the foreign general limitation category is 
$31.50. The adjusted taxable income of Y in the foreign general 
limitation category is $70, and the adjusted taxable income of Z in the 
foreign general limitation category is $35. Therefore, $21 is drawn from 
Y and $10.50 is drawn from Z.
    The members must then separately compute the sum of the limitation 
reductions. Y has limitation reductions of $1.75 in the foreign passive 
limitation category and $21 in the foreign general limitation category, 
yielding total limitation reductions of $22.75. Under these facts, 
domestic income is the only limitation category requiring a positive 
adjustment. Accordingly, Y's domestic income is increased by $22.75. Z 
has limitation reductions of $1.75 in the foreign passive limitation 
category and $10.50 in the foreign general limitation category, yielding 
total limitation reductions of $12.25. Under these facts, domestic 
income is the only limitation category requiring a positive adjustment. 
Accordingly, Z's domestic income is increased by $12.25.

------------------------------------------------------------------------
 Recharacterization adjustments       X         Y         Z       Total
------------------------------------------------------------------------
Domestic........................         0   + 22.75   + 12.25   + 35.00
Foreign Passive.................         0     -1.75     -1.75     -3.50
Foreign General.................         0    -21.00    -10.50    -31.50
------------------------------------------------------------------------


[[Page 236]]

    These recharacterization adjustments yield the following final 
taxable income figures:

------------------------------------------------------------------------
      Final taxable income            X         Y         Z       Total
------------------------------------------------------------------------
Domestic........................    -40.00     22.75    112.25     95.00
Foreign Passive.................      0         3.25      3.25      6.50
Foreign General.................      0        49.00     24.50     73.50
                                 ---------------------------------------
    Total.......................    -40.00     75.00    140.00    175.00
------------------------------------------------------------------------

    (h) Effective/applicability date. In general, the rules of this 
section apply for taxable years beginning after December 31, 1986.

[T.D. 8228, 53 FR 35490, Sept. 14, 1988, as amended by T.D. 8916, 65 FR 
274, Jan. 3, 2001; T.D. 9456, 74 FR 38875, Aug. 4, 2009; T.D. 9571, 77 
FR 2227, Jan. 17, 2012; 77 FR 9844, Feb. 21, 2012; T.D. 9676, 79 FR 
41426, July 16, 2014]



Sec.  1.861-12  Characterization rules and adjustments for certain assets.

    (a) through (c)(1) [Reserved] For further guidance, see Sec.  1.861-
12T(a) through (c)(1).
    (2) Basis adjustment for stock in nonaffiliated 10 percent owned 
corporations--(i) Taxpayers using the tax book value method--(A) General 
rule. For purposes of apportioning expenses on the basis of the tax book 
value of assets, the adjusted basis of any stock in a 10 percent owned 
corporation owned by the taxpayer either directly or, for taxable years 
beginning after April 25, 2006, indirectly through a partnership or 
other pass-through entity shall be--
    (1) Increased by the amount of the earnings and profits of such 
corporation (and of lower-tier 10 percent owned corporations) 
attributable to such stock and accumulated during the period the 
taxpayer or other members of its affiliated group held 10 percent or 
more of such stock; or
    (2) Reduced (but not below zero) by any deficit in earnings and 
profits of such corporation (and of lower-tier 10 percent owned 
corporations) attributable to such stock for such period.
    (c)(2)(i)(B) through (c)(3) [Reserved] For further guidance, see 
Sec.  1.861-12T(c)(2)(i)(B) through (c)(3).
    (4) Characterization of stock of noncontrolled section 902 
corporations--(i) General rule. The principles of Sec.  1.861-12T(c)(3) 
shall apply to stock in a noncontrolled section 902 corporation (as 
defined in section 904(d)(2)(E)). Accordingly, stock in a noncontrolled 
section 902 corporation shall be characterized as an asset in the 
various separate limitation categories on the basis of either the asset 
method described in Sec.  1.861-12T(c)(3)(ii) or the modified gross 
income method described in Sec.  1.861-12T(c)(3)(iii). Stock in a 
noncontrolled section 902 corporation the interest expense of which is 
apportioned on the basis of assets shall be characterized in the hands 
of its domestic shareholders (as defined in Sec.  1.902-1(a)(1)) under 
the asset method described in Sec.  1.861-12T(c)(3)(ii). Stock in a 
noncontrolled section 902 corporation the interest expense of which is 
apportioned on the basis of gross income shall be characterized in the 
hands of its domestic shareholders under the gross income method 
described in Sec.  1.861-12T(c)(3)(iii).
    (ii) Nonqualifying shareholders. Stock in a noncontrolled section 
902 corporation shall be characterized as a passive category asset in 
the hands of a shareholder that is not eligible to compute an amount of 
foreign taxes deemed paid with respect to a dividend from the 
noncontrolled section 902 corporation for the taxable year, and in the 
hands of any shareholder with respect to whom look-through treatment is 
not substantiated. See Sec.  1.904-5(c)(4)(iii).
    (5) Effective/applicability date. Paragraphs (c)(2)(i)(A) and (4) of 
this section apply to taxable years of shareholders ending on or after 
April 20, 2009. See 26 CFR Sec.  1.861-12T(c)(2)(i) introductory text, 
(2)(i)(A), (2)(i)(B), and (4) (revised as of April 1, 2009) for rules 
applicable to taxable years of shareholders ending after the first day 
of the first taxable year of the noncontrolled section 902 corporation 
beginning after December 31, 2002, and ending before April 20, 2009.
    (d) through (j) [Reserved] For further guidance, see Sec.  1.861-
12T(d) through (j).

[T.D. 9452, 74 FR 27874, June 11, 2009]



Sec.  1.861-12T  Characterization rules and adjustments 
for certain assets (temporary).

    (a) In general. These rules are applicable to taxpayers in 
apportioning expenses under an asset method to income in various 
separate limitation categories under section 904(d), and

[[Page 237]]

supplement other rules provided in Sec. Sec.  1.861-9T, 1.861-10T, and 
1.861-11T. The rules of this section apply to taxable years beginning 
after December 31, 1986, except as otherwise provided in Sec.  1.861-
13T. Paragraph (b) of this section describes the treatment of 
inventories. Paragraph (c)(1) of this section concerns the treatment of 
various stock assets. Paragraph (c)(2) of this section describes a basis 
adjustment for stock in nonaffiliated 10 percent owned corporations. 
Paragraph (c)(3) of this section sets forth rules for characterizing the 
stock in controlled foreign corporations. Paragraph (c)(4) of this 
section describes the treatment of stock of noncontrolled section 902 
corporations. Paragraph (d)(1) of this section concerns the treatment of 
notes. Paragraph (d)(2) of this section concerns the treatment of the 
notes of controlled foreign corporations. Paragraph (e) of this section 
describes the treatment of certain portfolio securities that constitute 
inventory or generate income primarily in the form of gains. Paragraph 
(f) of this section describes the treatment of assets that are subject 
to the capitalization rules of section 263A. Paragraph (g) of this 
section concerns the treatment of FSC stock and of assets of the related 
supplier generating foreign trade income. Paragraph (h) of this section 
concerns the treatment of DISC stock and of assets of the related 
supplier generating qualified export receipts. Paragraph (i) of this 
section is reserved. Paragraph (j) of this section sets forth an example 
illustrating the rules of this section, as well as the rules of Sec.  
1.861-9T(g).
    (b) Inventories. Inventory must be characterized by reference to the 
source and character of sales income, or sales receipts in the case of 
LIFO inventory, from that inventory during the taxable year. If a 
taxpayer maintains separate inventories for any federal tax purpose, 
including the rules for establishing pools of inventory items under 
sections 472 and 474 of the Code, each separate inventory shall be 
separately characterized in accordance with the previous sentence.
    (c) Treatment of stock--(1) In general. Subject to the adjustment 
and special rules of paragraphs (c) and (e) of this section, stock in a 
corporation is taken into account in the application of the asset method 
described in Sec.  1.861-9T(g). However, an affiliated group (as defined 
in Sec.  1.861-11T(d)) does not take into account the stock of any 
member in the application of the asset method.
    (2) Basis adjustment for stock in nonaffiliated 10 percent owned 
corporations--
    (i)(A) [Reserved] For further guidance, see Sec.  1.861-
12(c)(2)(i)(A).
    (B) Computational rules. Solely for purposes of this section, a 
taxpayer's basis in the stock of a controlled foreign corporation shall 
not include any amount included in basis under section 961 or 1293(d) of 
the Code. For purposes of this paragraph (c)(2), earnings and profits 
and deficits are computed under the rules of section 312 and, in the 
case of a foreign corporation, section 902 and the regulations 
thereunder for taxable years of the 10 percent owned corporation ending 
on or before the close of the taxable year of the taxpayer. The rules of 
section 1248 and the regulations thereunder shall apply to determine the 
amount of earnings and profits that is attributable to stock without 
regard to whether earned and profits (or deficits) were derived (or 
incurred) during taxable years beginning before or after December 31, 
1962. This adjustment is to be made annually and is noncumulative. Thus, 
the adjusted basis of the stock (determined without prior years' 
adjustments under this section) is to be adjusted annually by the amount 
of accumulated earnings and profits (or any deficit) attributable to 
such stock as of the end of each year. Earnings and profits or deficits 
of a qualified business unit that has a functional currency other than 
the dollar must be computed under this paragraph (c)(2) in functional 
currency and translated into dollars using the exchange rate at the end 
of the taxpayer's current taxable year with respect to which interest is 
being allocated (and not the exchange rates for the years in which the 
earnings and profits or deficits were derived or incurred).
    (ii) 10 percent owned corporation defined--(A) In general. The term 
``10 percent owned corporation'' means any corporation (domestic or 
foreign)--

[[Page 238]]

    (1) Which is not included within the taxpayer's affiliated group as 
defined in Sec.  1.861-11T(d) (1) or (6).
    (2) In which the members of the taxpayer's affiliated group own 
directly or indirectly 10 percent or more of the total combined voting 
power of all classes of the stock entitled to vote, and
    (3) Which is taken into account for purposes of apportionment.
    (B) Rule of attribution. Stock that is owned by a corporation, 
partnership, or trust shall be treated as being indirectly owned 
proportionately by its shareholders, partners, or beneficiaries. For 
this purpose, a partner's interest in stock held by a partnership shall 
be determined by reference to the partner's distributive share of 
partnership income.
    (iii) Earnings and profits of lower-tier corporations taken into 
account. For purposes of the adjustment to the basis of the stock of the 
10 percent owned corporation owned by the taxpayer under paragraph 
(c)(2)(i) of this section, the earnings and profits of that corporation 
shall include its pro rata share of the earnings and profits (or any 
deficit therein) of each succeeding lower-tier 10 percent owned 
corporation. Thus, a first-tier 10 percent owned corporation shall 
combine with its own earnings and profits its pro rata share of the 
earnings and profits of all such lower-tier corporations. The affiliated 
group shall then adjust its basis in the stock of the first-tier 
corporation by its pro rata share of the total combined earnings and 
profits of the first-tier and the lower-tier corporations. In the case 
of a 10 percent owned corporation whose tax year does not conform to 
that of the taxpayer, the taxpayer shall include the annual earnings and 
profits of such 10 percent owned corporation for the tax year ending 
within the tax year of the taxpayer, whether or not such 10 percent 
owned corporation is owned directly by the taxpayer.
    (iv) Special rules for foreign corporations in pre-effective date 
tax years. Solely for purposes of determining the adjustment required 
under paragraph (c)(2)(i) of this section, for tax years beginning after 
1912 and before 1987, financial earnings (or losses) of a foreign 
corporation computed using United States generally accepted accounting 
principles may be substituted for earnings and profits in making the 
adjustment required by paragraph (c)(2)(i) of this section. A taxpayer 
is not required to isolate the financial earnings of a foreign 
corporation derived or incurred during its period of 10 percent 
ownership or during the post-1912 taxable years and determine earnings 
and profits (or deficits) attributable under section 1248 principles to 
the taxpayer's stock in a 10 percent owned corporation. Instead, the 
taxpayer may include all historic financial earnings for purposes of 
this adjustment. If the affiliated group elects to use financial 
earnings with respect to any foreign corporation, financial earnings 
must be used by that group with respect to all foreign corporations, 
except that earnings and profits may in any event be used for controlled 
foreign corporations for taxable years beginning after 1962 and before 
1987. However, if the affiliated group elects to use earnings and 
profits with respect to any single controlled foreign corporation for 
the 1963 through 1986 period, such election shall apply with respect to 
all its controlled foreign corporations.
    (v) Taxpayers using the fair market value method. Because the fair 
market value of any asset which is stock will reflect retained earnings 
and profits, taxpayers who use the fair market value method shall not 
adjust stock basis by the amount of retained earnings and profits, as 
otherwise required by paragraph (c)(2)(i) of this section.
    (vi) Examples. Certain of the rules of this paragraph (c)(2) may be 
illustrated by the following examples.

    Example 1. X, an affiliated group that uses the tax book value 
method of apportionment, owns 20 percent of the stock of Y, which owns 
50 percent of the stock of Z. X's basis in the Y stock is $1,000. X, Y, 
and Z have calendar taxable years. The undistributed earnings and 
profits of Y and Z at year-end attributable to X's period of ownership 
are $80 and $40, respectively. Because Y owns half of the Z stock, X's 
pro rata share of Z's earnings and profits attributable to X's Y stock 
is $4. X's pro rata share of Y's earnings attributable to X's Y stock is 
$16. For purposes of apportionment, the tax book value of the Y stock 
is, therefore, considered to be $1,020.
    Example 2. X, an unaffiliated domestic corporation that was 
organized on January 1,

[[Page 239]]

1987, has owned all the stock of Y, a foreign corporation with a 
functional currency other than the U.S. dollar, since January 1, 1987. 
Both X and Y have calendar taxable years. All of Y's assets generate 
general limitation income. X has a deductible interest expense incurred 
in 1987 of $160,000. X apportions its interest expense using the tax 
book value method. The adjusted basis of its assets that generate 
domestic income is $7,500,000. The adjusted basis of its assets that 
generate foreign source general limitation income (other than the stock 
of Y) is $400,000. X's adjusted basis in the Y stock is $2,000,000. Y 
has undistributed earnings and profits for 1987 of $100,000, translated 
into dollars from Y's functional currency at the exchange rate on the 
last day of X's taxable year. Because X is required under paragraph 
(b)(1) of this Sec.  1.861-10T to increase its basis in the Y stock by 
the computed amount of earnings and profits, X's adjusted basis in the Y 
stock is considered to be $2,100,000, and its adjusted basis of assets 
that generate foreign source general limitation income is, thus, 
considered to be $2,500,000. X would apportion its interest expense as 
follows:
    To foreign source general limitation income:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.009
    
    To domestic source income:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.010
    
    (3) Characterization of stock of controlled foreign corporations--
(i) In general. Stock in a controlled foreign corporation (as defined in 
section 957) shall be characterized as an asset in the various separate 
limitation categories either on the basis of:
    (A) The asset method described in paragraph (c)(3)(ii) of this 
section, or
    (B) The modified gross income method described in paragraph 
(c)(3)(iii) of this section.


Stock in a controlled foreign corporation whose interest expense is 
apportioned on the basis of assets shall be characterized in the hands 
of its United States shareholders under the asset method described in 
paragraph (c)(3)(ii). Stock in a controlled foreign corporation whose 
interest expense is apportioned on the basis of gross income shall be 
characterized in the hands of its United States shareholders under the 
gross income method described in paragraph (c)(3)(iii).
    (ii) Asset method. Under the asset method, the taxpayer 
characterizes the tax book value or fair market value of the stock of a 
controlled foreign corporation based on an analysis of the assets owned 
by the controlled foreign corporation during the foreign corporation's 
taxable year that ends with or within the taxpayer's taxable year. This 
process is based on the application of Sec.  1.861-9T(g) at the level of 
the controlled foreign corporation. In the case of a controlled foreign 
corporation that

[[Page 240]]

owns stock in one or more lower-tier controlled foreign corporations in 
which the United States taxpayer is a United States shareholder, the 
characterization of the tax book value of the fair market value of the 
stock of the first-tier controlled foreign corporation to the various 
separate limitation categories of the affiliated group must take into 
account the stock in lower-tier corporations. For this purpose, the 
stock of each such lower-tier corporation shall be characterized by 
reference to the assets owned during the lower-tier corporation's 
taxable year that ends during the taxpayer's taxable year. The analysis 
of assets within a chain of controlled foreign corporations must begin 
at the lowest-tier controlled foreign corporation and proceed up the 
chain to the first-tier controlled foreign corporation. For purposes of 
this paragraph (c), the value of any passive asset to which related 
person interest is allocated under Sec.  1.904-5(c)(2)(ii) must be 
reduced by the principal amount of indebtedness on which such interest 
is incurred. Furthermore, the value of any asset to which interest 
expense is directly allocated under Sec.  1.861-10T must be reduced as 
provided in Sec.  1.861-9T(g)(2)(iii). See Sec.  1.861-9T(h)(5) for 
further guidance concerning characterization of stock in a related 
person under the fair market value method.
    (iii) Modified gross income method. Under the gross income method, 
the taxpayer characterizes the tax book value of the stock of the first-
tier controlled foreign corporation based on the gross income net of 
interest expense of the controlled foreign corporation (as computed 
under Sec.  1.861-9T(j)) within each relevant category for the taxable 
year of the controlled foreign corporation ending with or within the 
taxable year of the taxpayer. For this purpose, however, the gross 
income of the first-tier controlled foreign corporation shall include 
the total amount of net subpart F income of any lower-tier controlled 
foreign corporation that was excluded under the rules of Sec.  1.861-
9T(j)(2)(ii)(B).
    (4) [Reserved] For further guidance, see Sec.  1.861-12(c)(4).
    (5) [Reserved] For further guidance, see Sec.  1.861-12(c)(5).
    (d) Treatment of notes--(1) General rule. Subject to the adjustments 
and special rules of this paragraph (d) and paragraph (e) of this 
section, all notes held by a taxpayer are taken into account in the 
application of the asset method described in Sec.  1.861-9T(g). However, 
the notes of an affiliated corporation are subject to special rules set 
forth in Sec.  1.861-11T(e). For purposes of this section, the term 
``notes'' means all interest bearing debt, including debt bearing 
original issue discount.
    (2) Characterization of related controlled foreign corporation 
notes. The debt of a controlled foreign corporation shall be 
characterized according to the taxpayer's treatment of the interest 
income derived from that debt obligation after application of the look-
through rule of section 904(d)(3)(C). Thus, a United States shareholder 
includes interest income from a controlled foreign corporation in the 
same category of income as the category of income from which the 
controlled foreign corporation deducts the interest expense. See section 
954(b)(5) and Sec.  1.904-5(c)(2) for rules concerning the allocation of 
related person interest payments to the foreign personal holding company 
income of a controlled foreign corporation.
    (e) Portfolio securities that constitute inventory or generate 
primarily gains. Because gain on the sale of securities is sourced by 
reference to the residence of the seller, a resident of the United 
States will generally receive domestic source income (and a foreign 
resident will generally receive foreign source income) upon sale or 
disposition of securities that otherwise generate foreign source 
dividends and interest (or domestic source dividends and interest in the 
case of a foreign resident). Although under paragraphs (c) and (d) of 
this section securities are characterized by reference to the source and 
character of dividends and interest, the source and character of income 
on gain or disposition must also be taken into account for purposes of 
characterizing portfolio securities if:
    (1) The securities constitute inventory in the hands of the holder, 
or
    (2) 80 percent or more of the gross income generated by a taxpayer's 
entire

[[Page 241]]

portfolio of such securities during a taxable year consists of gains.


For this purpose, a portfolio security is a security in any entity other 
than a controlled foreign corporation with respect to which the taxpayer 
is a United States shareholder under section 957, a noncontrolled 
section 902 corporation with respect to the taxpayer, or a 10 percent 
owned corporation as defined in Sec.  1.861-12(c)(2)(ii). In taking 
gains into account, a taxpayer must treat all portfolio securities 
generating foreign source dividends and interest as a single asset and 
all portfolio securities generating domestic source dividends as a 
single asset and shall characterize the total value of that asset based 
on the source of all income and gain generated by those securities in 
the taxable year.
    (f) Assets funded by disallowed interest--(1) Rule. In the case of 
any asset in connection with which interest expense accruing at the end 
of the taxable year is capitalized, deferred, or disallowed under any 
provision of the Code, the adjusted basis or fair market value 
(depending on the taxpayer's choice of apportionment methods) of such an 
asset shall be reduced by the principal amount of indebtedness the 
interest on which is so capitalized, deferred, or disallowed.
    (2) Example. The rules of this paragraph (f) may be illustrated by 
the following example.

    Example. X is a domestic corporation which uses the tax book value 
method of apportionment. X has $1000 of indebtedness and $100 of 
interest expense. X constructs an asset with an adjusted basis of $800 
before interest capitalization and is required under the rules of 
section 263A to capitalize $80 in interest expense. Because interest on 
$800 of debt is capitalized and because the production period is in 
progress at the end of X's taxable year, $800 of the principal amount of 
X's debt is allocable to the building. The $800 of debt allocable to the 
building reduces its adjusted basis for purposes of apportioning the 
balance of X's interest expense ($20).

    (g) Special rules for FSCs--(1) Treatment of FSC stock. No interest 
expense shall be allocated or apportioned to stock of a foreign sales 
corporation (``FSC'') to the extent that the FSC stock is attributable 
to the separate limitation for certain FSC distributions described in 
section 904(d)(1)(H). FSC stock is considered to be attributable solely 
to the separate limitation category described in section 904(d)(1)(H) 
unless the taxpayer can demonstrate that more than 20 percent of the 
FSC's gross income for the taxable year consists of income other than 
foreign trading income.
    (2) Treatment of assets that generate foreign trade income. Assets 
of the related supplier that generate foreign trade income must be 
prorated between assets attributable to foreign source general 
limitation income and assets attributable to domestic source income in 
proportion to foreign source general limitation income and domestic 
source income derived from transactions generating foreign trade income.
    (i) Value of assets attributable to foreign source income. The value 
of assets attributable to foreign source general limitation income is 
computed by multiplying the value of assets for the taxable year 
generating foreign trading gross receipts by a fraction:
    (A) The numerator of which is foreign source general limitation 
income for the taxable year derived from transactions giving rise to 
foreign trading gross receipts, after the application of the limitation 
provided in section 927(e)(1), and
    (B) The denominator of which is total income for the taxable year 
derived from the transaction giving rise to foreign trading gross 
receipts.
    (ii) Value of assets attributable to domestic source income. The 
value of assets attributable to domestic source income is computed by 
subtracting from the total value of assets for the taxable year 
generating foreign trading gross receipts the value of assets 
attributable to foreign source general limitation income as computed 
under paragraph (g)(2)(i) of this section.
    (h) Special rules for DISCs--(1) Treatment of DISC stock. No 
interest shall be allocated or apportioned to stock in a DISC (or stock 
in a former DISC to the extent that the stock in the former DISC is 
attributable to the separate limitation category described in section 
904(d)(1)(F)).
    (2) Treatment of assets that generate qualified export receipts. 
Assets of the related supplier that generate qualified

[[Page 242]]

export receipts must be prorated between assets attributable to foreign 
source general limitation income and assets attributable to domestic 
source income in proportion to foreign source general limitation income 
and domestic source income derived from transactions during the taxable 
year from transactions generating qualified export receipts.
    (i) [Reserved]
    (j) Examples. Certain of the rules in this section and Sec. Sec.  
1.861-9T(g) and 1.861-10(e) are illustrated by the following example.

    Example 1. (1) Facts. X, a domestic corporation organized on January 
1, 1987, has a calendar taxable year and apportions its interest expense 
on the basis of the tax book value of its assets. In 1987, X incurred a 
deductible third-party interest expense of $100,000 on an average month-
end debt amount of $1 million. The total tax book value of X's assets 
(adjusted as required under paragraph (b) of this section for retained 
earnings and profits) is $2 million. X manufactures widgets. One-half of 
the widgets are sold in the United States and one-half are exported and 
sold through a foreign branch with title passing outside the United 
States.
    X owns all the stock of Y, a controlled foreign corporation that 
also has a calendar taxable year and is also engaged in the manufacture 
and sale of widgets. Y has no earnings and profits or deficits in 
earnings and profits prior to 1987. For 1987, Y has taxable income and 
earnings and profits of $50,000 before the deductible for related person 
interest expense. Half of the $50,000 is foreign source personal holding 
company income and the other half is derived from widget sales and 
constitutes foreign source general limitation income. Assume that Y has 
no deductibles from gross income other than interest expense. Y's 
foreign personal holding company taxable income is included in X's gross 
income under section 951. Y paid no dividends in 1987. Prior to 1987, Y 
did not borrow any funds from X. The average month-end level of 
borrowings by Y from X in 1987 is $100,000, on which Y paid a total of 
$10,000 in interest. The total tax book value of Y's assets in 1987 is 
$500,000. Y has no liabilities to third parties. X elects pursuant to 
Sec.  1.861-9T for Y to apportion Y's interest expense under the gross 
income method prescribed in Sec.  1.861-9T(g).
    In addition to its stock in Y, X owns 20 percent of the stock of Z, 
a noncontrolled section 902 corporation.

X's total assets and their tax book values are:

------------------------------------------------------------------------
                                                               Tax book
                            Asset                                value
------------------------------------------------------------------------
Plant & equipment...........................................  $1,000,000
Corporate headquarters......................................     500,000
Inventory...................................................     200,000
Automobiles.................................................      20,000
Patents.....................................................      50,000
Trademarks..................................................      10,000
Y stock (including paragraph (c)(2) adjustment).............      80,000
Y note......................................................     100,000
Z stock.....................................................      40,000
------------------------------------------------------------------------

    (2) Categorization of Assets.

                         Single Category Assets

    1. Automobiles: X's automobiles are used exclusively by its domestic 
sales force in the generation of United States source income. Thus, 
these assets are attributable solely to the grouping of domestic income.
    2. Y Note: Under paragraph (d)(2) of this section, the Y note in the 
hands of X is characterized according to X's treatment of the interest 
income received on the Y note. In determining the source and character 
of the interest income on the Y note, the look-through rules of sections 
904(d)(3)(C) and 904(g) apply. Under section 954(b)(5) and Sec.  1.904-
5(c)(2)(ii), Y's $10,000 interest payment to X is allocated directly to, 
and thus reduces, Y's foreign personal holding company income of $25,000 
(yielding foregin personal holding company taxable income of $15,000). 
Therefore, the Y note is attributable solely to the statutory grouping 
of foreign source passive income.
    3. Z stock: Because Z is a noncontrolled section 902 corporation, 
the dividends paid by Z are subject to a separate limitation under 
section 904(d)(1)(E). Thus, this asset is attributable solely to the 
statutory grouping consisting of Z dividends.

                        Multiple Category Assets

    1. Plant & equipment, inventory, patents, and trademarks: In 1987, X 
sold half its widgets in the United States and exported half outside the 
United States. A portion of the taxable income from export sales will be 
foreign source income, since the export sales were accomplished through 
a foreign branch and title passed outside the United States. Thus, these 
assets are attributable both to the statutory grouping of foreign 
general limitation and the grouping of domestic income.
    2. Y Stock: Since Y's interest expense is apportioned under the 
gross income method prescribed in Sec.  1.861-9T(j), the Y stock must be 
characterized under the gross income method described in paragraph 
(c)(3)(iii) of this section.

               Assets without Directly Identifiable Yield

    1. Corporate headquarters: This asset generates no directly 
identifiable income yield. The value of the asset is disregarded.

[[Page 243]]

    (3) Analysis of Income Yield for Multiple Category Assets.
    1. Plant & Equipment, inventory, patents, and trademarks: As noted 
above, X's 1987 widget sales were half domestic and half foreign. Assume 
that Example 2 of Sec.  1.863-3(b)(2) applies in sourcing the export 
income from the export sales. Under Example 2, the income generated by 
the export sales is sourced half domestic and half foreign. The income 
gnerated by the domestic sales is entirely domestic source. Accordingly, 
three-quarters of the income generated on all sales is domestic source 
and one-quarter of the income is foreign source. Thus, three-quarters of 
the fair market value of these assets are attributed to the grouping of 
domestic source income and one-quarter of the fair market value of these 
assets is attributed to the statutory grouping of foreign source general 
limitation income.
    2. Y Stock: Under the gross income method described in paragraph 
(c)(3)(iii) of this section, Y's gross income net of interest expenses 
in each limitation category must be determined--$25,000 foreign source 
general limitation income and $15,000 of foreign source passive income. 
Of X's adjusted basis of $80,000 in Y stock, $50,000 is attributable to 
foreign source general limitation income and $30,000 is attributable to 
foreign source passive income.
    (4) Application of the Special Allocation Rule of Sec.  1.861-
10T(e). Assume that the taxable year in question is 1990 and that the 
appliable percentage prescribed by Sec.  1.861-10T(e)(1)(iv)(A) is 80 
percent. Assume that X has elected to use the quadratic formula provided 
in Sec.  1.861-10T(e)(1)(iv)(B).
    Step 1. X's average month-end level of debt owning to unrelated 
persons is $1 million. The tax book value of X's assets is $2 million. 
Thus, X's debt-to-asset ratio computed under Sec.  1.861-10T(e)(1)(i) is 
1 to 2.
    Step 2. The tax book value of Y's assets is $500,000. Because Y has 
no debt to persons other than X, Y's debt-to-asset ratio computed under 
Sec.  1.861-10T(e)(1)(ii) is $0 to $500,000.
    Step 3. Y's average month-end liabilities to X, as computed under 
Sec.  1.861-10T(e)(1)(iii) for 1987 are $100,000.
    Step 4. Adding the $100,000 of Y's liabilities owed to X as computed 
under Step 3 to Y's third party liabilities ($0) would be insufficient 
to make Y's debt-to-asset ratio computed in Step 2 ($100,000-to-
$500,000, or 1:5) equal to at least 80 percent of X's debt-to-asset 
ratio computed under Step 1, as adjusted to reflect a reduction in X's 
debt and assets by the $100,000 of excess related person indebtedness 
(.80 x $900,000/$1,900,000 or 1:2.6). Therefore, the entire amount of 
Y's liabilities to X ($100,000) constitute excess related person 
indebtedness under Sec.  1.861-10T(e)(1)(ii). Thus, the entire $10,000 
of interest received by X from Y during 1987 constitutes interest 
received on excess related person indebtedness.
    Step 5. The Y note held by X has a tax book value of $100,000. 
Solely for purposes of Sec.  1.861-10(e)(1)(v), the Y note is attributed 
to separate limitation categories in the same manner as the Y stock. 
Under paragraph (c)(3)(iii) of this section, of the $80,000 of Y stock 
held by X, $50,000 is attributable to foreign source general limitation 
income, and $30,000 is attributable to foreign source passive income. 
Thus, for purposes of $1.861-10T(e)(1)(v), $62,500 of the $100,000 Y 
note is considered to be a foreign source general limitation asset and 
$37,500 of the $100,000 Y note is considered to be a foreign source 
passive asset.
    Step 6. Since $8,000 of the $10,000 in related person interest 
income received by Y constitutes interest received on excessive related 
person indebtedness, $10,000 of X's third party interest expense is 
allocated to X's debt investment in Y. Under Sec.  1.861-10T(e)(1)(vi), 
62.5 percent of the $10,000 of X's third party interest expense ($6,250) 
is allocated to foreign source general limitation income and 37.5 
percent of the $10,000 of X's third party interest expense ($3,750) is 
allocated to foreign source passive income. As a result of this direct 
allocation, the value of X's assets generating foreign source general 
limitation income shall be reduced by the principal amount of 
indebtedness the interest on which is directly allocated to foreign 
source general limitation income ($62,500), and X's assets generating 
foreign general limitation income shall be reduced by the principal 
amount of indebtedness the interest on which is directly allocated to 
foreign passive income ($37,500).
    (5) Totals.
    Having allocated $10,000 of its third party interest expense to its 
debt investment in Y, X would apportion the $90,000 balance of its 
interest according to the following apportionment fractions:

----------------------------------------------------------------------------------------------------------------
                                                             Domestic     Foreign      Foreign     Noncontrolled
                          Asset                               source      general      passive      section 902
----------------------------------------------------------------------------------------------------------------
Plant and equipment......................................     $750,000    $250,000   ...........  ..............
Inventory................................................     $150,000     $50,000   ...........  ..............
Automobiles..............................................      $20,000  ...........  ...........  ..............
Patents..................................................      $37,500     $12,500   ...........  ..............
Trademarks...............................................       $7,500      $2,500   ...........  ..............
Y stock..................................................  ...........     $50,000      $30,000   ..............
Y note...................................................  ...........  ...........    $100,000   ..............

[[Page 244]]

 
Z stock..................................................  ...........  ...........  ...........         $40,000
                                                          ------------------------------------------------------
      Totals.............................................     $965,000    $365,000     $130,000          $40,000
                                                          ======================================================
      Adjustments for directly allocable interest........  ...........    ($62,250)    ($37,750)  ..............
                                                          ------------------------------------------------------
      Adjusted totals....................................     $965,000    $302,750      $92,250          $40,000
                                                          ======================================================
Percentage...............................................           69          22            6                3
----------------------------------------------------------------------------------------------------------------

    Example 2. Assume the same facts as in Example 1, except that Y has 
$100,000 of third party indebtedness. Further, assume for purposes of 
the application of the special allocation rule of Sec.  1.861-10T(e) 
that the taxable year is 1990 and that the applicable percentage 
prescribed by Sec.  1.861-10T(e)(1)(iv)(A) is 80 percent. The 
application of the Sec.  1.861-10(e) would be modified as follows.
    Step 1. X's debt-to-asset ratio computed under Sec.  1.861-
10T(e)(1)(i) remains 1 to 2 (or 0.5).
    Step 2. The tax book value of Y's assets is $500,000. Y has $100,000 
of indebtedness to third parties. Y's debt-to-asset ratio computed under 
Sec.  1.861-10T(e)(1)(ii) is $100,000 to $500,000 (1:5 or 0.2).
    Step 3. Y's average month-end liabilities to X, as computed under 
Sec.  1.861-10T(e)(1)(iii) remain $100,000.
    Step 4. X's debt-to-asset ratio is 0.5 and 80 percent of 0.5 is 0.4. 
Because Y's debt-to-asset ratio is 0.2, there is excess related person 
indebtedness, the amount of which can be computed based on the following 
formula:
[GRAPHIC] [TIFF OMITTED] TC07OC91.011

    Supplying the facts as given, this equation is as follows:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.012
    
    Multiply both sides by 500,000 and (2,000,000-X), yielding:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.013
    
    Since there is an X\2\ in this equation, a quadratic formula must be 
utilized to solve for X. Group the components in this equation, 
segregating the X and the X\2\:
[GRAPHIC] [TIFF OMITTED] TC07OC91.014

    Apply the quadratic formula:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.015
    
a = 1 (coefficient of X\2\)
b = -2,300,000 (coefficient of X)
c = 2 x 10\11\ (remaining element of equation)


Therefore, X equals either 90,519 or (2.21 x 10\11\). for purposes of 
computing excess related person indebtedness, X is the lowest

[[Page 245]]

positive amount derived from this equation, which is 90,519.
    Steps 5 and 6 are unchanged from Example 1, except that the total 
amount of interest on excess related party indebtedness is $9,051.
    (k) Effective/applicability date. The rules of this section apply 
for taxable years beginning after December 31, 1986.

[T.D. 8228, 53 FR 35495, Sept. 14, 1988, as amended by T.D. 9260, 71 FR 
24526, Apr. 25, 2006, T.D. 9452, 74 FR 27875, June 11, 2009; T.D. 9456, 
74 FR 38875, Aug. 4, 2009]



Sec.  1.861-13T  Transition rules for interest expenses 
(temporary regulations).

    (a) In general--(1) Optional application. The rules of this section 
may be applied at the choice of a corporate taxpayer. In the case of an 
affiliated group, however, the choice must be made on a consistent basis 
for all members. Therefore, a corporate taxpayer (or affiliated group) 
may allocate and apportion its interest expense entirely on the basis of 
the rules contained in Sec. Sec.  1.861-8T through 1.861-12T and without 
regard to the rules of this section. The choice is made on an annual 
basis and, thus, is not binding with respect to subsequent tax years.
    (2) Transition relief. This section contains transitional rules that 
limit the application of the rules for allocating and apportioning 
interest expense of corporate taxpayers contained in Sec. Sec.  1.861-8T 
through 1.861-12T, which are applicable in allocating and apportioning 
the interest expense of corporate taxpayers generally for taxable years 
beginning after 1986. Sections 1.861-9(d) (relating to individuals, 
estates, and certain trusts) and 1.861-9(e) (relating to partnerships) 
are effective for taxable years beginning after 1986. Thus, the 
taxpayers to whom those sections apply do not qualify for transition 
relief under this section.
    (3) Indebtedness defined. For purposes of this section, the term 
``indebtedness'' means any obligation or other evidence of indebtedness 
that qenerates an expense that constitutes interest expense within the 
meaning of Sec.  1.861-9T(a). In the case of an obligation that does not 
bear interest initially, but becomes interest bearing with the lapse of 
time or upon the occurrence of an event, such obligation shall only be 
considered to constitute indebtedness when it first bears interest. 
Obligations that are outstanding as of November 16, 1985 shall only 
qualify for transition relief under this section if they bear interest-
bearing as of that date. For this purpose, any obligation that has 
original issue discount within the meaning of section 1273(a)(1) of the 
Code shall be considered to be interest-bearing.
    (4) Exceptions. The term ``indebtedness'' shall not include any 
obligation existing between affiliated corporations, as defined in Sec.  
1.861-llT(d). Moreover, the term ``indebtedness'' shall not include any 
obligation the interest on which is directly allocable under Sec. Sec.  
1.861-10T(b) and 1.861-10T(c). Under Sec.  1.861-9T(b)(6)(iv)(B), 
certain interest expense is directly allocated to the gain derived from 
an appropriately identified financial product. When interest expense on 
a liability is reduced by such gain, the principal amount of such 
liability shall be reduced pro rata by the relative amount of interest 
expense that is directly allocated.
    (b) General phase-in--(1) In general. In the case of each of the 
first three taxable years of the taxpayer beginning after December 31, 
1986, the rules of Sec. Sec.  1.861-8T through 1.861-12T shall not apply 
to interest expenses paid or accrued by the taxpayer during the taxable 
year with respect to an aggregate amount of indebtedness which does not 
exceed the general phase-in amount, as defined in paragraph (b)(2) of 
this section.
    (2) General phase-in amount defined. Subject to the limitation 
imposed by paragraph (b)(3) of this section, the general phase-in amount 
means the amount which is the applicable percentage (determined under 
the following table) of the aggregate amount of indebtedness of the 
taxpayer outstanding on November 16, 1985:

 
       Taxable year beginning after December 31, 1986         Percentage
 
First......................................................           75
Second.....................................................           50
Third......................................................           25
 

    (3) Reductions in indebtedness. The general phase-in amount shall 
not exceed the taxpayer's historic lowest

[[Page 246]]

month-end debt level taking into account all months after October 1985. 
However, for the taxable year ln which a taxpayer attains a new historic 
lowest month-end debt level (but not for subsequent taxable years), the 
general phase-in amount shall not exceed the average of month-end debt 
levels within that taxable year (without taking into account any 
increase in month-end debt levels occurring in such taxable Year after 
the new historic lowest month-end debt level is attained).

    Example. X is a calendar year taxpayer that had $100 of indebtedness 
outstanding on November 16, 1985. X's month-end debt level remained $100 
for all subsequent months until July 1987, when X's month-end debt level 
fell to $50. In computing transition relief for 1987, X's general phase-
in amount cannot exceed $75 (900 divided by 12), which is the average of 
month-end debt levels in 1987. Assuming that X's month-end debt level 
for any subsequent month does not fall below $50, the limitation on its 
general phase-in amount for all taxable years after 1987 will be $50, 
its historic lowest month-end debt level after October 1985.

    (c) Nonapplication of the consolidation rule--(1) General rule. In 
the case of each of the first five taxable years of the taxpayer 
beginning after December 31, 1986, the consolidation rule contained in 
Sec.  1.861-11T(c) shall not apply to interest expenses paid or accrued 
by the taxpayer during the taxable year with respect to an aggregate 
amount of indebtedness which does not exceed the special phase-in 
amount, as defined in paragraph (c)(2) of this section.
    (2) Special phase-in amount. The special phase-in amount is the sum 
of--
    (i) The general phase-in amount,
    (ii) The five-year phase-in amount, and
    (iii) The four-year phase-in amount.
    (3) Five-year phase-in amount. The five-year phase-in amount is the 
lesser of--
    (i) The applicable percentage (the ``unreduced percentage'' in the 
following table) of the five-year debt amount, or
    (ii) The applicable percentage (the ``reduced percentage'' in the 
following table) of the five-year debt amount reduced by paydowns (if 
any):

------------------------------------------------------------------------
                                                 Unreduced     Reduced
                Transition year                  percentage   percentage
------------------------------------------------------------------------
Year 1........................................       8\1/3\           10
Year 2........................................      16\2/3\           25
Year 3........................................           25           50
Year 4........................................      33\1/3\          100
Year 5........................................      16\2/3\          100
------------------------------------------------------------------------

    (4) Four-year phase-in amount. The four-year phase-in amount is the 
lesser of--
    (i) The applicable percentage (the ``unreduced percentage'' in the 
following table) of the four-year debt amount, or
    (ii) The applicable percentage (the ``reduced percentage'' in the 
following table) of the four-year debt amount reduced by paydowns (if 
any) to the extent that such paydowns exceed the five-year debt amount:

------------------------------------------------------------------------
                                                 Unreduced     Reduced
                Transition year                  percentage   percentage
------------------------------------------------------------------------
Year 1........................................            5       6\1/4\
Year 2........................................           10      16\2/3\
Year 3........................................           15      37\1/2\
Year 4........................................           20          100
------------------------------------------------------------------------

    (5) Five-year debt amount. The ``five-year debt amount'' means the 
excess (if any) of--
    (i) The amount of the outstanding indebtedness of the taxpayer on 
May 29, 1985, over
    (ii) The amount of the outstanding indebtedness of the taxpayer on 
December 31, 1983. The five-year debt amount shall not exceed the 
aggregate amount of indebtedness of the taxpayer outstanding on November 
16, 1985.
    (6) Four-year debt amount. The ``four-year debt amount'' means the 
excess (if any) of--
    (i) The amount of the outstanding indebtedness of the taxpayer on 
December 31, 1983, over
    (ii) The amount of the outstanding indebtedness of the taxpayer on 
December 31, 1982.


The four-year debt amount shall not exceed the aggregate amount of 
indebtedness of the taxpayer outstanding on November 16, 1985, reduced 
by the five-year debt amount.
    (7) Paydowns. The term ``paydowns'' means the excess (if any) of--
    (i) The aggregate amount of indebtedness of the taxpayer outstanding 
on November 16, 1985, over

[[Page 247]]

    (ii) The limitation on the general phase-in amount described in 
paragraph (b)(3) of this section.
    Paydowns are first applied to the five-year debt amount to the 
extent thereof and then to the four-year debt amount for purposes of 
computing the five-year and the four-year phase-in amounts.
    (d) Treatment of affiliated group. For purposes of this section, all 
members of the same affiliated group of corporations (as defined in 
Sec.  1.861-11(d)) shall be treated as one taxpayer whether or not such 
members filed a consolidated return. Interaffiliate debt is not taken 
into account in computing transition relief. Moreover, any reduction in 
the amount of interaffiliate debt is not taken into account in 
determining the amount of paydowns.
    (e) Mechanics of computation--(1) Step 1: Determination of the 
amounts within the various categories of debt. Each separate member of 
an affiliated group must determine each of its following amounts:
    (i) November 16, 1985 amount. The amount of its debt outstanding on 
November 16, 1985 (after the elimination of interaffiliate 
indebtedness),
    (ii) Unreduced five-year debt. The amount of any net increase in the 
amount of its indebtedness on May 29, 1985 (after elimination of 
interaffiliate indebtedness) over the amount of its indebtedness on 
December 31, 1983 (after elimination of interaffiliate indebtedness),
    (iii) Unreduced four-year debt. The amount of any net increase in 
the amount of its indebtedness on December 31, 1983 (after elimination 
of interaffiliate indebtedness) over the amount of its indebtedness on 
December 31, 1982 (after elimination of interaffiliate indebtedness), 
and
    (iv) Month-end debt. The amount of its month-end debt level for all 
months after October 1985 (after elimination of interaffiliate 
indebtedness).
    (2) Step 2: Aggregation of the separate company amounts. Each of the 
designated amounts for the separate companies identified in Step 1 must 
be aggregated in order to compute consolidated transition relief. 
Paragraph (e)(10)(iv) of this section (Step 10) requires the use of the 
taxpayer's current year average debt level for the purpose of computing 
the percentages of debt that are subject to the three sets of rules that 
are identified in Step 10. For use in that computation, the taxpayer 
should compute the current year average debt level by aggregating 
separate company month-end debt levels and then by averaging those 
aggregate amounts.
    (3) Step 3: Calculation of the lowest historic month-end debt level 
of the taxpayer. In order to calculate the lowest historic month-end 
debt level of the taxpayer, determine the month-end debt level of each 
separate company for each month ending after October 1985 and aggregate 
these amounts on a month-by-month basis. On such aggregate basis, in any 
taxable year in which the taxpayer attains an aggregate new lowest 
historic month-end debt level, add together all the aggregate month-end 
debt levels within the taxable year (without taking into account any 
increase in aggregate debt level subsequent to the attainment of such 
lowest historic month-end debt level) and divide by the number of months 
in that taxable year, yielding the average of month-end debt levels for 
such year. Such average shall constitute the taxpayer's lowest historic 
month-end debt level for that taxable year in which the aggregate new 
lowest historic month-end debt level was attained. Unless otherwise 
specified, all subsequent references to any amount refer to the 
aggregate amount for all members of the same affiliated group of 
corporations.
    (4) Step 4: Computation of paydowns. Paydowns equal the amount by 
which the November 16, 1985 amount exceeds the taxpayer's lowest 
historic month-end debt level, determined under Step 3.
    (5) Step 5: Computation of limitations on unreduced five-year debt 
and unreduced four-year debt. (i) The unreduced five-year debt cannot 
exceed the November 16, 1985 amount.
    (ii) The unreduced four-year debt cannot exceed the November 16, 
1985 amount less the unreduced five-year debt.
    (6) Step 6: Computation of reduced five-year and reduced four-year 
debt--(i) Reduced five-year debt. Compute the

[[Page 248]]

amount of reduced five-year debt by subtracting from the unreduced five-
year debt (see Step 5) the amount of paydowns (see Step 4).
    (ii) Reduced four-year debt. To the extent that the amount of 
paydowns (see step 4) exceeds the amount of unreduced five-year debt 
(see Step 5), compute the amount of reduced four-year debt by 
subtracting such excess from the unreduced four-year debt (see Step 1).
    (iii) To the extent that paydowns do not offset either the unreduced 
five-year amount or the unreduced four-year amount, the reduced and the 
unreduced amounts are the same.
    (7) Step 7: Computation of the general phase-in amount. The general 
phase-in amount is the lesser of--
    (i) The percentage of the November 16, 1985 amount designated for 
the relevant transition year in the table below, or
    (ii) The lowest group month-end debt level (see Step 3).

                         General Phase-in Table
------------------------------------------------------------------------
                      Transition year                         Percentage
------------------------------------------------------------------------
Year 1.....................................................           75
Year 2.....................................................           50
Year 3.....................................................           25
------------------------------------------------------------------------

    (8) Step 8: Computation of Five-Year Phase-in Amount. The five-year 
phase-in amount is the lesser of--
    (i) The percentage of the unreduced five-year debt designated for 
the relevant transition year in the table below, or
    (ii) The percentage of the reduced five-year debt designated for the 
relevant transition year in the table below.

                        Five-Year Phase-In Table
------------------------------------------------------------------------
                                                 Unreduced     Reduced
                Transition year                  percentage   percentage
------------------------------------------------------------------------
Year 1........................................       8\1/3\           10
Year 2........................................      16\2/3\           25
Year 3........................................           25           50
Year 4........................................      33\1/3\          100
Year 5........................................      16\2/3\          100
------------------------------------------------------------------------

    (9) Step 9: Computation of Four-year Phase-in Amount. The four-year 
phase-in amount is the lesser of--
    (i) The percentage of the unreduced four-year debt designated for 
the relevant transition year in the table below, or
    (ii) The percentage of the reduced four-year debt designated for the 
relevant transition year in the table below.

                        Four-Year Phase-In Table
------------------------------------------------------------------------
                                                 Unreduced     Reduced
                Transition year                  percentage   percentage
------------------------------------------------------------------------
Year 1........................................            5       6\1/4\
Year 2........................................           10      16\2/3\
Year 3........................................           15      37\1/2\
Year 4........................................           20          100
------------------------------------------------------------------------

    (10) Step 10: Determination of group debt ratio and application of 
transition relief to separate company interest expense. (i) The general 
phase-in amount consists of the amount computed under Step 7. Interest 
expense on this amount is subject to pre-1987 rules of allocation and 
apportionment.
    (ii) The post-1986 separate company amount consists of the sum of 
the amounts determined under Steps 8 and 9. Interest expense on this 
amount is subject to post-1986 rules of allocation and apportionment as 
applied on a separate company basis. Thus, Sec.  1.861-11T(c) does not 
apply with respect to this amount of indebtedness. Because the 
consolidation rule does not apply, stock in affiliated corporations 
shall be taken into account in computing the apportionment fractions for 
each separate company in the same manner as under pre-1987 rules.
    (iii) The post-1986 one-taxpayer amount consists of any indebtedness 
that does not qualify for transition relief under Steps 7, 8, and 9. 
Interest expense on this amount is subject to post-1986 rules as applied 
on a consolidated basis.
    (iv) To determine the extent to which the interest expense of each 
separate company is subject to any of these sets of allocation and 
apportionment rules, each company shall prorate its own interest expense 
using two fractions. The general phase-in fraction is the general phase-
in amount over the current year average debt level of the affiliated 
group (see Step 2). The post-1986 separate company fraction is the post-
1986 separate company amount over the current year average debt level of 
the affiliated group. The balance of each

[[Page 249]]

separate company's interest expense is subject to post-1986 one-taxpayer 
rules.
    (f) Example. XYZ form an affiliate group.
    (1) Step 1: Determination of the amounts within the various debt 
categories.

------------------------------------------------------------------------
                                                  Historic
                                                 3rd party     Increase
                                                    debt
------------------------------------------------------------------------
Company X:
    Nov. 16, 1985.............................     $100,000  ...........
    May 29, 1983 (5-year).....................       90,000      $10,000
    Dec. 31, 1983 (4-year)....................       80,000       10,000
    Dec. 31, 1982.............................       70,000  ...........
    Current Interest Expense..................       10,000  ...........
Company Y:
    Nov. 16, 1985.............................      200,000  ...........
    May 29, 1985 (5-year).....................      170,000      120,000
    Dec. 31, 1983 (4-year)....................       50,000       10,000
    Dec. 31, 1982.............................       40,000  ...........
    Current Interest Expense..................       30,000  ...........
Company Z:
    Nov. 16, 1985.............................      300,000  ...........
    May 29, 1985 (5-year).....................      300,000       50,000
    Dec. 31, 1983 (4-year)....................      250,000      100,000
    Dec. 31, 1982.............................      150,000  ...........
    Current Interest Expense..................       30,000  ...........
------------------------------------------------------------------------

    (2) Step 2: Aggregation of the separate company amounts.

Aggregate Nov. 16, 1985......................................   $600,000
Aggregate 5-year debt........................................    180,000
Aggregate 4-year debt........................................    120,000
Current year average debt level..............................    700,000
 

    (3) Step 3: Calculation of lowest historic month-end debt level.
    An analysis of historic month-end debt levels indicates that in 
1986, XYZ's aggregate month-end debt level fell to $500,000, which 
represents the lowest sum for all years under consideration. Because 
this historic low occurred in a prior tax year, there is no averaging of 
month-end debt levels in the current taxable year.
    (4) Step 4: Computation of paydowns.
    The aggregate November 16, 1985 amount ($600,000), less the lowest 
historic month-end debt level ($500,000), yields a total paydown in the 
amount of $100,000.
    (5) Step 5: Computation of limitations on aggregate unreduced five-
year debt and aggregate unreduced four-year debt.

Aggregate Nov. 16, 1985 amount...............................   $600,000
Aggregate unreduced 5-year debt..............................    180,000
Aggregate unreduced 4-year debt..............................    120,000
 

    Because the November 16, 1985 amount exceeds the unreduced 4- and 5-
year debt, the full amount of the 4- and 5-year debt qualify for 
transition relief. In cases where the November 16, 1985 amount is less 
than the 4- or 5-year debt (or the sum of both), the latter amounts are 
limited to the November 16, 1985 amount. See the limitations on the 4-
year and 5-year debt amounts in paragraphs (c)(6) and (c)(5), 
respectively, of this section.
    (6) Step 6: Computation of reduced five-year and four-year debt. The 
paydowns computed under Step 4 are deemed to first offset the aggregate 
unreduced five-year debt. Accordingly, the reduced amount of five-year 
debt is $80,000. Since the paydowns are less than the aggregate 
unreduced five-year debt, there is no paydown in connection with 
aggregate unreduced four-year debt. Accordingly, the unreduced four-year 
debt and the reduced four-year debt are both considered to be $120,000.
    (7) Step 7: Computation of the general phase-in amount. In 
transition year 1, the general transition amount is the lesser of:
    (i) 75 percent of the aggregate November 16, 1985 amount (75% of 
$600,000 = $450,000); or
    (ii) the lowest month-end debt level since November 16, 1985 
($500,000).
    Therefore, the general transition amount is $450,000.
    (8) Step 8: Computation of the five-year phase-in amount. In 
transition year 1, the five-year phase-in amount is the lesser of:
    (i) 8\1/3\ percent of the unreduced five-year amount (8\1/3\% of 
$180,000 = $15,000); or
    (ii) 10 percent of the reduced five-year amount (10% of $80,000 = 
$8,000).
    Therefore, the five-year phase-in amount is $8,000.
    (9) Step 9: Computation of the four-year phase-in amount. In 
transition year 1, the four-year phase-in amount is the lesser of:
    (i) 5 percent of the unreduced four-year amount (5% of $120,000 = 
$6,000); or
    (ii) 6\1/4\ percent of the reduced four-year amount (6\1/4\% of 
$120,000 = $7,500).
    Therefore, the four-year phase-in amount is $6,000.
    (10) Step 10: Determination of group debt ratio and application of 
relief to separate company interest expense.

[[Page 250]]

    (i) As determined under Step 7, interest expense on a total of 
$450,000 of the XYZ debt in the first transition year is computed under 
pre-1987 rules of allocation and apportionment.
    (ii) The sum of Steps 8 ($8,000) and 9 ($6,000) is $14,000. Interest 
expense on a total of $14,000 of XYZ debt is computed under post-1986 
rules of allocation and apportionment as applied on a separate company 
basis.
    (iii) The balance of XYZ's current year interest expense is computed 
under post-1986 rules of allocation and apportionment as applied on a 
consolidated basis. X, Y, and Z, respectively, have current interest 
expense of $10,000, $30,000, and $30,000. Thus, 64.3 percent (450,000/
700,000) of the interest expense of each separate company is subject to 
pre-1987 rules. Two percent (14,000/700,000) of the interest expense of 
each separate company is subject to post-1986 rules applied on a 
separate company basis. Finally, the balance of each separate company's 
current year interest expense (33.7 percent) is subject to post-1986 
rules applied on a consolidated basis.
    (g) Corporate transfers--(1) Effect on transferee--(i) General rule. 
Except as provided in paragraph (g)(1)(ii) of this section, if a 
domestic corporation or an affiliated group acquires stock in a domestic 
corporation that was not a member of the transferee's affiliated group 
before the acquisition, but becomes a member of the transferee's 
affiliated group after the acquisition, the transferee group shall take 
into account the following transition attributes of the acquired 
corporation in computing its transition relief:
    (A) November 16, 1985 amount;
    (B) Unreduced five-year amount;
    (C) Unreduced four-year amount; and
    (D) The amount of any transferor paydowns attributed to the acquired 
corporation under the rules of paragraph (h)(1) of this section.
    (ii) Special rule for year of acquisition. To compute the amount of 
the transition attributes described in paragraph (g)(1)(i) of this 
section that a transferee takes into account in the transferee's taxable 
year of the acquisition, such transition attributes shall be multiplied 
by a fraction, the numerator of which is the number of months within the 
taxable year that the transferee held the acquired corporation and the 
denominator of which is the number of months in such taxable year. In 
order for the transferee to assert ownership of a subsidiary for a given 
month, the transferee and the acquired corporation must be affiliated 
corporations as of the last day of the month. In addition, the 
transferor and the transferee shall take account of the month-end debt 
level of the transferred corporation only for those months at the end of 
which the transferred corporation was a member of the transferor's or 
the transferee's respective affiliated group.
    (iii) Aggregation of transition attributes. The transition 
attributes of the acquired corporation shall be aggregated with the 
respective amounts of the transferee group.
    (iv) Conveyance of transferor paydowns. The total paydowns of the 
transferee group shall include the amount of any paydown of the 
transferor group that was attributed to the acquired corporation under 
the rules of paragraph (h)(1) of this section.
    (v) Effect of certain elections. If an election--
    (A) Is made under section 338(g) (whether or not an election under 
338(h)(10) is made),
    (B) Is deemed to be made under section 338(e) (other than (e)(2)), 
or section 338(f), or,
    (C) Is made under section 336(e), no indebtedness of the acquired 
corporation shall qualify for transition relief for the year such 
election first becomes effective and for subsequent taxable years, and 
no other transition attributes of the acquired corporation shall be 
taken into account by the transferee group.
    (2) Effect on transferor--(i) General rule. Except as provided in 
paragraph (g)(2)(ii) of this section, in the case of an acquisition of a 
member of an affiliated group by a nonmember of the group, the 
transferor shall not take into account the transition attributes of the 
acquired corporation in computing the transition relief of the 
transferor group in subsequent taxable years. Thus, the November 16, 
1985 amount, the unreduced five-year and four-year debt amounts, and the 
end-of-month debt levels of the transferor

[[Page 251]]

group shall be computed without regard to the acquired corporation's 
respective amounts for purposes of computing transition relief of the 
tranferor group for years thereafter.
    (ii) Special rule for the year of disposition. To compute the amount 
of the transition attributes described in paragraph (g)(2)(i) of this 
section that a transferor shall take into account in the transferor's 
taxable year of the disposition, such transition attributes shall be 
multiplied by a fraction, the numerator of which is the number of months 
within the taxable year that the transferor held the acquired 
corporation and the denominator of which is the number of months in such 
taxable year. In order for the transferor to assert ownership of a 
subsidiary for a given month, the transferor and the acquired 
corporation must be affiliated corporations as of the last day of the 
month.
    (iii) Effect of prior paydowns. Any paydowns of the acquired 
corporation that are considered to reduce the debt of other members of 
the transferor group under the rules of paragraph (h)(1) of this section 
(whether incurred in a prior taxable year or in that portion of a year 
of disposition that is taken into account by the transferor) shall 
continue to be taken into account by the transferor group after the 
disposition.
    (3) Special rule for assumptions of indebtedness. In connection with 
the transfer of a corporation, if the indebtedness of an acquired 
corporation is assumed by any party other than the transferee or another 
member of the transferee's affiliated group, the transition attributes 
of the acquired corporation shall not be taken into account in computing 
the transition relief of the transferee group. See paragraph (g)(2) of 
this section concerning the treatment of the transferor group. Also in 
connection with the transfer of a corporation, if the transferee or 
another member of the transferee's affiliated group assumes the 
indebtedness of an acquired corporation, such assumed indebtedness shall 
only qualify for transition relief during the period in which the 
acquired corporation remains a member of the transferee group. Further, 
if the transferee group subsequently disposes of the acquired 
corporation, the indebtedness of the acquired corporation will continue 
to qualify for transition relief only if the indebtedness is assumed by 
the new purchaser as of the time such corporation is acquired.
    (4) Effect of asset sales. If substantially all of the assets of a 
corporation are sold, the indebtedness of such corporation shall cease 
to be qualified for transition relief. Thus, the transition attributes 
of such corporation shall not be taken into account in computing 
transition relief.
    (h) Rules for attributing paydowns among separate companies--(1) 
General rule. In the case of a corporate transfer under paragraph (g) of 
this section, it is necessary to determine the amount of paydowns 
attributable to the acquired corporation. Under paragraph (c)(7) of this 
section, paydowns are deemed to reduce first the five-year phase-in 
amount, then the four-year phase-in amount, and then the general phase-
in amount. Thus, for example, a reduction in indebtedness of the group 
caused by a reduction in the debt of a group member that has no five-
year debt will nevertheless be deemed under this ordering rule to reduce 
the indebtedness of those group members that do have five-year debt. In 
order to preserve the effect of paydowns caused by a reduction, each 
member must determine on a separate company basis at the time of any 
transfer of any member of the affiliated group the impact of paydowns 
(including those paydowns occurring in the year of transfer prior to the 
time of the transfer) on the various categories of indebtedness.
    (2) Mechanics of computation. Separate company accounts of paydowns 
are determined by prorating any paydown among all group members with 
five-year debt to the extent thereof on the basis of the relative 
amounts of five-year debt. Paydowns in excess of five-year debt are 
prorated on a similar basis among all group members with four-year debt 
to the extent thereof on the basis of the relative amounts of four-year 
debt. Paydowns in excess of four-year and five-year debt are prorated 
among all group members with general phase-in debt to the extent thereof 
on the basis of the relative

[[Page 252]]

amounts of general phase-in debt. After an initial paydown has been 
prorated among the members of an affiliated group, any further reduction 
in the amount of aggregate month-end debt level as compared to the 
November 16, 1985 amount is prorated among all members of the affiliated 
group based on the remaining net amounts of four-year and five-year 
debt.
    (3) Examples. The rules of paragraphs (g) and (h) of this section 
may be illustrated by the following examples.

    Example 1. Computing separate company accounts of reductions. (i) 
Facts. XYZ constitutes an affiliated group of corporations that has a 
calendar taxable year and the following transition attributes:

------------------------------------------------------------------------
                                                  Historic
                                                 3rd party     Increase
                                                    debt
------------------------------------------------------------------------
Company X:
    Nov. 16, 1985.............................     $100,000  ...........
    May 29, 1985 (5-year).....................       80,000           $0
    Dec. 31, 1983 (4-year)....................       80,000       10,000
    Dec. 31, 1982.............................       70,000  ...........
Company Y:
    Nov. 16, 1985.............................      200,000  ...........
    May 29, 1985 (5-year).....................      170,000      120,000
    Dec. 31, 1983 (4-year)....................       50,000       10,000
    Dec. 31, 1982.............................       40,000  ...........
Company Z:
    Nov. 16, 1985.............................      300,000  ...........
    May 29, 1985 (5-year).....................      290,000       40,000
    Dec. 31, 1983 (4-year)....................      250,000      100,000
    Dec. 31, 1982.............................      150,000  ...........
------------------------------------------------------------------------


In 1986, the XYZ group attained its lowest historic month-end debt level 
of $500,000. Because the November 16, 1985 amount is $600,000 the XYZ 
group therefore has a paydown in the amount of $100,000. This paydown 
partially offsets the $160,000 of five-year debt in the XYZ group.
    (ii) Analysis. Applying the rule of paragraph (h)(1) of this 
section, separate company accounts of paydowns are computed by prorating 
the $100,000 paydown among those members of the group that have five-
year debt. Accordingly, the paydown is prorated between Y and Z as 
follows:

    To Y:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.016
    
    To Z:
    [GRAPHIC] [TIFF OMITTED] TC07OC91.017
    
    Example 2. Corporate acquisitions. (i) Facts. The facts are the same 
as in example 1. On July 15, 1987, the XYZ group sells all the stock of 
Y to A. Having held the stock of Y for six months in 1987, the XZ group 
computes its transition relief for that year taking into account half of 
the transition attributes of Y. AY constitutes an affiliated group of 
corporations after the acquisition. Having held the stock of Y for six 
months in 1987, the AY group computes its transition relief for that 
year taking into account half of the transition attributes of Y. In 
1987, the AY group attained a new lowest month-end debt level that 
yields an average lowest month-end debt level for 1987 of $150,000.
    (ii) Transferee group. The following analysis applies in determining 
transition relief for purposes of apportioning the interest expense of 
the transferee group for 1987. The AY group has the following transition 
attributes for 1987:

------------------------------------------------------------------------
                                                  Historic
                                                 3rd party     Increase
                                                    debt
------------------------------------------------------------------------
Company A:
    Nov. 16, 1985.............................     $100,000  ...........
    May 29, 1985 (5-year).....................      250,000       $5,000
    Dec. 31, 1983 (4-year)....................      245,000       10,000
    Dec. 31, 1982.............................      235,000  ...........
Company Y (half-year amounts):
    Nov. 16, 1985.............................      100,000  ...........
    May 29, 1985 (5-year).....................       85,000       60,000
    Dec. 31, 1983 (4-year)....................       25,000        5,000
    Dec. 31, 1982.............................       20,000  ...........
    Pre-acquisition year paydown by another          37,500  ...........
     member of the transferor group that
     reduced Y's five-year debt (one half of
     $75,000).................................
------------------------------------------------------------------------


Because the November 16, 1985 amount of the AY group in 1987 is $200,000 
and because the 1987 average of historic month-end debt levels was 
$150,000, the AY group has a paydown in the amount of $50,000. In 
addition, the 1986 paydown by the XYZ group that was deemed to reduce Y 
debt is added to the paydown computed above, yielding a total paydown of 
$87,500. This amount is prorated between members, eliminating the four 
and five year debt of the AY group. Note that Y is only a member of the 
AY group for half of the 1987 taxable year. In 1988, Y's entire 
transition indebtedness and a $75,000 paydown must be taken into account 
in computing the amount of interest expense eligible for transition 
relief.
    (iii) Transferor group. The following analysis applies in 
determining transition relief for purposes of apportioning the interest 
expense of the transferor group for 1987. The XZ group has the 
transition attributes stated below for 1987. In 1987, the XZ group 
attained a new lowest month-end debt level that yields an average lowest 
month-end debt level for 1987 of $250,000.

[[Page 253]]



------------------------------------------------------------------------
                                                  Historic
                                                 3rd party     Increase
                                                    debt
------------------------------------------------------------------------
Company X:
    Nov. 16, 1985.............................     $100,000  ...........
    May 29, 1985 (5-year).....................       80,000           $0
    Dec. 31, 1983 (4-year)....................       80,000       10,000
    Dec. 31, 1982.............................       70,000  ...........
    Pre-disposition paydown that reduced X's              0  ...........
     debt.....................................
Company Y (half-year amounts):
    Nov. 16, 1985.............................      100,000  ...........
    May 29, 1985 (5-year).....................       85,000       60,000
    Dec. 31, 1983 (4-year)....................       25,000        5,000
    Dec. 31, 1982.............................       20,000  ...........
    Pre-disposition paydown that reduced Y's         37,500  ...........
     debt.....................................
Company Z:
    Nov. 16, 1985.............................      300,000  ...........
    May 29, 1985 (5-year).....................      290,000       40,000
    Dec. 31, 1983 (4-year)....................      250,000      100,000
    Dec. 31, 1982.............................      150,000  ...........
    Pre-disposition paydown that reduced Z's         25,000  ...........
     debt.....................................
------------------------------------------------------------------------

Because the revised November 16, 1985 amount of the XZ group is $500,000 
and because the 1987 average of lowest historic month-end debt levels of 
the XZ group was $250,000, the XZ group has a paydown in the amount of 
$250,000. This paydown offsets the total five and four year debt of the 
XZ group. Had the 1987 paydown of the XZ group been an amount less than 
the five-year amount, the paydown would have been prorated based on Y's 
adjusted 5-year amount of $22,500 and Z's adjusted 5-year amount of 
$15,000.

[T.D. 8257, 54 FR 31820, Aug. 2, 1989]



Sec.  1.861-14  Special rules for allocating and apportioning certain expenses 
(other than interest expense) of an affiliated group of corporations.

    (a)-(c) [Reserved]. For further guidance, see Sec.  1.861-14T(a) 
through (c).
    (d) Definition of affiliated group--(1) General rule. For purposes 
of this section, the term affiliated group has the same meaning as is 
given that term by section 1504, except that section 936 corporations 
(as defined in Sec.  1.861-11(d)(2)(ii)) are also included within the 
affiliated group to the extent provided in paragraph (d)(2) of this 
section. Section 1504(a) defines an affiliated group as one or more 
chains of includible corporations connected through 80-percent stock 
ownership with a common parent corporation which is an includible 
corporation (as defined in section 1504(b)). In the case of a 
corporation that either becomes or ceases to be a member of the group 
during the course of the corporation's taxable year, only the expenses 
incurred by the group member during the period of membership shall be 
allocated and apportioned as if all members of the group were a single 
corporation. In this regard, the apportionment factor chosen shall 
relate only to the period of membership. For example, if apportionment 
on the basis of assets is chosen, the average amount of assets (tax book 
value or fair market value) for the taxable year shall be multiplied by 
a fraction, the numerator of which is the number of months of the 
corporation's taxable year during which the corporation was a member of 
the affiliated group, and the denominator of which is the number of 
months within the corporation's taxable year. If apportionment on the 
basis of gross income is chosen, only gross income generated during the 
period of membership shall be taken into account. If apportionment on 
the basis of units sold or sales receipts is chosen, only units sold or 
sales receipts during the period of membership shall be taken into 
account. Expenses incurred by the group member during its taxable year, 
but not during the period of membership, shall be allocated and 
apportioned without regard to other members of the group. This paragraph 
(d)(1) applies to taxable years beginning after December 31, 1989.
    (2) Inclusion of section 936 corporations--(i) General rule. Except 
as otherwise provided in paragraph (d)(2)(ii) of this section, the 
exclusion from the affiliated group of section 936 corporations under 
section 1504(b)(4) does not apply for purposes of this section. Thus, a 
section 936 corporation that meets the ownership requirements of section 
1504(a) is a member of the affiliated group.
    (ii) Exception for purposes of alternative minimum tax. The 
exclusion from the affiliated group of section 936 corporations under 
section 1504(b)(4) shall be operative for purposes of the application of 
this section solely in determining the amount of foreign source 
alternative minimum taxable income within each separate category and the 
alternative minimum tax foreign tax credit pursuant to section 59(a). 
Thus, a section 936 corporation that meets the ownership requirements of 
section

[[Page 254]]

1504(a) is not a member of the affiliated group for purposes of 
determining the amount of foreign source alternative minimum taxable 
income within each separate category and the alternative minimum tax 
foreign tax credit pursuant to section 59(a).
    (iii) Effective date. This paragraph (d)(2) applies to taxable years 
beginning after December 31, 1989.
    (d)(3) through (e)(5) [Reserved]. For further guidance, see Sec.  
1.861-14T(d)(3) through (e)(5).
    (e)(6) Charitable contribution expenses--(i) In general. A deduction 
for a charitable contribution by a member of an affiliated group shall 
be allocated and apportioned under the rules of Sec. Sec.  1.861-
8(e)(12) and 1.861-14T(c)(1).
    (ii) Effective date. (A) The rules of this paragraph shall apply to 
charitable contributions subject to Sec.  1.861-8(e)(12)(i) that are 
made on or after July 28, 2004, and, for taxpayers applying the second 
sentence of Sec.  1.861-8(e)(12)(iv)(A), to charitable contributions 
made during the taxable year ending on or after July 28, 2004.
    (B) The rules of this paragraph shall apply to charitable 
contributions subject to Sec.  1.861-8(e)(12)(ii) that are made on or 
after July 14, 2005, and, for taxpayers applying the second sentence of 
Sec.  1.861-8(e)(12)(iv)(B), to charitable contributions made during the 
taxable year ending on or after July 14, 2005.
    (f) through (j) [Reserved] For further guidance, see Sec.  1.861-
14T(f) through (j).

[T.D. 8916, 66 FR 274, Jan. 3, 2001, as amended by T.D. 9211, 70 FR 
40663, July 14, 2005]



Sec.  1.861-14T  Special rules for allocating and apportioning 
certain expenses (other than interest expense) of an affiliated group 
of corporations (temporary).

    (a) In general. Section 1.861-11T provides special rules for 
allocating and apportioning interest expense of an affiliated group of 
corporations. The rules of this Sec.  1.861-14T also relate to 
affiliated groups of corporations and implement section 864(e)(6), which 
requires affiliated group allocation and apportionment of expenses other 
than interest which are not directly allocable and apportionable to any 
specific income producing activity or property. In general, the rules of 
this section apply to taxable years beginning after December 31, 1986. 
Paragraph (b) of this section describes the scope of the application of 
the rule for the allocation and apportionment of such expenses of 
affiliated groups of corporations. Such rule is then set forth in 
paragraph (c) of this section. Paragraph (d) of this section contains 
the definition of the term ``affiliated group'' for purposes of this 
section. Paragraph (e) of this section describes the expenses subject to 
allocation and apportionment under the rules of this section. Paragraph 
(f) of this section provides rules concerning the affiliated group 
allocation and apportionment of such expenses in computing the combined 
taxable income of a FSC or DISC and its related supplier. Paragraph (g) 
of this section describes the treatment of losses caused by 
apportionment of such expenses in the case of an affiliated group that 
does not file a consolidated return. Paragraph (h) of this section 
provides rules concerning the treatment of the reserve expenses of a 
life insurance company. Paragraph (j) of this section provides examples 
illustrating the application of this section.
    (b) Scope--(1) Application of section 864(e)(6). Section 864(e)(6) 
and this section apply to the computation of taxable income for purposes 
of computing separate limitations on the foreign tax credit under 
section 904. Section 864(e)(6) and this section also apply in connection 
with section 907 to determine reductions in the amount allowed as a 
foreign tax credit under section 901. Section 864(e)(6) and this section 
also apply to the computation of the combined taxable income of the 
related supplier and a foreign sales corporation (FSC) (under sections 
921 through 927) as well as the combined taxable income of the related 
supplier and a domestic international sales corporation (DISC) (under 
sections 991 through 997).
    (2) Nonapplication of section 864(e)(6). Section 864(e)(6) and this 
section do not apply to the computation of subpart F income of 
controlled foreign corporations (under sections 951 through 964) or the 
computation of effectively connected taxable income of foreign 
corporations.
    (3) Application of section 864(e)(6) to the computation of combined 
taxable income

[[Page 255]]

of a possessions corporation and its affiliates. [Reserved]
    (c) General rule for affiliated corporations--(1) General rule. (i) 
Except as otherwise provided in paragraph (c)(2) of this section, the 
taxable income of each member of an affiliated group within each 
statutory grouping shall be determined by allocating and apportioning 
the expenses described in paragraph (e) of this section of each member 
according to apportionment fractions which are computed as if all 
members of such group were a single corporation. For purposes of 
determining these apportionment fractions, any interaffiliate 
transactions or property that are duplicative with respect to the 
measure of apportionment chosen shall be eliminated. For example, in the 
application of an asset method of apportionment, stock in affiliated 
corporations shall not be taken into account, and loans between members 
of an affiliated group shall be treated in accordance with the rules of 
Sec.  1.861-11T(e). Similarly, in the application of a gross income 
method of apportionment, interaffiliate dividends and interest, gross 
income from sales or services, and other interaffiliate gross income 
shall be eliminated. Likewise, in the application of a method of 
apportionment based on units sold or sales receipts, interaffiliate 
sales shall be eliminated.
    (ii) Except as otherwise provided in this section, the rules of 
Sec.  1.861-8T apply to the allocation and apportionment of the expenses 
described in paragraph (e) of this section. Thus, allocation under this 
paragraph (c) is accomplished by determining, with respect to each 
expense described in paragraph (e), the class of gross income to which 
the expense is definitely related and then allocating the deduction to 
such class of gross income. For this purpose, the gross income of all 
members of the affiliated group must be taken in account. Then, the 
expense is apportioned by attributing the expense to gross income 
(within the class to which the expense has been allocated) which is in 
the statutory grouping and to gross income (within the class) which is 
in the residual grouping. Section 1.861-8T(c)(1) identifies a number of 
factors upon which apportionment may be based, such as comparison of 
units sold, gross sales or receipts, assets used, or gross income. The 
apportionment method chosen must be applied consistently by each member 
of the affiliated group in apportioning the expense when more than one 
member incurred the expense or when members incurred separate portions 
of the expense. The apportionment fraction must take into account the 
apportionment factors contributed by all members of the affiliated 
group. In the case of an affiliated group of corporations that files a 
consolidated return, consolidated foreign tax credit limitations are 
computed for the group in accordance with the rules of Sec.  1.1502-4. 
For purposes of this section the term ``taxpayer'' refers to the 
affiliated group (regardless of whether the group files a consolidated 
return), rather than to the separate members thereof.
    (2) Expenses relating to fewer than all members. An expense relates 
to fewer than all members of an affiliated group if the expense is 
allocable under paragraph (e)(1) of this section to gross income of at 
least one member other than the member that incurred the expense but 
fewer than all members of the affiliated group. The taxable income of 
the member that incurred the expense shall be determined by apportioning 
that expense under the rules of paragraph (c)(1) of this section as if 
the members of the affiliated group that derive gross income to which 
such expense is allocable under paragraph (e)(1) were treated as a 
single corporation.
    (3) Prior application of section 482. The rules of this section do 
not supersede the application of section 482 and the regulations 
thereunder. Section 482 may be applied effectively to deny a deduction 
for an expense to one member of an affiliated group and to allow a 
deduction for that expense to another member of the affiliated group. In 
cases to which section 482 is applied, expenses shall be reallocated and 
reapportioned under section 864(e)(6) and this section after taking into 
account the application of section 482.
    (d)(1)-(2) [Reserved]. For further guidance, see Sec.  1.861-
14(d)(1) and (2).
    (e) Expenses to be allocated and apportioned under this section--(1) 
Expenses

[[Page 256]]

not directly traceable to specific income producing activities or 
property. (i) The expenses that are required to be allocated and 
apportioned under the rules of this section are expenses related to 
certain supportive functions, research and experimental expenses, 
stewardship expenses, and legal and accounting expenses, to the extent 
that such expenses are not directly allocable to specific income 
producing activities or property solely of the member of the affiliated 
group that incurred the expense. Interest expense of members of an 
affiliated group of corporations is allocated and apportioned under 
Sec.  1.861-11T and not under the rules of this section. Expenses that 
are included in inventory costs or that are capitalized are not subject 
to allocation and apportionment under the rules of this section.
    (ii) An item of expense is not considered to be directly allocable 
to specific income producing activities or property solely of the member 
incurring the expense if, were all members of the affiliated group 
treated as a single corporation, the expense would not be considered 
definitely related, within the meaning of Sec.  1.861-8T(b)(2), only to 
a class of gross income derived solely by the member which actually 
incurred the expense. Furthermore, the expense is presumed not to be 
definitely related only to a class of gross income derived solely by the 
member incurring the expense (and is, therefore, presumed not to be 
directly allocable to specific income producing activities or property 
of that member) unless the taxpayer is able affirmatively to establish 
otherwise. As provided in paragraph (c)(1) of this section, expenses 
described in this paragraph (e)(1) generally shall be apportioned by the 
member incurring the expense according to apportionment fractions 
computed as if all members of the affiliated group were a single 
corporation. Under paragraph (c)(2) of this section, however, an expense 
shall be apportioned according to apportionment fractions computed as if 
only some (but fewer than all) members of the affiliated group were a 
single corporation, if the expense is considered allocable to gross 
income of at least one member other than the member incurring the 
expense but fewer than all members of the affiliated group. An item of 
expense shall be considered to be allocable to gross income of fewer 
than all members of the group if, were all members of the affiliated 
group treated as a single corporation, the expense would not be 
considered definitely related within the meaning of Sec.  1.861-8T(b)(2) 
to gross income derived by all members of the group. In such case, the 
expense shall be considered allocable, for purposes of paragraph (c)(2) 
of this section, to gross income of those members of the group that 
generated (or could reasonably be expected to generate) the gross income 
to which the expense would be considered definitely related if the group 
were treated as a single corporation.
    (2) Research and experimental expenses--(i) In general. The 
allocation and apportionment of research and experimental expenses is 
governed by the rules of Sec.  1.861-8T(e)(3). In the case of research 
and experimental expenses incurred by a member of an affiliated group, 
the rules of Sec.  1.861-8T(e)(3) shall be applied as if all members of 
the affiliated group were a single taxpayer. Thus, research and 
experimental expenses shall be allocated to all income of all members of 
the affiliated group reasonably connected with the relevant broad 
product category to which such expenses are definitely related under 
Sec.  1.861-8T(e)(3)(i). If fewer than all members of the affiliated 
group derive gross income reasonably connected with that relevant broad 
product cagetory, then such expenses shall be apportioned under the 
rules of this paragraph (c)(2) only among those members, as if those 
members were a single corporation. See Example (1) of paragraph (j) of 
this section. Such expenses shall then be apportioned, if the sales 
method is used, in accordance with the rules of Sec.  1.861-8T(e)(3)(ii) 
between the statutory grouping (within the class of gross income) and 
the residual grouping (within the class of gross income) taking into 
account the amount of sales of all members of the affiliated group from 
the product category which resulted in such gross income. Section 1.861-
8T(e)(3)(ii)(D), relating to sales of controlled parties, shall be 
applied as if all members of

[[Page 257]]

the affiliated group were the ``taxpayer'' referred to therein. If 
either of the optional gross income methods of apportionment is used, 
gross income of all members of the affiliated group that generate, have 
generated, or could reasonably have been expected to generate gross 
income within the relevant class of gross income must be taken into 
account.
    (ii) Expenses subject to the statutory moratorium. The rules of this 
section do not apply to research and experimental expenses allocated 
under section 126 of Pub. L. 98-368.
    (3) Expenses related to supportive functions. Expenses which are 
supportive in nature (such as overhead, general and administrative, 
supervisory expenses, advertising, marketing, and other sales expenses) 
are to be allocated and apportioned in accordance with the rules of 
Sec.  1.861-8T(b)(3). To the extent that such expenses are not directly 
allocable under paragraph (e)(1)(ii) of this section to specific income 
producing activities or property of the member of the affiliated group 
that incurred the expense, such expenses must be allocated and 
apportioned as if all members of the affiliated group were a single 
corporation in accordance with the rules of paragraph (c) of this 
section. Specifically, such expenses must be allocated to a class of 
gross income that take into account gross income that is generated, has 
been generated, or could reasonably have been expected to have been 
generated by the members of the affiliated group. If the expenses relate 
to the gross income of fewer than all members of the affiliated group as 
determined under paragraph (c)(2) of this section, then those expenses 
must be apportioned under the rules of paragraph (c)(2) of this section, 
as if those fewer members were a single corporation. See Example (3) of 
paragraph (j) of this section. Such expenses must be apportioned between 
statutory and residual groupings of income within the appropriate class 
of gross income by reference to the apportionment factors contributed by 
the members of the affiliated group that are treated as a single 
corporation.
    (4) Stewardship expenses. Stewardship expenses are to be allocated 
and apportioned in accordance with the rules of Sec.  1.861-8T(e)(4). In 
general, stewardship expenses are considered definitely related and 
allocable to dividends received or to be received from a related 
corporation. If members of the affiliated group, other than the member 
that incurred the stewardship expense, receive or may receive dividends 
from the related corporation, such expense must be allocated and 
apportioned in accordance with the rules of paragraph (c) of this 
section as if all such members of the affiliated group that receive or 
may receive dividends were a single corporation. See Example (4) of 
paragraph (j) of this section. Such expenses must be apportioned between 
statutory and residual groupings of income within the appropriate class 
of gross income by reference to the apportionment factors contributed by 
the members of the affiliated group treated as a single corporation.
    (5) Legal and accounting fees and expenses. Legal and accounting 
fees and expenses are to be allocated and apportioned under the rules of 
Sec.  1.861-8T (e)(5). To the extent that such expenses are not directly 
allocable under paragraph (e)(1)(ii) of this section to specific income 
producing activities or property of the member of the affiliated group 
that incurred the expense, such expenses must be allocated and 
apportioned as if all members of the affiliated group were a single 
corporation. Specifically, such expenses must be allocated to a class of 
gross income that takes into account the gross income which is 
generated, has been generated, or could reasonably have been expected to 
have been generated by the other members of the affiliated group. If the 
expenses relate to the gross income of fewer than all members of the 
affiliated group as determined under paragraph (c)(2) of this section, 
then those expenses must be apportioned under the rules of paragraph 
(c)(2) of this section, as if those fewer members were a single 
corporation. See Example (5) of paragraph (j) of this section. Such 
expenses must be apportioned taking into account the apportionment 
factors contributed by the members of the group that are treated as a 
single corporation.

[[Page 258]]

    (f) Computation of FSC or DISC combined taxable income. In the 
computation under the pricing rules of sections 925 and 994 of the 
combined taxable income of any FSC or DISC and its related supplier 
which are members of an affiliated group, the combined taxable income of 
such FSC or DISC and its related supplier shall be reduced by the 
portion of the expenses of the affiliated group described in paragraph 
(e) of this section that is incurred in connection with export sales 
involving that FSC or DISC. In order to determine the portion of the 
expenses of the affiliated group that is incurred in connection with 
export sales by or through a FSC or DISC, the portion of the total of 
the apportionment factor chosen that relates to the generation of that 
export income must be determined. Thus, if gross income is the 
apportionment factor chosen, the portion of total gross income of the 
affiliated group that consists of combined gross income derived from 
transactions involving the FSC or DISC and related supplier must be 
determined. Similarly, if units sold or sales receipts is the 
apportionment factor chosen, the portion of total units sold or sales 
receipts that generated export income of the FSC or DISC and related 
supplier must be determined. The amount of the expense shall then be 
multiplied by a fraction, the numerator of which is the export related 
apportionment factor as determined above, and the denominator of which 
is the total apportionment factor. Thus, if gross income is the 
apportionment factor chosen, apportionment is based on a fraction, the 
numerator of which is export related combined gross income of the FSC or 
DISC and related supplier and the denominator of which is the total 
gross income of the affiliated group. Similarly, if units sold or sales 
receipts is the apportionment factor chosen, the fraction is the units 
sold or sales receipts that generated export income of the FSC or DISC 
and related supplier over the total units sold or sales receipts of the 
affiliated group. Under this rule, expenses of other group members may 
be attributed to the combined gross income of a FSC of DISC and its 
related supplier without affecting the amount of expenses (other than 
any commission payable by the related supplier to the FSC or DISC) 
otherwise deductible by the FSC or DISC, the related supplier, or other 
members of the affiliated group. The FSC or DISC must calculate combined 
taxable income, taking into account any reduction by expenses attributed 
from other members of the affiliated group to determine the commission 
derived by the FSC or DISC or the transfer price of qualifying export 
property sold to the FSC or DISC.
    (g) Losses created through apportionment. In the case of an 
affiliated group that does not file a consolidated return, the taxable 
income in any separate limitation category must be adjusted under this 
paragraph (g) for purposes of computing the separate foreign tax credit 
limitations under section 904(d). As a consequence of the affiliated 
group allocation and apportionment of expenses required by section 
864(e)(6) and this section, expenses of a group member may be 
apportioned for section 904 purposes to a limitation category with a 
consequent loss in that limitation category. For purposes of this 
paragraph, the term ``limitation category'' includes domestic source 
income, as well as the types of income described in section 904(d)(1) 
(A) through (I). A loss of one affiliate in a limitation category will 
reduce the income of another member in the same limitation category if a 
consolidated return is filed. (See Sec.  1.1502-4.) If a consolidated 
return is not filed, this netting does not occur. Accordingly, in such a 
case, the following adjustments among members are required, in order to 
give effect to the group allocation of expense:
    (1) Losses created through group apportionment of expense in one or 
more limitation categories within a given member must be eliminated; and
    (2) A corresponding amount of income of other members in the same 
limitation category must be recharacterized.


Such adjustments shall be accomplished in accordance with the rules of 
Sec.  1.861-11T(g).
    (h) Special rule for the allocation of reserve expenses of a life 
insurance company. An amount of reserve expenses of a life insurance 
company equal to the dividends received deduction that is

[[Page 259]]

disallowed because it is attributable to the policyholders' share of 
dividends received shall be treated as definitely related to such 
dividends. The remaining reserve expenses of such company shall be 
allocated and apportioned under the rules of Sec.  1.861-8 and this 
section.
    (i) [Reserved]
    (j) Examples. The rules of this section may be illustrated by the 
following examples. All of these examples assume that section 482 has 
not been applied by the Commissioner.

    Example 1: (i) Facts. P owns all of the stock of X and all of the 
stock of Y. P, X and Y are domestic corporations. P is a holding company 
for the stock of X and Y. Both X and Y manufacture and sell a product 
which is included in a broad product category listed in Sec.  1.861-
8(e)(3)(i). During 1988, X incurred $100,000 on research connected with 
that product. All of the research was performed in the United States. In 
1988, the domestic sales by X of the product totalled $400,000 and the 
foreign sales of the product totalled $200,000; Y's domestic sales of 
the product totalled $200,000 and Y's foreign sales of the product 
totalled $200,000. In 1988, X's gross income is $300,000, of which 
$200,000 is from domestic sales and $100,000 is from foreign sales; Y's 
gross income is $200,000 of which $100,000 is from domestic sales and 
$100,000 is from foreign sales.
    (ii) P, X and Y are affiliated corporations within the meaning of 
section 864(e)(5) and this section. The research expenses incurred by X 
are allocable to all income connected with the relevant broad category 
listed in Sec.  1.861-8T(e)(3)(i). Both X and Y have gross income 
includible within the class of gross income related to that product 
category. Accordingly, the research and experimental expenses incurred 
by X are to be allocated and apportioned as if X and Y were a single 
corporation. The apportionment for 1988 is as follows:

              Tentative Apportionment on the Basis of Sales

Research expenses to be apportioned.............................$100,000
Exclusive apportionment to United States source gross income.....$30,000
Research expense to be apportioned on the basis of sales.........$70,000

Apportionment of research expense to foreign source general limitation 
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.018


Apportionment of research expense to United States source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.019

Total apportioned deduction for research........................$100,000

Of which--

Apportioned to foreign source gross income.......................$28,000
Apportioned to U.S. source gross income ($30,000 + $42,000)......$72,000

          Tentative Apportionment on the Basis of Gross Income

Research expense apportioned to foreign source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.020

Research expense apportioned to United States income:

[[Page 260]]

  
[GRAPHIC] [TIFF OMITTED] TC07OC91.021

    Example 2: (i) Facts. P owns all of the stock of X, which owns all 
of the stock of Y. P, X and Y are all domestic corporations. P has 
incurred general training program expenses of $100,000 in 1987. 
Employees of P, X and Y participate in the training program. In 1987, P 
had United States source gross income of $200,000 and foreign source 
general limitation income of $200,000; X had U.S. source gross income of 
$100,000 and foreign source general limitation income of $100,000; and Y 
had U.S. source gross income of $300,000 and foreign source general 
limitation income of $100,000.
    (ii) Analysis. P, X and Y are an affiliated group of corporations 
within the meaning of section 864(e)(5). The training expenses incurred 
by P are not definitely related solely to specific income producing 
activities or property of P. The employees of X and Y also participate 
in the training program. Thus, this expense relates to gross income 
generated by P, X and Y. This expense is definitely related and 
allocable to all of the gross income from foreign and domestic sources 
of P, X and Y. It is assumed that apportionment on the basis of gross 
income is reasonable. The apportionment of the expense is as follows:
Apportionment of $100,000 expense to foreign source general limitation 
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.022

Apportionment of $100,000 expense to United States source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.023

Total apportioned expense.......................................$100,000
    Example 3: (i) Facts. The facts are the same as in Example (2) 
above, except that only employees of P and X participate in the training 
program.
    (ii) Analysis. Because only the employees of P and X participate in 
the training program and they perform no services for Y, the expense 
relates only to gross income generated by P and X. Accordingly, the 
$100,000 expense must be allocated and apportioned as if P and X were a 
single corporation. The apportionment of the $100,000 expense is as 
follows:
Apportionment of $100,000 expense to foreign source general limitation 
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.024

Apportionment of $100,000 expense to U.S. source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.025


[[Page 261]]


    Example 4: (i) Facts. P owns all of the stock of X which owns all of 
the stock of Y. P and X are domestic corporations; Y is a foreign 
corporation. In 1987 P incurred $10,000 of stewardship expenses relating 
to an audit of Y.
    (ii) Analysis. The stewardship expenses incurred by P are not 
directly allocable to specific income producing activities or property 
of P. The expense is definitely related and allocable to dividends 
received or to be received by X. Accordingly, the expense of P is 
allocated and apportioned as if P and X were a single corporation. The 
expense is definitely related to dividends received or to be received by 
X from Y, a foreign corporation. Such dividends are foreign source 
general limitation income. Thus, the entire amount of the expense must 
be allocated to foreign source dividend income.
    Example 5: (i) Facts. P owns all of the stock of X which owns all of 
the stock of Y. P, X and Y are all domestic corporations. In 1987, P 
incurred $10,000 legal expense relating to the testimony of certain 
employees of P in connection with litigation to which Y is a party. This 
expense is not allocable to specific income of Y. In 1987, Y had 
$100,000 foreign source general limitation income and $300,000 U.S. 
source gross income.
    (ii) Analysis. The legal expenses incurred by P are not definitely 
related solely to specific income producing activities or property of P. 
The expense is definitely related and allocable to the class of gross 
income which includes only gross income generated by Y. Accordingly, the 
expense of P is allocated and apportioned as if Y were the only member 
of the affiliated group, as follows:

Apportionment of legal expenses to foreign source general limitation 
income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.026

Apportionment of legal expenses to U.S. source gross income:
[GRAPHIC] [TIFF OMITTED] TC07OC91.027

    Example 6: (i) Facts. P owns all of the stock of R, which owns all 
of the stock of F. P and R are domestic corporations, and F is a foreign 
sales corporation under section 922 of the Code. R and F have entered 
into an agreement whereby F is paid a commission with respect to sales 
of product A. In 1987, P had gross receipts of $1,000,000 from domestic 
sales of product A, and gross receipts of $1,000,000 from foreign sales 
of product A. R had gross receipts of $1,000,000 from domestic sales of 
product A, and $1,000,000 from export sales of product A. R's cost of 
goods sold attributable to export sales is $500,000. R has deductible 
expenses of $100,000 directly related to its export sales, and F has 
such deductible expenses of $100,000. During 1987, P incurred an expense 
of $100,000 for marketing studies involving the worldwide market for 
product A.
    (ii) Analysis. P and R are an affiliated group of corporations 
within the meaning of section 864(e)(5) and this section. The expense 
incurred by P for marketing studies regarding the worldwide market for 
product A is an expense that is not directly related solely to the 
activities of P, but also to the activities of R. This expense must be 
allocated and apportioned under the rules of paragraph (c)(1) of this 
section, as if P and R were a single corporation. The expense is 
allocable to the class of gross income that includes all gross income 
generated by sales of product A. Apportionment on the basis of gross 
receipts is reasonable under these facts. F, a foreign corporation, is 
not a member of the affiliated group. However, for purposes of 
determining F's commission on its sales, the combined gross income of F 
and R must be reduced by the portion of the marketing studies expense of 
P that is incurred in connection with export sales involving F under the 
rules of paragraph (f) of this section. The computation of the combined 
taxable income of R and F is as follows:

                   Combined Taxable Income of R and F
 
R's gross receipts from export sales.......................   $1,000,000
  R's cost of goods sold...................................     $500,000
                                                            ------------
Combined Gross Income......................................     $500,000
                                                            ------------
Less:
  R's other deductible expenses............................     $100,000
  F's other deductible expenses............................      100,000
  Apportionment of P's expense:
 

  [GRAPHIC] [TIFF OMITTED] TC07OC91.028
  

[[Page 262]]


      Total..................................................   $225,000
                                                              ----------
Combined Taxable Income......................................   $275,000
                                                              ==========
 

    (k) Effective/applicability date. The rules of this section apply 
for taxable years beginning after December 31, 1986.

[T.D. 8228, 53 FR 35501, Sept. 14, 1988, as amended by T.D. 8916, 65 FR 
274, Jan. 3, 2001; T.D. 9143, 69 FR 44932, July 28, 2004; T.D. 9211, 70 
FR 40663, July 14, 2005; T.D. 9456, 74 FR 38875, Aug. 4, 2009]



Sec.  1.861-15  Income from certain aircraft or vessels first leased 
on or before December 28, 1980.

    (a) General rule. A taxpayer who owns an aircraft or vessel 
described in paragraph (b) of this section and who leases the aircraft 
or vessel to a United States person (other than a member of the same 
controlled group of corporations (as defined in section 1563) as the 
taxpayer) may elect under paragraph (f) of this section to treat all 
amounts includible in gross income with respect to the aircraft or 
vessel as income from sources within the United States for any taxable 
year ending after the commencement of the lease. This paragraph (a) 
applies only with respect to taxable years ending after August 15, 1971, 
and only with respect to leases entered into after that date of aircraft 
or vessels first leased by the taxpayer on or before December 28, 1980. 
An election once made applies to the taxable year for which made and to 
all subsequent taxable years unless it is revoked or terminated in 
accordance with paragraph (g) of this section. A taxpayer need not be a 
United States person to be eligible to make the election under this 
section, unless otherwise required by a provision of law not contained 
in the Internal Revenue Code of 1954. In addition, the taxpayer need not 
be a bank or other financial institution to be eligible to make this 
election. The term ``United States person'' as used in this section has 
the meaning assigned to it by section 7701(a)(30).
    (b) Property to which the election applies--(1) Section 38 property. 
An election made under this section may be made only if the aircraft or 
vessel is section 38 property, or property which would be section 38 
property but for section 48(a)(5) (relating to property used by 
governmental units), at the time the election is made and for all 
taxable years to which the election applies. The aircraft or vessel must 
be property which qualifies for the investment credit under section 38 
unless the property does not qualify because it is described in section 
48(a)(5). If an aircraft is used predominantly outside the United States 
(determined under Sec.  1.48-1(g)(1)), it must qualify under the 
provisions of section 48(a)(2)(B)(i) and Sec.  1.48-1(g)(2)(i). If a 
vessel is used predominantly outside the United States, it must qualify 
under the provisions of section 48(a)(2)(B)(iii) and Sec.  1.48-
1(g)(2)(iii). The aircraft or vessel may not be suspension or 
termination period property described in section 48(h) or section 49(a) 
(as in effect before the enactment of the Revenue Act of 1978). See 
paragraph (g) (3) and (4) of this section for rules which apply if the 
property ceases to be section 38 property.
    (2) United States manufacture or construction. An election under 
this section may be made only if the aircraft or vessel is manufactured 
or constructed in the United States. The aircraft or vessel will be 
considered to be manufactured or constructed in the United States if 50 
percent or more of the basis of the aircraft or vessel is attributable 
to value added within the United States.
    (3) Exclusion of certain property used outside the United States. 
The term ``aircraft or vessel'' as used in this paragraph (b) does not 
include any property which is used predominantly outside the United 
States and which qualifies as section 38 property under--
    (i) Section 48(a)(2)(B)(v), relating to containers used in the 
transportation of property to and from the United States,
    (ii) Section 48(a)(2)(B)(vi), relating to certain property used for 
the purpose of exploring for, developing, removing, or transporting 
resources from the Outer Continental Shelf, or
    (iii) Section 48(a)(2)(B)(x), relating to certain property used in 
international or territorial waters.
    (c) Leases or subleases to which the election applies. At the time 
the election under this section is made and for all taxable years for 
which the election applies, the lessee of the aircraft or

[[Page 263]]

vessel must be a United States person. In addition, the aircraft or 
vessel may not be subleased to a person who is not a United States 
person unless the sublease is a short-term sublease. For purposes of 
this section, a short-term sublease is a sublease for a period of time 
(including any period for which the sublease may be renewed or extended) 
which is less than 30 percent of the asset guideline period of the 
aircraft or vessel leased (determined under section 167(m)). See 
paragraphs (g) (3) and (4) of this section for rules which apply if the 
requirements of this paragraph (c) are not met.
    (d) Income to which the election applies. An election under this 
section applies to all amounts derived by the taxpayer with respect to 
the aircraft or vessel which is subject to the election. The election 
applies to all amounts which are includible in the taxpayer's gross 
income whether or not includible during or after the period of a lease 
to which the election applies. Amounts derived by the taxpayer with 
respect to the aircraft or vessel include any gain from the sale, 
exchange, or other disposition of the aircraft or vessel. If by reason 
of the allowance of expenses and other deductions, there is a loss with 
respect to an aircraft or vessel, the election applies to treat the loss 
as having a source within the United States. Similarly, if the sale, 
exchange or other disposition of the aircraft or vessel which is subject 
to an election results in a loss, it is treated as having a source 
within the United States. See paragraph (e)(2) of this section for the 
application of an election under this section to the income of certain 
transferees or distributees.
    (e) Effect of election--(1) In general. An election under this 
section applies to the taxable year for which it is made and to all 
subsequent taxable years for which amounts in respect of the aircraft or 
vessel to which the election relates are includible in gross income. 
However, the election may be revoked under paragraph (g) (1) or (2) of 
this section or terminated under paragraph (g)(3) of this section.
    (2) Certain transfers involving carryover of basis. (i) If an 
electing taxpayer transfers or distributes an aircraft or vessel which 
is subject to the election under this section, the transferee or 
distributee will be treated as having made an election under this 
section with respect to the aircraft or vessel if the basis of the 
aircraft or vessel in the hands of the transferee or distributee is 
determined by reference to its basis in the hands of the transferor or 
distributor. This paragraph (e)(2)(i) applies even though the transferor 
or distributor recognizes an amount of gain which increases basis in the 
hands of the transferee or distributee and even though the transferee of 
distributee is a nonresident alien individual or foreign corporation. 
For example, if a corporation distributes a vessel which is subject to 
an election under this section to its parent corporation in a complete 
liquidation described in section 332(b), the parent corporation will be 
required to treat all amounts includible in its gross income with 
respect to the vessel as income from source within the United States if, 
unless the election is revoked or terminated under paragraph (g) of this 
section, the basis of the property in the hands of the parent is 
determined under section 334(b)(1) (relating to the general rule on 
carryover of basis). In further illustration, if a corporation 
distributes a vessel (subject to an election) in a distribution to which 
section 301(a) applies, the distributee will be treated as having made 
the election with respect to the vessel if its basis is determined under 
section 301(d)(2) (relating to basis of corporate distributees) even 
though the basis is the fair market value of the vessel under section 
301(d)(2)(A).
    (ii) If a member of an affiliated group which files a consolidated 
return transfers an aircraft or vessel subject to an election to another 
member of that group, the transferee will be treated as having made the 
election with respect to the aircraft or vessel. In addition, if a 
partnership distributes an aircraft or vessel subject to an election to 
a partner, the partner will be treated as having made the election with 
respect to the aircraft or vessel.
    (iii) If paragraph (e)(2) (i) and (ii) of this section do not apply, 
the election under this section with respect to an aircraft or vessel 
will not be considered as made by a transferee or distributee.

[[Page 264]]

    (f) Election--(1) Time for making the election. The election under 
this section must be made before the expiration of the period prescribed 
by section 6511(a) (or section 6511(c) if the period is extended by 
agreement) for making a claim for credit or refund of the tax imposed by 
chapter 1 for the first taxable year for which the election is to apply. 
The period for that first taxable year is determined without regard to 
the special periods prescribed by section 6511(d).
    (2) Manner of making the election. An election under this section 
must be made by filing with the income tax return (or an amended return) 
for the first taxable year for which the election is to apply a 
statement, signed by the taxpayer, to the effect that the election under 
section 861(e) is being made. The statement must--
    (i) Set forth sufficient facts to identify the aircraft or vessel 
which is the subject of the election,
    (ii) State that the aircraft or vessel was manufactured or 
constructed in the United States,
    (iii) State that the aircraft or vessel is section 38 property 
described in Sec.  1.861-9(b) which was leased to a United States person 
(as defined in section 7701(a)(30) of the Code) pursuant to a lease 
entered into after August 15, 1971,
    (iv) State that the electing taxpayer is the owner of the aircraft 
or vessel,
    (v) State the lessee of the aircraft or vessel is not a member of a 
controlled group of corporations (as defined in section 1563) of which 
the taxpayer is a member,
    (vi) Give the name and taxpayer identification number of the lessee 
of the aircraft or vessel, and
    (vii) State that the aircraft or vessel is not subject to a sublease 
(other than a short-term sublease) to any person who is not a United 
States person.
    (3) Election by partnership. Any election under this section with 
respect to an aircraft or vessel owned by a partnership shall be made by 
the partnership. Any partnership election is applicable to each 
partner's partnership interest in the aircraft or vessel. However, an 
election made by a partner before August 8, 1979 will be recognized 
where the partnership made no election and the election can no longer be 
revoked without the consent of the Commissioner under paragraph (g)(1) 
of this section.
    (g) Termination of election--(1) Revocation without consent. A 
taxpayer may revoke an election within the time prescribed in paragraph 
(f)(1) of this section without the consent of the Commissioner. In such 
a case, the taxpayer must file an amended income tax return for any 
taxable year to which the election applied.
    (2) Revocation with consent. Except as provided in paragraph (g) (1) 
or (3) of this section, an election made under this section is binding 
unless consent to revoke is obtained from the Commissioner. A request to 
revoke the election must be made in writing and addressed to the 
Assistant Commissioner of Internal Revenue (Technical), Attention: 
T:C:C:3, Washington, DC 20224. The request must include the name and 
address of the taxpayer and be signed by the taxpayer or his duly 
authorized representative. It must specify the taxable year or years for 
which the revocation is to be effective and must be filed at least 90 
days prior to the time (not including extensions) prescribed by law for 
filing the income tax return for the first taxable year for which the 
revocation of the election is to be effective or by November 6, 1979 
whichever is later. The request must specify the grounds which are 
considered to justify the revocation. The Commissioner may require such 
additional information as may be necessary in order to determine whether 
the proposed revocation will be permitted. Consent will generally not be 
given to revoke an election where the revocation would result in 
treating gross income with respect to the aircraft or vessel (including 
any gain from the sale, exchange, or other disposition of such aircraft 
or vessel) as income from sources without the United States where, 
during the period the election was in effect, there were losses from 
sources within the United States. A copy of the consent of the 
Commissioner to revoke must be attached to the taxpayer's income tax 
return (or amended return) for each taxable year affected by the 
revocation.
    (3) Automatic termination. If an aircraft or vessel subject to an 
election

[[Page 265]]

under section 861(e) ceases to be section 38 property, ceases to be 
leased by its owner directly to a United States person, or is subleased 
(other than a short-term sublease) to a person who is not a United 
States person, within the period set forth in section 6511(a) (or 
section 6511(c) if the period is extended by agreement) for making a 
claim for credit or refund of the tax imposed by chapter 1 for the first 
taxable year for which the election applied, then the election with 
respect to such aircraft or vessel will automatically terminate. If the 
election terminates, the taxpayer who made the election must file an 
amended tax return or claim for credit or refund, as the case may be, 
for any taxable year to which the election applied.
    (4) Factors not causing revocation or termination. The fact that an 
aircraft or vessel ceases to be section 38 property, ceases to be leased 
by its owner directly to a United States person, or is leased or 
subleased for any period of time to a person who is not a United States 
person, after expiration of the period set forth in section 6511(a) (or 
section 6511(c) if the period is extended by agreement) for making a 
claim for credit or refund of the tax imposed by chapter 1 for the first 
taxable year for which the election applied, will not cause a 
termination of the election made under this section with respect to the 
aircraft or vessel. For example, the electing taxpayer is not relieved 
from any of the consequences of making the election merely because the 
aircraft or vessel is subleased to a person who is not a United States 
person for a period in excess of that allowed for short-term subleases 
under paragraph (c) of this section after expiration of the later of 3 
years from the time the return was filed for the first taxable year to 
which the election applied or 2 years from the time the tax was paid for 
that year where the period set forth in section 6511(a) has not been 
extended by agreement.
    (5) Effect of revocation or termination. If an election is revoked 
or terminated under this paragraph (g), the taxpayer is required to 
recompute the tax for the appropriate taxable years without reference to 
section 861(e)(1).
    (6) Revocation or termination after December 28, 1980. The rules in 
paragraph (g)(1) through (g)(5) continue to apply with respect to any 
election made pursuant to this section even though the revocation or 
termination may occur after December 28, 1980.

[T.D. 7635, 44 FR 46457, Aug. 8, 1979, as amended by T.D. 7928, 48 FR 
55846, Dec. 16, 1983. Redesignated at 53 FR 35477, Sept. 14, 1988]



Sec.  1.861-16  Income from certain craft first leased after December 28, 1980.

    (a) General rule. If a taxpayer--
    (1) Owns a qualified craft (as defined in paragraph (b) of this 
section).
    (2) Leases such qualified craft after December 28, 1980, to a United 
States person that is not a member of the same controlled group of 
corporations as the taxpayer, and
    (3) The lease is the taxpayer's first lease of the craft and the 
taxpayer is not considered to have made an election with respect to the 
craft under Sec.  1.861-9(e)(2),


then the taxpayer shall treat all amounts includible in gross income 
with respect to the qualified craft as income from sources within the 
United States for each taxable year ending after commencement of the 
lease. If this section applies to income with respect to a craft, it 
applies to all such amounts that are includible in the taxpayer's gross 
income, whether or not includible during or after the period of a lease 
to a United States person. Amounts derived by the taxpayer with respect 
to the qualified craft include any gain from the sale, exchange, or 
other disposition of the qualified craft. If this section applies to 
income with respect to a craft and there is a loss with respect to that 
craft (either due to the allowance of expenses and other deductions or 
due to a sale, exchange, or other disposition of the qualified craft), 
such loss is treated as allocable or apportionable to sources within the 
United States. The fact that a craft ceases to be section 38 property, 
ceases to be leased by the taxpayer to a United States person, or is 
leased or subleased for any period of time to a person who is not a 
United States person will not terminate the application of this section.

[[Page 266]]

    (b) Qualified craft--(1) In general. A qualified craft is a vessel, 
aircraft, or spacecraft that--
    (i) Is section 38 property (or would be section 38 property but for 
section 48(a)(5), relating to use by governmental units), and
    (ii) Is manufactured or constructed in the United States.
    (2) Vessel. The term ``vessel'' includes every type of watercraft 
capable of being used as a means of transportation on water, and any 
items of property that are affixed in a permanent fashion or are 
integral to the vessel. A vessel that is used predominately outside the 
United States must be described in section 48(a)(2)(B)(iii) and Sec.  
1.48-1(g)(2)(iii), relating to vessels documented for use in the foreign 
or domestic commerce of the United States, to be a qualified craft.
    (3) Aircraft. An aircraft used predominantly outside the United 
States must be described in section 48(a)(2)(B)(i) and Sec.  1.48-
1(g)(2)(i), relating to aircraft registered by the Administrator of the 
Federal Aviation Agency, and operated to and from the United States or 
operated under contract with the United States, to be a qualified craft.
    (4) Spacecraft. A spacecraft must be described in section 
48(a)(2)(B)(viii) and Sec.  1.48-1(g)(2)(viii), relating to 
communications satellites, or any interest therein, of a United States 
person, to be a qualified craft.
    (5) United States manufacture or construction. A craft will be 
considered to be manufactured or constructed in the United States if 50 
percent or more of the basis of the craft on the date of the lease to a 
United States person is attributable to value added within the United 
States.
    (c) United States person. For purposes of this section, the term 
``United States person'' includes those persons described in section 
7701(a)(30) and individuals with respect to whom an election under 
section 6013 (g) or (h) (relating to nonresident alien individuals 
married to United States citizens or residents) is in effect.
    (d) Controlled group. For purposes of paragraph (a)(2) of this 
section, whether a taxpayer and a United States person are members of 
the same controlled group of corporations is determined under section 
1563. Solely for purposes of this section, if at least 80% of the 
capital interest, or the profits interest, in a partnership is owned, 
directly or indirectly, by a member or members of a controlled group of 
corporations, then the partnership shall be considered a member of that 
controlled group of corporations. In addition, if at least 80% of the 
capital interest, or the profits interest, in a partnership is owned, 
directly or indirectly, by a corporation, then the partnership and that 
corporation shall be considered members of a controlled group of 
corporations.
    (e) Certain transfers and distributions--(1) Transfers and 
distributions involving carryover of basis. If--
    (i) The income with respect to a craft is subject to this section,
    (ii) The taxpayer transfers or distributes such craft, and
    (iii) The basis of such craft in the hands of the transferee or 
distributee is determined by reference to its basis in the hands of the 
transferor or distributor,


then this section will apply to the income with respect to the craft 
includible in the gross income of the transferee or distributee. This 
paragraph (e)(1) applies even though the transferor or distributor 
recognizes an amount of gain that increases basis in the hands of the 
transferee or distributee and even though the transferee or distributee 
is a nonresident alien or foreign corporation. For example, if a 
corporation distributes a craft the income of which is subject to this 
section to its parent corporation in a complete liquidation described in 
section 332(b), the parent corporation will be treated as if it 
satisified the requirements of paragraph (a) of this section with 
respect to such craft if the basis of the property in the hands of the 
parent corporation is determined under section 334(b) (relating to the 
general rule on carryover of basis in liquidations). In further 
illustration, if a corporation distributes a craft the income of which 
is subject to this section, in a distribution to which section 301(a) 
applies, the distributee will be treated as if it satisfied the 
requirements of paragraph (a) of this section with respect to such craft 
if its basis is determined

[[Page 267]]

under section 301(d)(2) (relating to basis of corporate distributees) 
even though the basis may be the fair market value of the craft under 
section 301(d)(2)(A).
    (2) Partnerships. If a partnership satisfies the requirements of 
paragraph (a) (1), (2), and (3) of this section, each partner shall 
treat all amounts includible in gross income with respect to the craft 
as income from sources within the United States for any taxable year of 
the partnership ending after commencement of the lease. In addition, if 
a partnership distributes a craft the income of which is subject to this 
section, to a partner, the partner will be treated as if he or she 
satisfied the requirements of paragraph (a) of this section with respect 
to such craft.
    (3) Affiliated groups. If a member of a group of corporations that 
files a consolidated return transfers a craft, the income of which is 
subject to this section, to another member of that same group, the 
transferee will be treated as if it satisfied the requirements of 
paragraph (a) of this section with respect to the craft.

[T.D. 7928, 48 FR 55846, Dec. 16, 1983. Redesignated by T.D. 8228, 53 FR 
35477, Sept. 14, 1988]



Sec.  1.861-17  Allocation and apportionment of research 
and experimental expenditures.

    (a) Allocation--(1) In general. The methods of allocation and 
apportionment of research and experimental expenditures set forth in 
this section recognize that research and experimentation is an 
inherently speculative activity, that findings may contribute unexpected 
benefits, and that the gross income derived from successful research and 
experimentation must bear the cost of unsuccessful research and 
experimentation. Expenditures for research and experimentation that a 
taxpayer deducts under section 174 ordinarily shall be considered 
deductions that are definitely related to all income reasonably 
connected with the relevant broad product category (or categories) of 
the taxpayer and therefore allocable to all items of gross income as a 
class (including income from sales, royalties, and dividends) related to 
such product category (or categories). For purposes of this allocation, 
the product category (or categories) that a taxpayer may be considered 
to have shall be determined in accordance with the provisions of 
paragraph (a)(2) of this section.
    (2) Product categories--(i) Allocation based on product categories. 
Ordinarily, a taxpayer's research and experimental expenditures may be 
divided between the relevant product categories. Where research and 
experimentation is conducted with respect to more than one product 
category, the taxpayer may aggregate the categories for purposes of 
allocation and apportionment; however, the taxpayer may not subdivide 
the categories. Where research and experimentation is not clearly 
identified with any product category (or categories), it will be 
considered conducted with respect to all the taxpayer's product 
categories.
    (ii) Use of three digit standard industrial classification codes. A 
taxpayer shall determine the relevant product categories by reference to 
the three digit classification of the Standard Industrial Classification 
Manual (SIC code). A copy may be purchased from the Superintendent of 
Documents, United States Government Printing Office, Washington, DC 
20402. The individual products included within each category are 
enumerated in Executive Office of the President, Office of Management 
and Budget, Standard Industrial Classification Manual, 1987 (or later 
edition, as available).
    (iii) Consistency. Once a taxpayer selects a product category for 
the first taxable year for which this section is effective with respect 
to the taxpayer, it must continue to use that product category in 
following years, unless the taxpayer establishes to the satisfaction of 
the Commissioner that, due to changes in the relevant facts, a change in 
the product category is appropriate. For this purpose, a change in the 
taxpayer's selection of a product category shall include a change from a 
three digit SIC code category to a two digit SIC code category, a change 
from a two digit SIC code category to a three digit SIC code category, 
or any other aggregation, disaggregation or change of a previously 
selected SIC code category.
    (iv) Wholesale trade category. The two digit SIC code category 
``Wholesale

[[Page 268]]

trade'' is not applicable with respect to sales by the taxpayer of goods 
and services from any other of the taxpayer's product categories and is 
not applicable with respect to a domestic international sales 
corporation (DISC) or foreign sales corporation (FSC) for which the 
taxpayer is a related supplier of goods and services from any of the 
taxpayer's product categories.
    (v) Retail trade category. The two digit SIC code category ``Retail 
trade'' is not applicable with respect to sales by the taxpayer of goods 
and services from any other of the taxpayer's product categories, except 
wholesale trade, and is not applicable with respect to a DISC or FSC for 
which the taxpayer is a related supplier of goods and services from any 
other of the taxpayer's product categories, except wholesale trade.
    (3) Affiliated Groups--(i) In general. Except as provided in 
paragraph (a)(3)(ii) of this section, the allocation and apportionment 
required by this section shall be determined as if all members of the 
affiliated group (as defined in Sec.  1.861-14T(d)) were a single 
corporation. See Sec.  1.861-14T.
    (ii) Possessions corporations. (A) For purposes of the allocation 
and apportionment required by this section, sales and gross income from 
products produced in whole or in part in a possession by an electing 
corporation (within the meaning of section 936(h)(5)(E)), and dividends 
from an electing corporation, shall not be taken into account, except 
that this paragraph (a)(3)(ii) shall not apply to sales of (and gross 
income and dividends attributable to sales of) products with respect to 
which an election under section 936(h)(5)(F) is not in effect.
    (B) The research and experimental expenditures taken into account 
for purposes of this section shall be reduced by the amount of such 
expenditures included in computing the cost-sharing amount (determined 
under section 936(h)(5)(C)(i)).
    (4) Legally mandated research and experimentation. Where research 
and experimentation is undertaken solely to meet legal requirements 
imposed by a political entity with respect to improvement or marketing 
of specific products or processes, and the results cannot reasonably be 
expected to generate amounts of gross income (beyond de minimis amounts) 
outside a single geographic source, the deduction for such research and 
experimentation shall be considered definitely related and therefore 
allocable only to the grouping (or groupings) of gross income within 
that geographic source as a class (and apportioned, if necessary, 
between such groupings as set forth in paragraphs (c) and (d) of this 
section). For example, where a taxpayer performs tests on a product in 
response to a requirement imposed by the U.S. Food and Drug 
Administration, and the test results cannot reasonably be expected to 
generate amounts of gross income (beyond de minimis amounts) outside the 
United States, the costs of testing shall be allocated solely to gross 
income from sources within the United States.
    (b) Exclusive apportionment--(1) In general. An exclusive 
apportionment shall be made under this paragraph (b), where an 
apportionment based upon geographic sources of income of a deduction for 
research and experimentation is necessary (after applying the exception 
in paragraph (a)(4) of this section).
    (i) Exclusive apportionment under the sales method. If the taxpayer 
apportions on the sales method under paragraph (c) of this section, an 
amount equal to fifty percent of such deduction for research and 
experimentation shall be apportioned exclusively to the statutory 
grouping of gross income or the residual grouping of gross income, as 
the case may be, arising from the geographic source where the research 
and experimental activities which account for more than fifty percent of 
the amount of such deduction were performed.
    (ii) Exclusive apportionment under the optional gross income 
methods. If the taxpayer apportions on the optional gross income methods 
under paragraph (d) of this section, an amount equal to twenty-five 
percent of such deduction for research and experimentation shall be 
apportioned exclusively to the statutory grouping or the residual 
grouping of gross income, as the case may be, arising from the 
geographic source where the research and experimental activities which 
account for more than

[[Page 269]]

fifty percent of the amount of such deduction were performed.
    (iii) Exception. If the applicable fifty percent geographic source 
test of the preceding paragraph (b)(1)(i) or (ii) is not met, then no 
part of the deduction shall be apportioned under this paragraph (b)(1).
    (2) Facts and circumstances supporting an increased exclusive 
apportionment--(i) In general. The exclusive apportionment provided for 
in paragraph (b)(1) of this section reflects the view that research and 
experimentation is often most valuable in the country where it is 
performed, for two reasons. First, research and experimentation often 
benefits a broad product category, consisting of many individual 
products, all of which may be sold in the nearest market but only some 
of which may be sold in foreign markets. Second, research and 
experimentation often is utilized in the nearest market before it is 
used in other markets, and in such cases, has a lower value per unit of 
sales when used in foreign markets. The taxpayer may establish to the 
satisfaction of the Commissioner that, in its case, one or both of the 
conditions mentioned in the preceding sentences warrant a significantly 
greater exclusive allocation percentage than allowed by paragraph (b)(1) 
of this section because the research and experimentation is reasonably 
expected to have very limited or long delayed application outside the 
geographic source where it was performed. Past experience with research 
and experimentation may be considered in determining reasonable 
expectations.
    (ii) Not all products sold in foreign markets. For purposes of 
establishing that only some products within the product category (or 
categories) are sold in foreign markets, the taxpayer shall compare the 
commercial production of individual products in domestic and foreign 
markets made by itself, by uncontrolled parties (as defined under 
paragraph (c)(2)(i) of this section) of products involving intangible 
property which was licensed or sold by the taxpayer, and by those 
controlled corporations (as defined under paragraph (c)(3)(ii) of this 
section) that can reasonably be expected to benefit directly or 
indirectly from any of the taxpayer's research expense connected with 
the product category (or categories). The individual products compared 
for this purpose shall be limited, for nonmanufactured categories, 
solely to those enumerated in Executive Office of the President, Office 
of Management and Budget Standard Industrial Classification Manual, 1987 
(or later edition, as available), and, for manufactured categories, 
solely to those enumerated at a 7-digit level in the U.S. Bureau of the 
Census, Census of Manufacturers: 1992, Numerical List of Manufactured 
Products, 1993, (or later edition, as available). Copies of both of 
these documents may be purchased from the Superintendent of Documents, 
United States Government Printing Office, Washington, DC 20402.
    (iii) Delayed application of research findings abroad. For purposes 
of establishing the delayed application of research findings abroad, the 
taxpayer shall compare the commercial introduction of its own particular 
products and processes (not limited by those listed in the Standard 
Industrial Classification Manual or the Numerical List of Manufactured 
Products) in the United States and foreign markets, made by itself, by 
uncontrolled parties (as defined under paragraph (c)(2)(i) of this 
section) of products involving intangible property that was licensed or 
sold by the taxpayer, and by those controlled corporations (as defined 
under paragraph (c)(3)(i) of this section) that can reasonably be 
expected to benefit, directly or indirectly, from the taxpayer's 
research expense. For purposes of evaluating the delay in the 
application of research findings in foreign markets, the taxpayer shall 
use a safe haven discount rate of 10 percent per year of delay unless he 
is able to establish to the satisfaction of the Commissioner, by 
reference to the cost of money and the number of years during which 
economic benefit can be directly attributable to the results of the 
taxpayer's research, that another discount rate is more appropriate.
    (c) Sales method--(1) In general. The amount equal to the remaining 
portion of such deduction for research and experimentation, not 
apportioned under paragraph (a)(4) or (b)(1)(i) of this section, shall 
be apportioned between the

[[Page 270]]

statutory grouping (or among the statutory groupings) within the class 
of gross income and the residual grouping within such class in the same 
proportions that the amount of sales from the product category (or 
categories) that resulted in such gross income within the statutory 
grouping (or statutory groupings) and in the residual grouping bear, 
respectively, to the total amount of sales from the product category (or 
categories).
    (i) Apportionment in excess of gross income. Amounts apportioned 
under this section may exceed the amount of gross income related to the 
product category within the statutory grouping. In such case, the excess 
shall be applied against other gross income within the statutory 
grouping. See Sec.  1.861-8(d)(1) for instances where the apportionment 
leads to an excess of deductions over gross income within the statutory 
grouping.
    (ii) Leased property. For purposes of this paragraph (c), amounts 
received from the lease of equipment during a taxable year shall be 
regarded as sales receipts for such taxable year.
    (2) Sales of uncontrolled parties. For purposes of the apportionment 
under paragraph (c)(1) of this section, the sales from the product 
category (or categories) by each party uncontrolled by the taxpayer, of 
particular products involving intangible property that was licensed or 
sold by the taxpayer to such uncontrolled party shall be taken fully 
into account both for determining the taxpayer's apportionment and for 
determining the apportionment of any other member of a controlled group 
of corporations to which the taxpayer belongs if the uncontrolled party 
can reasonably be expected to benefit directly or indirectly (through 
any member of the controlled group of corporations to which the taxpayer 
belongs) from the research expense connected with the product category 
(or categories) of such other member. An uncontrolled party can 
reasonably be expected to benefit from the research expense of a member 
of a controlled group of corporations to which the taxpayer belongs if 
such member can reasonably be expected to license, sell, or transfer 
intangible property to that uncontrolled party or transfer secret 
processes to that uncontrolled party, directly or indirectly through a 
member of the controlled group of corporations to which the taxpayer 
belongs. Past experience with research and experimentation shall be 
considered in determining reasonable expectations.
    (i) Definition of uncontrolled party. For purposes of this paragraph 
(c)(2) the term uncontrolled party means a party that is not a person 
with a relationship to the taxpayer specified in section 267(b), or is 
not a member of a controlled group of corporations to which the taxpayer 
belongs (within the meaning of section 993(a)(3) or 927(d)(4)).
    (ii) Licensed products. In the case of licensed products, if the 
amount of sales of such products is unknown (for example, where the 
licensed product is a component of a large machine), a reasonable 
estimate based on the principles of section 482 should be made.
    (iii) Sales of intangible property. In the case of sales of 
intangible property, regardless of whether the consideration received in 
exchange for the intangible is a fixed amount or is contingent on the 
productivity, use, or disposition of the intangible, if the amount of 
sales of products utilizing the intangible property is unknown, a 
reasonable estimate of sales shall be made annually. If necessary, 
appropriate economic analyses shall be used to estimate sales.
    (3) Sales of controlled parties. For purposes of the apportionment 
under paragraph (c)(1) of this section, the sales from the product 
category (or categories) of the taxpayer shall be taken fully into 
account and the sales from the product category (or categories) of a 
corporation controlled by the taxpayer shall be taken into account to 
the extent provided in this paragraph (c)(3) for determining the 
taxpayer's apportionment, if such corporation can reasonably be expected 
to benefit directly or indirectly (through another member of the 
controlled group of corporations to which the taxpayer belongs) from the 
taxpayer's research expense connected with the product category (or 
categories). A corporation controlled by the taxpayer can reasonably be 
expected to benefit from the taxpayer's research expense if the taxpayer 
can be expected to license, sell, or transfer intangible property to 
that

[[Page 271]]

corporation or transfer secret processes to that corporation, either 
directly or indirectly through a member of the controlled group of 
corporations to which the taxpayer belongs. Past experience with 
research and experimentation shall be considered in determining 
reasonable expectations.
    (i) Definition of a corporation controlled by the taxpayer. For 
purposes of this paragraph (c)(3), the term a corporation controlled by 
the taxpayer means any corporation that has a relationship to the 
taxpayer specified in section 267(b) or is a member of a controlled 
group of corporations to which the taxpayer belongs (within the meaning 
of section 993(a)(3) or 927(d)(4).
    (ii) Sales to be taken into account. The sales from the product 
category (or categories) of a corporation controlled by the taxpayer 
taken into account shall be equal to the amount of sales that bear the 
same proportion to the total sales of the controlled corporation as the 
total value of all classes of the stock of such corporation owned 
directly or indirectly by the taxpayer, within the meaning of section 
1563, bears to the total value of all classes of stock of such 
corporation.
    (iii) Sales not to be taken into account more than once. Sales from 
the product category (or categories) between or among such controlled 
corporations or the taxpayer shall not be taken into account more than 
once; in such a situation, the amount sold by the selling corporation to 
the buying corporation shall be subtracted from the sales of the buying 
corporation.
    (iv) Effect of cost sharing arrangements. If the corporation 
controlled by the taxpayer has entered into a cost sharing arrangement, 
in accordance with the provisions of Sec.  1.482-7, with the taxpayer 
for the purpose of developing intangible property, then that corporation 
shall not reasonably be expected to benefit from the taxpayer's share of 
the research expense.
    (d) Gross income methods--(1)(i) In general. In lieu of applying the 
sales method of paragraph (c) of this section, the remaining amount of 
the deduction for research and experimentation, not apportioned under 
paragraph (a)(4) or (b)(1)(ii) of this section, shall be apportioned as 
prescribed in paragraphs (d)(2) and (3) of this section, between the 
statutory grouping (or among the statutory groupings) of gross income 
and the residual grouping of gross income.
    (ii) Optional methods to be applied to all research and experimental 
expenditures. These optional methods must be applied to the taxpayer's 
entire deduction for research and experimental expense remaining after 
applying the exception in paragraph (a)(4) of this section, and may not 
be applied on a product category basis. Thus, after the allocation of 
the taxpayer's entire deduction for research and experimental expense 
under paragraph (a)(2) of this section (by attribution to SIC code 
categories), the taxpayer must then apportion as necessary the entire 
deduction as allocated by separate amounts to various product 
categories, using only the sales method under paragraph (c) of this 
section or only the optional gross income methods under this paragraph 
(d). The taxpayer may not use the sales method for a portion of the 
deduction and optional gross income methods for the remainder of the 
deduction separately allocated.
    (2) Option one. The taxpayer may apportion its research and 
experimental expenditures ratably on the basis of gross income between 
the statutory grouping (or among the statutory groupings) of gross 
income and the residual grouping of gross income in the same proportions 
that the amount of gross income in the statutory grouping (or groupings) 
and the amount of gross income in the residual grouping bear, 
respectively, to the total amount of gross income, if the conditions 
described in paragraph (d)(2)(i) and (ii) of this section are both met.
    (i) The amount of research and experimental expense ratably 
apportioned to the statutory grouping (or groupings in the aggregate) is 
not less than fifty percent of the amount that would have been so 
apportioned if the taxpayer had used the method described in paragraph 
(c) of this section; and
    (ii) The amount of research and experimental expense ratably 
apportioned to the residual grouping is not less than fifty percent of 
the amount that would have been so apportioned if

[[Page 272]]

the taxpayer had used the method described in paragraph (c) of this 
section.
    (3) Option two. If, when the amount of research and experimental 
expense is apportioned ratably on the basis of gross income, either of 
the conditions described in paragraph (d)(2)(i) or (ii) of this section 
is not met, the taxpayer may either--
    (i) Where the condition of paragraph (d)(2)(i) of this section is 
not met, apportion fifty percent of the amount of research and 
experimental expense that would have been apportioned to the statutory 
grouping (or groupings in the aggregate) under paragraph (c) of this 
section to such statutory grouping (or to such statutory groupings in 
the aggregate and then among such groupings on the basis of gross income 
within each grouping), and apportion the balance of the amount of 
research and experimental expenses to the residual grouping; or
    (ii) Where the condition of paragraph (d)(2)(ii) of this section is 
not met, apportion fifty percent of the amount of research and 
experimental expense that would have been apportioned to the residual 
grouping under paragraph (c) of this section to such residual grouping, 
and apportion the balance of the amount of research and experimental 
expenses to the statutory grouping (or to the statutory groupings in the 
aggregate and then among such groupings ratably on the basis of gross 
income within each grouping).
    (e) Binding election--(1) In general. A taxpayer may choose to use 
either the sales method under paragraph (c) of this section or the 
optional gross income methods under paragraph (d) of this section for 
its original return for its first taxable year to which this section 
applies. The taxpayer's use of either the sales method or the optional 
gross income methods for its return filed for its first taxable year to 
which this section applies shall constitute a binding election to use 
the method chosen for that year and for four taxable years thereafter.
    (2) Change of method. The taxpayer's election of a method may not be 
revoked during the period referred to in paragraph (e)(1) of this 
section without the prior consent of the Commissioner. After the 
expiration of that period, the taxpayer may change methods without the 
prior consent of the Commissioner. However, the taxpayer's use of the 
new method shall constitute a binding election to use the new method for 
its return filed for the first year for which the taxpayer uses the new 
method and for four taxable years thereafter. The taxpayer's election of 
the new method may not be revoked during that period without the prior 
consent of the Commissioner.
    (i) Short taxable years. For purposes of this paragraph (e), the 
term taxable year includes a taxable year of less than twelve months.
    (ii) Affiliated groups. In the case of an affiliated group, the 
period referred to in paragraph (e)(1) of this section shall commence as 
of the latest taxable year in which any member of the group has changed 
methods.
    (f) Special rules for partnerships--(1) Research and experimental 
expenditures. For purposes of applying this section, if research and 
experimental expenditures are incurred by a partnership in which the 
taxpayer is a partner, the taxpayer's research and experimental 
expenditures shall include the taxpayer's distributive share of the 
partnership's research and experimental expenditures.
    (2) Purpose and location of expenditures. In applying the exception 
for expenditures undertaken to meet legal requirements under paragraph 
(a)(4) of this section and the exclusive apportionment for the sales 
method and the optional gross income methods under paragraph (b) of this 
section, a partner's distributive share of research and experimental 
expenditures incurred by a partnership shall be treated as incurred by 
the partner for the same purpose and in the same location as incurred by 
the partnership.
    (3) Apportionment under the sales method. In applying the remaining 
apportionment for the sales method under paragraph (c) of this section, 
a taxpayer's sales from a product category shall include the taxpayer's 
share of any sales from the product category of any partnership in which 
the taxpayer is a partner. For purposes of the preceding sentence, a 
taxpayer's share of

[[Page 273]]

sales shall be proportionate to the taxpayer's distributive share of the 
partnership's gross income in the product category.
    (g) Effective date. This section applies to taxable years beginning 
after December 31, 1995. However, a taxpayer may at his or her option, 
apply this section in its entirety to all taxable years beginning after 
August 1, 1994.
    (h) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) Facts. X, a domestic corporation, is a manufacturer 
and distributor of small gasoline engines for lawn mowers. Gasoline 
engines are a product within the category, Engines and Turbines (SIC 
Industry Group 351). Y, a wholly owned foreign subsidiary of X, also 
manufactures and sells these engines abroad. During 1996, X incurred 
expenditures of $60,000 on research and experimentation, which it 
deducts as a current expense, to invent and patent a new and improved 
gasoline engine. All of the research and experimentation was performed 
in the United States. In 1996, the domestic sales by X of the new engine 
total $500,000 and foreign sales by Y total $300,000. X provides 
technology for the manufacture of engines to Y via a license that 
requires the payment of an arm's length royalty. In 1996, X's gross 
income is $160,000, of which $140,000 is U.S. source income from 
domestic sales of gasoline engines and $10,000 is foreign source 
royalties from Y, and $10,000 is U.S. source interest income.
    (ii) Allocation. The research and experimental expenditures were 
incurred in connection with small gasoline engines and they are 
definitely related to the items of gross income to which the research 
gives rise, namely gross income from the sale of small gasoline engines 
in the United States and royalties received from subsidiary Y, a foreign 
manufacturer of gasoline engines. Accordingly, the expenses are 
allocable to this class of gross income. The U.S. source interest income 
is not within this class of gross income and, therefore, is not taken 
into account.
    (iii) Apportionment. (A) For purposes of applying the foreign tax 
credit limitation, the statutory grouping is general limitation gross 
income from sources without the United States and the residual grouping 
is gross income from sources within the United States. Since the related 
class of gross income derived from the use of engine technology consists 
of both gross income from sources without the United States (royalties 
from Y) and gross income from sources within the United States (gross 
income from engine sales), X's deduction of $60,000 for its research and 
experimental expenditure must be apportioned between the statutory and 
residual grouping before the foreign tax credit limitation may be 
determined. Because more than 50 percent of X's research and 
experimental activity was performed in the United States, 50 percent of 
that deduction can be apportioned exclusively to the residual grouping 
of gross income, gross income from sources within the United States. The 
remaining 50 percent of the deduction can then be apportioned between 
the residual and statutory groupings on the basis of sales of small 
gasoline engines by X and Y. Alternatively, X's deduction for research 
and experimentation can be apportioned under the optional gross income 
method. The apportionment for 1996 is as follows:

            (1) Tentative Apportionment on the Basis of Sales

(i) Research and experimental expense to be apportioned          $60,000
 between residual and statutory groupings of gross income:...
(ii) Less: Exclusive apportionment of research and               $30,000
 experimental expense to the residual grouping of gross
 income ($60,000 x 50 percent):..............................
(iii) Research and experimental expense to be apportioned        $30,000
 between residual and statutory groupings of gross income on
 the basis of sales:.........................................
(iv) Apportionment of research and experimental expense to       $18,750
 the residual grouping of gross income ($30,000 x $500,000/
 ($500,000 + $300,000)):.....................................
(v) Apportionment of research and experimental expense to the    $11,250
 statutory grouping of gross income ($30,000 x $300,000/
 ($500,000 + $300,000)):.....................................
(vi) Total apportioned deduction for research and                $60,000
 experimentation:............................................
(vii) Amount apportioned to the residual grouping ($30,000 +     $48,750
 $18,750):...................................................
(viii) Amount apportioned to the statutory grouping:.........    $11,250
 

        (2) Tentative Apportionment on the Basis of Gross Income.

(i) Exclusive apportionment of research and experimental         $15,000
 expense to the residual grouping of gross income ($60,000 x
 25 percent):................................................
(ii) Research and experimental expense apportioned to sources    $42,000
 within the United States (residual grouping) ($45,000 x
 $140,000/($140,000 + $10,000)):.............................
(iii) Research and experimental expense apportioned to            $3,000
 sources within country Y (statutory grouping) ($45,000 x
 $10,000/($140,000 + $10,000)):..............................
(iv) Amount apportioned to the residual grouping:............    $57,000
(v) Amount apportioned to the statutory grouping:............     $3,000
 

    (B) The total research and experimental expense apportioned to the 
statutory grouping ($3,000) under the gross income method is 
approximately 26 percent of the amount apportioned to the statutory 
grouping under the sales method. Thus, X may use option two of the gross 
income method (paragraph (d)(3) of this section) and apportion to the 
statutory grouping fifty percent (50%) of the

[[Page 274]]

$11,250 apportioned to that grouping under the sales method. Thus, X 
apportions $5,625 of research and experimental expense to the statutory 
grouping. X's use of the optional gross income methods will constitute a 
binding election to use the optional gross income methods for 1996 and 
four taxable years thereafter.
    Example 2. (i) Facts. Assume the same facts as in Example 1 except 
that X also spends $30,000 in 1996 for research on steam turbines, all 
of which is performed in the United States, and X has steam turbine 
sales in the United States of $400,000. X's foreign subsidiary Y neither 
manufactures nor sells steam turbines. The steam turbine research is in 
addition to the $60,000 in research which X does on gasoline engines for 
lawnmowers. X thus has a deduction of $90,000 for its research activity. 
X's gross income is $200,000, of which $140,000 is U.S. source income 
from domestic sales of gasoline engines, $50,000 is U.S. source income 
from domestic sales of steam turbines, and $10,000 is foreign source 
royalties from Y.
    (ii) Allocation. X's research expenses generate income from sales of 
small gasoline engines and steam turbines. Both of these products are in 
the same three digit SIC code category, Engines and Turbines (SIC 
Industry Group 351). Therefore, the deduction is definitely related to 
this product category and allocable to all items of income attributable 
to it. These items of X's income are gross income from the sale of small 
gasoline engines and steam turbines in the United States and royalties 
from foreign subsidiary Y, a foreign manufacturer and seller of small 
gasoline engines.
    (iii) Apportionment. (A) For purposes of applying the foreign tax 
credit limitation, the statutory grouping is general limitation gross 
income from sources outside the United States and the residual grouping 
is gross income from sources within the United States. X's deduction of 
$90,000 must be apportioned between the statutory and residual 
groupings. Because more than 50 percent of X's research and experimental 
activity was performed in the United States, 50 percent of that 
deduction can be apportioned exclusively to the residual grouping, gross 
income from sources within the United States. The remaining 50 percent 
of the deduction can then be apportioned between the residual and 
statutory groupings on the basis of total sales of small gasoline 
engines and steam turbines by X and Y. Alternatively, X's deduction for 
research and experimentation can be apportioned under the optional gross 
income methods. The apportionment for 1996 is as follows:
    (1) Tentative Apportionment on the Basis of Sales

(i) Research and experimental expense to be apportioned          $90,000
 between residual and statutory groupings of gross income:...
(ii) Less: Exclusive apportionment of the research and           $45,000
 experimental expense to the residual grouping of gross
 income ($90,000 x 50 percent):..............................
(iii) Research and experimental expense to be apportioned        $45,000
 between the residual and statutory groupings of gross income
 on the basis of sales:......................................
(iv) Apportionment of research and experimental expense to       $33,750
 the residual grouping of gross income ($45,000 x ($500,000 +
 $400,000)/($500,000 + $400,000 + $300,000)):................
(v) Apportionment of research and experimental expense to the    $11,250
 statutory grouping of gross income ($45,000 x $300,000/
 ($500,000 + $400,000 + $300,000)):..........................
(vi) Total apportioned deduction for research and                $90,000
 experimentation:............................................
(vii) Amount apportioned to the residual grouping ($45,000 +     $78,750
 $33,750):...................................................
(viii) Amount apportioned to the statutory grouping:.........    $11,250
 

    (2) Tentative Apportionment on the Basis of Gross Income

(i) Exclusive apportionment of research and experimental         $22,500
 expense to the residual grouping of gross income ($90,000 x
 25 percent):................................................
(ii) Research and experimental expense apportioned to sources    $64,125
 within the United States (residual grouping) ($67,500 x
 $190,000/($140,000 + $50,000 + $10,000)):...................
(iii) Research and experimental expense apportioned to            $3,375
 sources within country Y (statutory grouping) ($67,500 x
 $10,000/($140,000 + $50,000 + $10,000)):....................
(iv) Amount apportioned to the residual grouping:............    $86,625
(v) Amount apportioned to the statutory grouping:............     $3,375
 

    (B) The total research and experimental expense apportioned to the 
statutory grouping ($3,375) under the gross income method is 30 percent 
of the amount apportioned to the statutory grouping under the sales 
method. Thus, X may use option two of the gross income method (paragraph 
(d)(3) of this section) and apportion to the statutory grouping fifty 
percent (50%) of the $11,250 apportioned to that grouping under the 
sales method. Thus, X apportions $5,625 of research and experimental 
expense to the statutory grouping. X's use of the optional gross income 
methods will constitute a binding election to use the optional gross 
income methods for 1996 and four taxable years thereafter.
    Example 3. (i) Facts. Assume the same facts as in Example 1 except 
that in 1997 X continues its sales of the new engines, with sales of 
$600,000 in the United States and $400,000 abroad by subsidiary Y. X 
also acquires a 60 percent (by value) ownership interest in foreign 
corporation Z and a 100 percent ownership interest in foreign 
corporation C. X transfers its engine technology to Z for a royalty 
equal to 5 percent of sales, and X enters into an arm's length cost-
sharing arrangement with C to share the funding of all of X's research 
activity. In 1997, corporation Z has sales in country Z equal to 
$1,000,000. X

[[Page 275]]

incurs expense of $80,000 on research and experimentation in 1997, and 
in addition, X performs $15,000 of research on gasoline engines which 
was funded by the cost-sharing arrangement with C. All of Z's sales are 
from the product category, Engines and Turbines (SIC Industry Group 
351). X performs all of its research in the United States and $20,000 of 
its expenditure of $80,000 is made solely to meet pollution standards 
mandated by law. X establishes, to the satisfaction of the Commissioner, 
that the expenditure in response to pollution standards is not expected 
to generate gross income (beyond de minimis amounts) outside the United 
States.
    (ii) Allocation. The $20,000 of research expense which X incurred in 
connection with pollution standards is definitely related and thus 
allocable to the residual grouping, gross income from sources within the 
United States. The remaining $60,000 in research and experimental 
expenditure incurred by X is definitely related to all gasoline engines 
and is therefore allocable to the class of gross income to which the 
engines give rise, gross income from sales of gasoline engines in the 
United States, royalties from country Y, and royalties from country Z. 
No part of the $60,000 research expense is allocable to dividends from 
country C, because corporation C has already paid, through its cost-
sharing arrangement, for research activity performed by X which may 
benefit C.
    (iii) Apportionment. For purposes of applying the foreign tax credit 
limitation, the statutory grouping is general limitation gross income 
from sources without the United States, and the residual grouping is 
gross income from sources within the United States. X's deduction of 
$60,000 for its research and experimental expenditure must be 
apportioned between these groupings. Because more than 50 percent of the 
research and experimentation was performed in the United States, 50 
percent of the $60,000 deduction can be apportioned exclusively to the 
residual grouping. The remaining 50 percent of the deduction can then be 
apportioned between the residual and the statutory grouping on the basis 
of sales of gasoline engines by X, Y, and Z. (If X utilized the optional 
gross income methods in 1996, then its use of such methods constituted a 
binding election to use the optional gross income methods in 1996 and 
for four taxable years thereafter. If X utilized the sales method in 
1996, then its use of such method constituted a binding election to use 
the sales method in 1996 and for four taxable years thereafter.) The 
optional gross income methods are not illustrated in this Example 3 (see 
instead Examples 1 and 2). Since X has only a 60 percent ownership 
interest in corporation Z, only 60 percent of Z's sales (60% of 
$1,000,000, or $600,000) are included for purposes of apportionment. The 
allocation and apportionment for 1997 is as follows:

(A) X's total research expense:..............................    $80,000
(B) Less: Legally mandated research directly allocated to the    $20,000
 residual grouping of gross income:..........................
(C) Tentative apportionment on the basis of sales............
(1) Research and experimental expense to be apportioned          $60,000
 between residual and statutory groupings of gross income:...
(2) Less: Exclusive apportionment of research and                $30,000
 experimental expense to the residual grouping of gross
 income ($60,000 x 50 percent):..............................
(3) Research and experimental expense to be apportioned          $30,000
 between the residual and the statutory groupings on the
 basis of sales:.............................................
(4) Apportionment of research and experimental expense to        $11,250
 gross income from sources within the United States (residual
 grouping) ($30,000 x $600,000/($600,000 + $400,000 +
 $600,000)):.................................................
(5) Apportionment of research and experimental expense to        $18,750
 general limitation gross income from countries Y and Z
 (statutory grouping) ($30,000 x $400,000 + $600,000/
 ($600,000 + $400,000 + $600,000)):..........................
(6) Total apportioned deduction for research and                 $60,000
 experimentation ($30,000 + $30,000):........................
(7) Amount apportioned to the residual grouping ($30,000 +       $41,250
 $11,250):...................................................
(8) Amount apportioned to the statutory grouping of gross        $18,750
 income from sources within countries Y and Z:...............
 

    Example 4. Research and Experimentation (i) Facts. X, a domestic 
corporation, manufactures and sells forklift trucks and other types of 
materials handling equipment in the United States. The manufacture and 
sale of forklift trucks and other materials handling equipment belongs 
to the product category, Construction, Mining, and Materials Handling 
Machinery and Equipment (SIC Industry Group 353). X also sells its 
forklift trucks to a wholesaling subsidiary located in foreign country Y 
(but title passes in the United States), and X manufactures forklift 
trucks in foreign country Z. The wholesaling of forklift trucks to 
country Y also belongs to X's product category Transportation equipment 
and, therefore, may not belong to the product category, Wholesale trade 
(SIC Major Group 50 and 51). In 1997, X sold $7,000,000 of forklift 
trucks to purchasers in the United States, $3,000,000 of forklift trucks 
to the wholesaling subsidiary in Y, and transferred forklift truck 
components with an FOB export value of $2,000,000 to its branch in Z. 
The branch's sales of finished forklift trucks were $5,000,000. In 
response to legally mandated emission control requirements, X's United 
States research department has been engaged in a research project to 
improve the performance and quality of engine exhaust systems used on 
its products in the United States. It incurs expenses of $100,000 for 
this purpose in 1997. In the past, X has customarily adapted the product 
improvements developed originally for the domestic market to its 
forklift trucks manufactured abroad. During the taxable year

[[Page 276]]

1997, development of an improved engine exhaust system is completed and 
X begins installing the new system during the latter part of the taxable 
year in products manufactured and sold in the United States. X continues 
to manufacture and sell forklift trucks in foreign countries without the 
improved engine exhaust systems.
    (ii) Allocation. X's deduction for its research expense is 
definitely related to the income to which it gives rise, namely income 
from the manufacture and sale of forklift trucks within the United 
States and in country Z. Although the research is undertaken in response 
to a legal mandate, it can reasonably be expected to generate gross 
income from the manufacture and sale of trucks by the branch in Z. 
Therefore, the deduction is not allocable solely to income from X's 
domestic sales of forklift trucks. It is allocable to income from such 
sales and income from the sales of X's branch in Z.
    (iii) Apportionment. For the method of apportionment on the basis of 
either sales or gross income, see Example 3. However, in determining the 
amount of research apportioned to income from foreign and domestic 
sources, the net sales of the branch in Z are $3,000,000 ($5,000,000 
less $2,000,000) and the sales within the United States are $12,000,000 
($7,000,000 plus $3,000,000 plus $2,000,000). See Sec.  1.861-
17(c)(3)(iii).
    Example 5. (i) Facts. X, a domestic corporation, is a drug company 
that manufactures a wide variety of pharmaceutical products for sale in 
the United States. Pharmaceutical products belong to the product 
category, Drugs (SIC Industry Group 283). X exports its pharmaceutical 
products through a foreign sales corporation (FSC). X's wholly owned 
foreign subsidiary Y also manufactures pharmaceutical products. In 1997, 
X has domestic sales of pharmaceutical products of $10,000,000, the FSC 
has sales of pharmaceutical products of $3,000,000, and Y has sales of 
pharmaceutical products of $5,000,000. In that same year, 1997, X incurs 
expense of $200,000 on research to test a product in response to 
requirements imposed by the United States Food and Drug Administration 
(FDA). X is able to show that, even though country Y imposes certain 
testing requirements on pharmaceutical products, the research performed 
in the United States is not accepted by country Y for purposes of its 
own licensing requirements, and the research has minimal use abroad. X 
is further able to show that FSC sells goods to countries that do not 
accept or do not require research performed in the United States for 
purposes of their own licensing standards.
    (ii) Allocation. Since X's research expense of $200,000 is 
undertaken to meet the requirements of the United States Food and Drug 
Administration, and since it is reasonable to expect that the 
expenditure will not generate gross income (beyond de minimis amounts) 
outside the United States, the deduction is definitely related and thus 
allocable to the residual grouping.
    (iii) Apportionment. No apportionment is necessary since the entire 
expense is allocated to the residual grouping, gross income from sales 
within the United States.
    Example 6. (i) Facts. X, a domestic corporation, is engaged in 
continuous research and experimentation to improve the quality of the 
products that it manufactures and sells, which are floodlights, 
flashlights, fuse boxes, and solderless connectors. X incurs and deducts 
$100,000 of expenditure for research and experimentation in 1997 that 
was performed exclusively in the United States. As a result of this 
research activity, X acquires patents that it uses in its own 
manufacturing activity. X licenses its floodlight patent to Y and Z, 
uncontrolled foreign corporations, for use in their own territories, 
countries Y and Z, respectively. Corporation Y pays X an arm's length 
royalty of $3,000 plus $0.20 for each floodlight sold. Sales of 
floodlights by Y for the taxable year are $135,000 (at $4.50 per unit) 
or 30,000 units, and the royalty is $9,000 ($3,000 + $0.20 x 30,000). Y 
has sales of other products of $500,000. Z pays X an arm's length 
royalty of $3,000 plus $0.30 for each unit sold. Z manufactures 30,000 
floodlights in the taxable year, and the royalty is $12,000 ($3,000 + 
$0.30 x 30,000). The dollar value of Z's floodlight sales is not known 
and cannot be reasonably estimated because, in this case, the 
floodlights are not sold separately by Z but are instead used as a 
component in Z's manufacture of lighting equipment for theaters. The 
sales of all Z's products, including the lighting equipment for 
theaters, are $1,000,000. Y and Z each sell the floodlights exclusively 
within their respective countries. X's sales of floodlights for the 
taxable year are $500,000 and its sales of its other products, 
flashlights, fuse boxes, and solderless connectors, are $400,000. X has 
gross income of $500,000, consisting of gross income from domestic 
sources from sales of floodlights, flashlights, fuse boxes, and 
solderless connectors of $479,000, and royalty income of $9,000 and 
$12,000 from foreign corporations Y and Z respectively. X utilized the 
optional gross income methods of apportionment for its return filed for 
its first taxable year to which this section applies.
    (ii) Allocation. X's research and experimental expenses are 
definitely related to all of the products that it produces, which are 
floodlights, flashlights, fuse boxes, and solderless connectors. All of 
these products are in the same three digit SIC Code category, Electric 
Lighting and Wiring Equipment (SIC Industry Group 364). Thus, X's 
research and experimental expenses are allocable to all items of income 
attributable to this product category, domestic sales income and royalty 
income from the foreign countries in which corporations Y and Z operate.

[[Page 277]]

    (iii) Apportionment. (A) The statutory grouping of gross income is 
general limitation income from sources without the United States. The 
residual grouping is gross income from sources within the United States. 
X's deduction of $100,000 for its research expenditures must be 
apportioned between the groupings. For apportionment on the basis of 
sales in accordance with paragraph (c) of this section, X is entitled to 
an exclusive apportionment of 50 percent of its research and 
experimental expense to the residual grouping, gross income from sources 
within the United States, since more than 50 percent of the research 
activity was performed in the United States. The remaining 50 percent of 
the deduction can then be apportioned between the residual and statutory 
groupings on the basis of sales. Since Y and Z are unrelated licensees 
of X, only their sales of the licensed product, floodlights, are 
included for purposes of apportionment. Floodlight sales of Z are 
unknown, but are estimated at ten times royalties from Z, or $120,000. 
All of X's sales from the entire product category are included for 
purposes of apportionment on the basis of sales. Alternatively, X may 
apportion its deduction on the basis of gross income, in accordance with 
paragraph (d) of this section. The apportionment is as follows:

            (1) Tentative Apportionment on the Basis of Sales

(i) Research and experimental expense to be apportioned         $100,000
 between statutory and residual groupings of gross income:...
(ii) Less: Exclusive apportionment of research and               $50,000
 experimental expense to the residual groupings of gross
 income ($100,000 x 50 percent):.............................
(iii) Research and experimental expense to be apportioned        $50,000
 between the statutory and residual groupings of gross income
 on the basis of sales:......................................
(iv) Apportionment of research and experimental expense to       $38,961
 the residual groupings of gross income ($50,000 x $900,000/
 ($900,000 + $135,000 + $120,000)):..........................
(v) Apportionment of research and experimental expense to the    $11,039
 statutory grouping, royalty income from countries Y and Z
 ($50,000 x $135,000 + $120,000/($900,000 + $135,000 +
 $120,000)):.................................................
(vi) Total apportioned deduction for research and               $100,000
 experimentation:............................................
(vii) Amount apportioned to the residual grouping ($50,000 +     $88,961
 $38,961):...................................................
(viii) Amount apportioned to the statutory grouping of           $11,039
 sources within countries Y and Z:...........................
 

            (2) Tentative Apportionment on Gross Income Basis

(i) Exclusive apportionment of research and experimental         $25,000
 expense to the residual grouping of gross income ($100,000 x
 25 percent):................................................
(ii) Apportionment of research and experimental expense to       $71,850
 the residual grouping of gross income ($75,000 x $479,000/
 $500,000):..................................................
(iii) Apportionment of research and experimental expense to       $3,150
 the statutory grouping of gross income ($75,000 x $9,000 +
 $12,000/$500,000):..........................................
(iv) Amount apportioned to the residual grouping:............    $96,850
(v) Amount apportioned to the statutory grouping of general       $3,150
 limitation income from sources without the United States:...
 

    (B) Since X has elected to use the optional gross income methods of 
apportionment and its apportionment on the basis of gross income to the 
statutory grouping, $3,150, is less than 50 percent of its apportionment 
on the basis of sales to the statutory grouping, $11,039, it must use 
Option two of paragraph (d)(3) of this section and apportion $5,520 (50 
percent of $11,039) to the statutory grouping.

[T.D. 8646, 60 FR 66503, Dec. 22, 1995, as amended by T.D. 9441, 74 FR 
390, Jan. 5, 2009; T.D. 9568, 76 FR 80136, Dec. 22, 2011]



Sec.  1.861-18  Classification of transactions involving computer programs.

    (a) General--(1) Scope. This section provides rules for classifying 
transactions relating to computer programs for purposes of subchapter N 
of chapter 1 of the Internal Revenue Code, sections 367, 404A, 482, 551, 
679, 1059A, chapter 3, chapter 5, sections 842 and 845 (to the extent 
involving a foreign person), and transfers to foreign trusts not covered 
by section 679.
    (2) Categories of transactions. This section generally requires that 
such transactions be treated as being solely within one of four 
categories (described in paragraph (b)(1) of this section) and provides 
certain rules for categorizing such transactions. In the case of a 
transfer of a copyright right, this section provides rules for 
determining whether the transaction should be classified as either a 
sale or exchange, or a license generating royalty income. In the case of 
a transfer of a copyrighted article, this section provides rules for 
determining whether the transaction should be classified as either a 
sale or exchange, or a lease generating rental income.
    (3) Computer program. For purposes of this section, a computer 
program is a set of statements or instructions to be used directly or 
indirectly in a computer in order to bring about a certain result. For 
purposes of this paragraph (a)(3), a computer program includes any 
media, user manuals, documentation, data base or similar item if the 
media, user manuals, documentation,

[[Page 278]]

data base or similar item is incidental to the operation of the computer 
program.
    (b) Categories of transactions--(1) General. Except as provided in 
paragraph (b)(2) of this section, a transaction involving the transfer 
of a computer program, or the provision of services or of know-how with 
respect to a computer program (collectively, a transfer of a computer 
program) is treated as being solely one of the following--
    (i) A transfer of a copyright right in the computer program;
    (ii) A transfer of a copy of the computer program (a copyrighted 
article);
    (iii) The provision of services for the development or modification 
of the computer program; or
    (iv) The provision of know-how relating to computer programming 
techniques.
    (2) Transactions consisting of more than one category. Any 
transaction involving computer programs which consists of more than one 
of the transactions described in paragraph (b)(1) of this section shall 
be treated as separate transactions, with the appropriate provisions of 
this section being applied to each such transaction. However, any 
transaction that is de minimis, taking into account the overall 
transaction and the surrounding facts and circumstances, shall not be 
treated as a separate transaction, but as part of another transaction.
    (c) Transfers involving copyright rights and copyrighted articles--
(1) Classification--(i) Transfers treated as transfers of copyright 
rights. A transfer of a computer program is classified as a transfer of 
a copyright right if, as a result of the transaction, a person acquires 
any one or more of the rights described in paragraphs (c)(2)(i) through 
(iv) of this section. Whether the transaction is treated as being solely 
the transfer of a copyright right or is treated as separate transactions 
is determined pursuant to paragraph (b)(1) and (b)(2) of this section. 
For example, if a person receives a disk containing a copy of a computer 
program which enables it to exercise, in relation to that program, a 
non-de minimis right described in paragraphs (c)(2)(i) through (iv) of 
this section (and the transaction does not involve, or involves only a 
de minimis provision of services as described in paragraph (d) of this 
section or of know-how as described in paragraph (e) of this section), 
then, under paragraph (b)(2) of this section, the transfer is classified 
solely as a transfer of a copyright right.
    (ii) Transfers treated solely as transfers of copyrighted articles. 
If a person acquires a copy of a computer program but does not acquire 
any of the rights described in paragraphs (c)(2)(i) through (iv) of this 
section (or only acquires a de minimis grant of such rights), and the 
transaction does not involve, or involves only a de minimis, provision 
of services as described in paragraph (d) of this section or of know-how 
as described in paragraph (e) of this section, the transfer of the copy 
of the computer program is classified solely as a transfer of a 
copyrighted article.
    (2) Copyright rights. The copyright rights referred to in paragraph 
(c)(1) of this section are as follows--
    (i) The right to make copies of the computer program for purposes of 
distribution to the public by sale or other transfer of ownership, or by 
rental, lease or lending;
    (ii) The right to prepare derivative computer programs based upon 
the copyrighted computer program;
    (iii) The right to make a public performance of the computer 
program; or
    (iv) The right to publicly display the computer program.
    (3) Copyrighted article. A copyrighted article includes a copy of a 
computer program from which the work can be perceived, reproduced, or 
otherwise communicated, either directly or with the aid of a machine or 
device. The copy of the program may be fixed in the magnetic medium of a 
floppy disk, or in the main memory or hard drive of a computer, or in 
any other medium.
    (d) Provision of services. The determination of whether a 
transaction involving a newly developed or modified computer program is 
treated as either the provision of services or another transaction 
described in paragraph (b)(1) of this section is based on all the facts 
and circumstances of the transaction, including, as appropriate, the 
intent of the parties (as evidenced by their agreement and conduct) as 
to

[[Page 279]]

which party is to own the copyright rights in the computer program and 
how the risks of loss are allocated between the parties.
    (e) Provision of know-how. The provision of information with respect 
to a computer program will be treated as the provision of know-how for 
purposes of this section only if the information is--
    (1) Information relating to computer programming techniques;
    (2) Furnished under conditions preventing unauthorized disclosure, 
specifically contracted for between the parties; and
    (3) Considered property subject to trade secret protection.
    (f) Further classification of transfers involving copyright rights 
and copyrighted articles--(1) Transfers of copyright rights. The 
determination of whether a transfer of a copyright right is a sale or 
exchange of property is made on the basis of whether, taking into 
account all facts and circumstances, there has been a transfer of all 
substantial rights in the copyright. A transaction that does not 
constitute a sale or exchange because not all substantial rights have 
been transferred will be classified as a license generating royalty 
income. For this purpose, the principles of sections 1222 and 1235 may 
be applied. Income derived from the sale or exchange of a copyright 
right will be sourced under section 865(a), (c), (d), (e), or (h), as 
appropriate. Income derived from the licensing of a copyright right will 
be sourced under section 861(a)(4) or 862(a)(4), as appropriate.
    (2) Transfers of copyrighted articles. The determination of whether 
a transfer of a copyrighted article is a sale or exchange is made on the 
basis of whether, taking into account all facts and circumstances, the 
benefits and burdens of ownership have been transferred. A transaction 
that does not constitute a sale or exchange because insufficient 
benefits and burdens of ownership of the copyrighted article have been 
transferred, such that a person other than the transferee is properly 
treated as the owner of the copyrighted article, will be classified as a 
lease generating rental income. Income from transactions that are 
classified as sales or exchanges of copyrighted articles will be sourced 
under sections 861(a)(6), 862(a)(6), 863, 865(a), (b), (c), or (e), as 
appropriate. Income derived from the leasing of a copyrighted article 
will be sourced under section 861(a)(4) or section 862(a)(4), as 
appropriate.
    (3) Special circumstances of computer programs. In connection with 
determinations under this paragraph (f), consideration must be given as 
appropriate to the special characteristics of computer programs in 
transactions that take advantage of these characteristics (such as the 
ability to make perfect copies at minimal cost). For example, a 
transaction in which a person acquires a copy of a computer program on 
disk subject to a requirement that the disk be destroyed after a 
specified period is generally the equivalent of a transaction subject to 
a requirement that the disk be returned after such period. Similarly, a 
transaction in which the program deactivates itself after a specified 
period is generally the equivalent of returning the copy.
    (g) Rules of operation--(1) Term applied to transaction by parties. 
Neither the form adopted by the parties to a transaction, nor the 
classification of the transaction under copyright law, shall be 
determinative. Therefore, for example, if there is a transfer of a 
computer program on a single disk for a one-time payment with 
restrictions on transfer and reverse engineering, which the parties 
characterize as a license (including, but not limited to, agreements 
commonly referred to as shrink-wrap licenses), application of the rules 
of paragraphs (c) and (f) of this section may nevertheless result in the 
transaction being classified as the sale of a copyrighted article.
    (2) Means of transfer not to be taken into account. The rules of 
this section shall be applied irrespective of the physical or electronic 
or other medium used to effectuate a transfer of a computer program.
    (3) To the public--(i) In general. For purposes of paragraph 
(c)(2)(i) of this section, a transferee of a computer program shall not 
be considered to have the right to distribute copies of the program to 
the public if it is permitted to distribute copies of the software to

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only either a related person, or to identified persons who may be 
identified by either name or by legal relationship to the original 
transferee. For purposes of this subparagraph, a related person is a 
person who bears a relationship to the transferee specified in section 
267(b)(3), (10), (11), or (12), or section 707(b)(1)(B). In applying 
section 267(b), 267(f), 707(b)(1)(B), or 1563(a), ``10 percent'' shall 
be substituted for ``50 percent.''
    (ii) Use by individuals. The number of employees of a transferee of 
a computer program who are permitted to use the program in connection 
with their employment is not relevant for purposes of this paragraph 
(g)(3). In addition, the number of individuals with a contractual 
agreement to provide services to the transferee of a computer program 
who are permitted to use the program in connection with the performance 
of those services is not relevant for purposes of this paragraph (g)(3).
    (h) Examples. The provisions of this section may be illustrated by 
the following examples:

    Example 1. (i) Facts. Corp A, a U.S. corporation, owns the copyright 
in a computer program, Program X. It copies Program X onto disks. The 
disks are placed in boxes covered with a wrapper on which is printed 
what is generally referred to as a shrink-wrap license. The license is 
stated to be perpetual. Under the license no reverse engineering, 
decompilation, or disassembly of the computer program is permitted. The 
transferee receives, first, the right to use the program on two of its 
own computers (for example, a laptop and a desktop) provided that only 
one copy is in use at any one time, and, second, the right to make one 
copy of the program on each machine as an essential step in the 
utilization of the program. The transferee is permitted by the shrink-
wrap license to sell the copy so long as it destroys any other copies it 
has made and imposes the same terms and conditions of the license on the 
purchaser of its copy. These disks are made available for sale to the 
general public in Country Z. In return for valuable consideration, P, a 
Country Z resident, receives one such disk.
    (ii) Analysis. (A) Under paragraph (g)(1) of this section, the label 
license is not determinative. None of the copyright rights described in 
paragraph (c)(2) of this section have been transferred in this 
transaction. P has received a copy of the program, however, and, 
therefore, under paragraph (c)(1)(ii) of this section, P has acquired 
solely a copyrighted article.
    (B) Taking into account all of the facts and circumstances, P is 
properly treated as the owner of a copyrighted article. Therefore, under 
paragraph (f)(2) of this section, there has been a sale of a copyrighted 
article rather than the grant of a lease.
    Example 2. (i) Facts. The facts are the same as those in Example 1, 
except that instead of selling disks, Corp A, the U.S. corporation, 
decides to make Program X available, for a fee, on a World Wide Web home 
page on the Internet. P, the Country Z resident, in return for payment 
made to Corp A, downloads Program X (via modem) onto the hard drive of 
his computer. As part of the electronic communication, P signifies his 
assent to a license agreement with terms identical to those in Example 
1, except that in this case P may make a back-up copy of the program on 
to a disk.
    (ii) Analysis. (A) None of the copyright rights described in 
paragraph (c)(2) of this section have passed to P. Although P did not 
buy a physical copy of the disk with the program on it, paragraph (g)(2) 
of this section provides that the means of transferring the program is 
irrelevant. Therefore, P has acquired a copyrighted article.
    (B) As in Example 1, P is properly treated as the owner of a 
copyrighted article. Therefore, under paragraph (f)(2) of this section, 
there has been a sale of a copyrighted article rather than the grant of 
a lease.
    Example 3. (i) Facts. The facts are the same as those in Example 1, 
except that Corp A only allows P, the Country Z resident, to use Program 
X for one week. At the end of that week, P must return the disk with 
Program X on it to Corp A. P must also destroy any copies made of 
Program X. If P wishes to use Program X for a further period he must 
enter into a new agreement to use the program for an additional charge.
    (ii) Analysis. (A) Under paragraph (c)(2) of this section, P has 
received no copyright rights. Because P has received a copy of the 
program under paragraph (c)(1)(ii) of this section, he has, therefore, 
received a copyrighted article.
    (B) Taking into account all of the facts and circumstances, P is not 
properly treated as the owner of a copyrighted article. Therefore, under 
paragraph (f)(2) of this section, there has been a lease of a 
copyrighted article rather than a sale. Taking into account the special 
characteristics of computer programs as provided in paragraph (f)(3) of 
this section, the result would be the same if P were required to destroy 
the disk at the end of the one week period instead of returning it since 
Corp A can make additional copies of the program at minimal cost.
    Example 4. (i) Facts. The facts are the same as those in Example 2, 
where P, the Country Z resident, receives Program X from Corp A's home 
page on the Internet, except that P may only use Program X for a period 
of one

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week at the end of which an electronic lock is activated and the program 
can no longer be accessed. Thereafter, if P wishes to use Program X, it 
must return to the home page and pay Corp A to send an electronic key to 
reactivate the program for another week.
    (ii) Analysis. (A) As in Example 3, under paragraph (c)(2) of this 
section, P has not received any copyright rights. P has received a copy 
of the program, and under paragraph (g)(2) of this section, the means of 
transmission is irrelevant. P has, therefore, under paragraph (c)(1)(ii) 
of this section, received a copyrighted article.
    (B) As in Example 3, P is not properly treated as the owner of a 
copyrighted article. Therefore, under paragraph (f)(2) of this section, 
there has been a lease of a copyrighted article rather than a sale. 
While P does retain Program X on its computer at the end of the one week 
period, as a legal matter P no longer has the right to use the program 
(without further payment) and, indeed, cannot use the program without 
the electronic key. Functionally, Program X is no longer on the hard 
drive of P's computer. Instead, the hard drive contains only a series of 
numbers which no longer perform the function of Program X. Although in 
Example 3, P was required to physically return the disk, taking into 
account the special characteristics of computer programs as provided in 
paragraph (f)(3) of this section, the result in this Example 4 is the 
same as in Example 3.
    Example 5. (i) Facts. Corp A, a U.S. corporation, transfers a disk 
containing Program X to Corp B, a Country Z corporation, and grants Corp 
B an exclusive license for the remaining term of the copyright to copy 
and distribute an unlimited number of copies of Program X in the 
geographic area of Country Z, prepare derivative works based upon 
Program X, make public performances of Program X, and publicly display 
Program X. Corp B will pay Corp A a royalty of $y a year for three 
years, which is the expected period during which Program X will have 
commercially exploitable value.
    (ii) Analysis. (A) Although Corp A has transferred a disk with a 
copy of Program X on it to Corp B, under paragraph (c)(1)(i) of this 
section because this transfer is accompanied by a copyright right 
identified in paragraph (c)(2)(i) of this section, this transaction is a 
transfer solely of copyright rights, not of copyrighted articles. For 
purposes of paragraph (b)(2) of this section, the disk containing a copy 
of Program X is a de minimis component of the transaction.
    (B) Applying the all substantial rights test under paragraph (f)(1) 
of this section, Corp A will be treated as having sold copyright rights 
to Corp B. Corp B has acquired all of the copyright rights in Program X, 
has received the right to use them exclusively within Country Z, and has 
received the rights for the remaining life of the copyright in Program 
X. The fact the payments cease before the copyright term expires is not 
controlling. Under paragraph (g)(1) of this section, the fact that the 
agreement is labelled a license is not controlling (nor is the fact that 
Corp A receives a sum labelled a royalty). (The result in this case 
would be the same if the copy of Program X to be used for the purposes 
of reproduction were transmitted electronically to Corp B, as a result 
of the application of the rule of paragraph (g)(2) of this section.)
    Example 6. (i) Facts. Corp A, a U.S. corporation, transfers a disk 
containing Program X to Corp B, a Country Z corporation, and grants Corp 
B the non exclusive right to reproduce (either directly or by 
contracting with either Corp A or another person to do so) and 
distribute for sale to the public an unlimited number of disks at its 
factory in Country Z in return for a payment related to the number of 
disks copied and sold. The term of the agreement is two years, which is 
less than the remaining life of the copyright.
    (ii) Analysis. (A) As in Example 5, the transfer of the disk 
containing the copy of the program does not constitute the transfer of a 
copyrighted article under paragraph (c)(1) of this section because Corp 
B has also acquired a copyright right under paragraph (c)(2)(i) of this 
section, the right to reproduce and distribute to the public. For 
purposes of paragraph (b)(2) of this section, the disk containing 
Program X is a de minimis component of the transaction.
    (B) Taking into account all of the facts and circumstances, there 
has been a license of Program X to Corp B, and the payments made by Corp 
B are royalties. Under paragraph (f)(1) of this section, there has not 
been a transfer of all substantial rights in the copyright to Program X 
because Corp A has the right to enter into other licenses with respect 
to the copyright of Program X, including licenses in Country Z (or even 
to sell that copyright, subject to Corp B's interest). Corp B has 
acquired no right itself to license the copyright rights in Program X. 
Finally, the term of the license is for less than the remaining life of 
the copyright in Program X.
    Example 7. (i) Facts. Corp C, a distributor in Country Z, enters 
into an agreement with Corp A, a U.S. corporation, to purchase as many 
copies of Program X on disk as it may from time-to-time request. Corp C 
will then sell these disks to retailers. The disks are shipped in boxes 
covered by shrink-wrap licenses (identical to the license described in 
Example 1).
    (ii) Analysis. (A) Corp C has not acquired any copyright rights 
under paragraph (c)(2) of this section with respect to Program X. It has 
acquired individual copies of Program X, which it may sell to others. 
The use of the term license is not dispositive under paragraph (g)(1) of 
this section. Under paragraph

[[Page 282]]

(c)(1)(ii) of this section, Corp C has acquired copyrighted articles.
    (B) Taking into account all of the facts and circumstances, Corp C 
is properly treated as the owner of copyrighted articles. Therefore, 
under paragraph (f)(2) of this section, there has been a sale of 
copyrighted articles.
    Example 8. (i) Facts. Corp A, a U.S. corporation, transfers a disk 
containing Program X to Corp D, a foreign corporation engaged in the 
manufacture and sale of personal computers in Country Z. Corp A grants 
Corp D the non-exclusive right to copy Program X onto the hard drive of 
an unlimited number of computers, which Corp D manufactures, and to 
distribute those copies (on the hard drive) to the public. The term of 
the agreement is two years, which is less than the remaining life of the 
copyright in Program X. Corp D pays Corp A an amount based on the number 
of copies of Program X it loads on to computers.
    (ii) Analysis. The analysis is the same as in Example 6. Under 
paragraph (c)(2)(i) of this section, Corp D has acquired a copyright 
right enabling it to exploit Program X by copying it on to the hard 
drives of the computers that it manufactures and then sells. For 
purposes of paragraph (b)(2) of this section, the disk containing 
Program X is a de minimis component of the transaction. Taking into 
account all of the facts and circumstances, Corp D has not, however, 
acquired all substantial rights in the copyright to Program X (for 
example, the term of the agreement is less than the remaining life of 
the copyright). Under paragraph (f)(1) of this section, this transaction 
is, therefore, a license of Program X to Corp D rather than a sale and 
the payments made by Corp D are royalties. (The result would be the same 
if Corp D included with the computers it sells an archival copy of 
Program X on a floppy disk.)
    Example 9. (i) Facts. The facts are the same as in Example 8, except 
that Corp D, the Country Z corporation, receives physical disks. The 
disks are shipped in boxes covered by shrink-wrap licenses (identical to 
the licenses described in Example 1). The terms of these licenses do not 
permit Corp D to make additional copies of Program X. Corp D uses each 
individual disk only once to load a single copy of Program X onto each 
separate computer. Corp D transfers the disk with the computer when it 
is sold.
    (ii) Analysis. (A) As in Example 7 (unlike Example 8) no copyright 
right identified in paragraph (c)(2) of this section has been 
transferred. Corp D acquires the disks without the right to reproduce 
and distribute publicly further copies of Program X. This is therefore 
the transfer of copyrighted articles under paragraph (c)(1)(ii) of this 
section.
    (B) Taking into account all of the facts and circumstances, Corp D 
is properly treated as the owner of copyrighted articles. Therefore, 
under paragraph (f)(2) of this section, the transaction is classified as 
the sale of a copyrighted article. (The result would be the same if Corp 
D used a single physical disk to copy Program X onto each computer, and 
transferred an unopened box containing Program X with each computer, if 
Corp D were not permitted to copy Program X onto more computers than the 
number of individual copies purchased.)
    Example 10. (i) Facts. Corp A, a U.S. corporation, transfers a disk 
containing Program X to Corp E, a Country Z corporation, and grants Corp 
E the right to load Program X onto 50 individual workstations for use 
only by Corp E employees at one location in return for a one-time per-
user fee (generally referred to as a site license or enterprise 
license). If additional workstations are subsequently introduced, 
Program X may be loaded onto those machines for additional one-time per-
user fees. The license which grants the rights to operate Program X on 
50 workstations also prohibits Corp E from selling the disk (or any of 
the 50 copies) or reverse engineering the program. The term of the 
license is stated to be perpetual.
    (ii) Analysis. (A) The grant of a right to copy, unaccompanied by 
the right to distribute those copies to the public, is not the transfer 
of a copyright right under paragraph (c)(2) of this section. Therefore, 
under paragraph (c)(1)(ii) of this section, this transaction is a 
transfer of copyrighted articles (50 copies of Program X).
    (B) Taking into account all of the facts and circumstances, P is 
properly treated as the owner of copyrighted articles. Therefore, under 
paragraph (f)(2) of this section, there has been a sale of copyrighted 
articles rather than the grant of a lease. Notwithstanding the 
restriction on sale, other factors such as, for example, the risk of 
loss and the right to use the copies in perpetuity outweigh, in this 
case, the restrictions placed on the right of alienation.
    (C) The result would be the same if Corp E were permitted to copy 
Program X onto an unlimited number of workstations used by employees of 
either Corp E or corporations that had a relationship to Corp E 
specified in paragraph (g)(3) of this section.
    Example 11. (i) Facts. The facts are the same as in Example 10, 
except that Corp E, the Country Z corporation, acquires the right to 
make Program X available to workstation users who are Corp E employees 
by way of a local area network (LAN). The number of users that can use 
Program X on the LAN at any one time is limited to 50. Corp E pays a 
one-time fee for the right to have up to 50 employees use the program at 
the same time.
    (ii) Analysis. Under paragraph (g)(2) of this section the mode of 
utilization is irrelevant. Therefore, as in Example 10, under paragraph 
(c)(2) of this section, no copyright right has

[[Page 283]]

been transferred, and, thus, under paragraph (c)(1)(ii) of this section, 
this transaction will be classified as the transfer of a copyrighted 
article. Under the benefits and burdens test of paragraph (f)(2) of this 
section, this transaction is a sale of copyrighted articles. The result 
would be the same if an unlimited number of Corp E employees were 
permitted to use Program X on the LAN or if Corp E were permitted to 
copy Program X onto LANs maintained by corporations that had a 
relationship to Corp E specified in paragraph (g)(3) of this section.
    Example 12. (i) Facts. The facts are the same as in Example 11, 
except that Corp E pays a monthly fee to Corp A, the U.S. corporation, 
calculated with reference to the permitted maximum number of users 
(which can be changed) and the computing power of Corp E's server. In 
return for this monthly fee, Corp E receives the right to receive 
upgrades of Program X when they become available. The agreement may be 
terminated by either party at the end of any month. When the disk 
containing the upgrade is received, Corp E must return the disk 
containing the earlier version of Program X to Corp A. If the contract 
is terminated, Corp E must delete (or otherwise destroy) all copies made 
of the current version of Program X. The agreement also requires Corp A 
to provide technical support to Corp E but the agreement does not 
allocate the monthly fee between the right to receive upgrades of 
Program X and the technical support services. The amount of technical 
support that Corp A will provide to Corp E is not foreseeable at the 
time the contract is entered into but is expected to be de minimis. The 
agreement specifically provides that Corp E has not thereby been granted 
an option to purchase Program X.
    (ii) Analysis. (A) Corp E has received no copyright rights under 
paragraph (c)(2) of this section. Corp A has not provided any services 
described in paragraph (d) of this section. Based on all the facts and 
circumstances of the transaction, Corp A has provided de minimis 
technical services to Corp E. Therefore, under paragraph (c)(1)(ii) of 
this section, the transaction is a transfer of a copyrighted article.
    (B) Taking into account all facts and circumstances, under the 
benefits and burdens test Corp E is not properly treated as the owner of 
the copyrighted article. Corp E does not receive the right to use 
Program X in perpetuity, but only for so long as it continues to make 
payments. Corp E does not have the right to purchase Program X on 
advantageous (or, indeed, any) terms once a certain amount of money has 
been paid to Corp A or a certain period of time has elapsed (which might 
indicate a sale). Once the agreement is terminated, Corp E will no 
longer possess any copies of Program X, current or superseded. Therefore 
under paragraph (f)(2) of this section there has been a lease of a 
copyrighted article.
    Example 13. (i) Facts. The facts are the same as in Example 12, 
except that, while Corp E must return copies of Program X as new 
upgrades are received, if the agreement terminates, Corp E may keep the 
latest version of Program X (although Corp E is still prohibited from 
selling or otherwise transferring any copy of Program X).
    (ii) Analysis. For the reasons stated in Example 10, paragraph 
(ii)(B), the transfer of the program will be treated as a sale of a 
copyrighted article rather than as a lease.
    Example 14. (i) Facts. Corp G, a Country Z corporation, enters into 
a contract with Corp A, a U.S. corporation, for Corp A to modify Program 
X so that it can be used at Corp G's facility in Country Z. Under the 
contract, Corp G is to acquire one copy of the program on a disk and the 
right to use the program on 5,000 workstations. The contract requires 
Corp A to rewrite elements of Program X so that it will conform to 
Country Z accounting standards and states that Corp A retains all 
copyright rights in the modified Program X. The agreement between Corp A 
and Corp G is otherwise identical as to rights and payment terms as the 
agreement described in Example 10.
    (ii) Analysis. (A) As in Example 10, no copyright rights are being 
transferred under paragraph (c)(2) of this section. In addition, since 
no copyright rights are being transferred to Corp G, this transaction 
does not involve the provision of services by Corp A under paragraph (d) 
of this section. This transaction will be classified, therefore, as a 
transfer of copyrighted articles under paragraph (c)(1)(ii) of this 
section.
    (B) Taking into account all facts and circumstances, Corp G is 
properly treated as the owner of copyrighted articles. Therefore, under 
paragraph (f)(2) of this section, there has been the sale of a 
copyrighted article rather than the grant of a lease.
    Example 15. (i) Facts. Corp H, a Country Z corporation, enters into 
a license agreement for a new computer program. Program Q is to be 
written by Corp A, a U.S. corporation. Corp A and Corp H agree that Corp 
A is writing Program Q for Corp H and that, when Program Q is completed, 
the copyright in Program Q will belong to Corp H. Corp H gives 
instructions to Corp A programmers regarding program specifications. 
Corp H agrees to pay Corp A a fixed monthly sum during development of 
the program. If Corp H is dissatisfied with the development of the 
program, it may cancel the contract at the end of any month. In the 
event of termination, Corp A will retain all payments, while any 
procedures, techniques or copyrightable interests will be the property 
of

[[Page 284]]

Corp H. All of the payments are labelled royalties. There is no 
provision in the agreement for any continuing relationship between Corp 
A and Corp H, such as the furnishing of updates of the program, after 
completion of the modification work.
    (ii) Analysis. Taking into account all of the facts and 
circumstances, Corp A is treated as providing services to Corp H. Under 
paragraph (d) of this section, Corp A is treated as providing services 
to Corp H because Corp H bears all of the risks of loss associated with 
the development of Program Q and is the owner of all copyright rights in 
Program Q. Under paragraph (g)(1) of this section, the fact that the 
agreement is labelled a license is not controlling (nor is the fact that 
Corp A receives a sum labelled a royalty).
    Example 16. (i) Facts. Corp A, a U.S. corporation, and Corp I, a 
Country Z corporation, agree that a development engineer employed by 
Corp A will travel to Country Z to provide know-how relating to certain 
techniques not generally known to computer programmers, which will 
enable Corp I to more efficiently create computer programs. These 
techniques represent the product of experience gained by Corp A from 
working on many computer programming projects, and are furnished to Corp 
I under nondisclosure conditions. Such information is property subject 
to trade secret protection.
    (ii) Analysis. This transaction contains the elements of know-how 
specified in paragraph (e) of this section. Therefore, this transaction 
will be treated as the provision of know-how.
    Example 17. (i) Facts. Corp A, a U.S. corporation, transfers a disk 
containing Program Y to Corp E, a Country Z corporation, in exchange for 
a single fixed payment. Program Y is a computer program development 
program, which is used to create other computer programs, consisting of 
several components, including libraries of reusable software components 
that serve as general building blocks in new software applications. No 
element of these libraries is a significant component of any overall new 
program. Because a computer program created with the use of Program Y 
will not operate unless the libraries are also present, the license 
agreement between Corp A and Corp E grants Corp E the right to 
distribute copies of the libraries with any program developed using 
Program Y. The license agreement is otherwise identical to the license 
agreement in Example 1.
    (ii) Analysis. (A) No non-de minimis copyright rights described in 
paragraph (c)(2) of this section have passed to Corp E. For purposes of 
paragraph (b)(2) of this section, the right to distribute the libraries 
in conjunction with the programs created using Program Y is a de minimis 
component of the transaction. Because Corp E has received a copy of the 
program under paragraph (c)(1)(ii) of this section, it has received a 
copyrighted article.
    (B) Taking into account all the facts and circumstances, Corp E is 
properly treated as the owner of a copyrighted article. Therefore, under 
paragraph (f)(2) of this section, there has been the sale of a 
copyrighted article rather than the grant of a lease.
    Example 18. (i) Facts. (A) Corp A, a U.S. corporation, transfers a 
disk containing Program X to Corp E, a country Z Corporation. The disk 
contains both the object code and the source code to Program X and the 
license agreement grants Corp E the right to--
    (1) Modify the source code in order to correct minor errors and make 
minor adaptations to Program X so it will function on Corp E's computer; 
and
    (2) Recompile the modified source code.
    (B) The license does not grant Corp E the right to distribute the 
modified Program X to the public. The license is otherwise identical to 
the license agreement in Example 1.
    (ii) Analysis. (A) No non-de minimis copyright rights described in 
paragraph (c)(2) of this section have passed to Corp E. For purposes of 
paragraph (b)(2) of this section, the right to modify the source code 
and recompile the source code in order to create new code to correct 
minor errors and make minor adaptations is a de minimis component of the 
transaction. Because Corp E has received a copy of the program under 
paragraph (c)(1)(ii) of this section, it has received a copyrighted 
article.
    (B) Taking into account all the facts and circumstances, Corp E is 
properly treated as the owner of a copyrighted article. Therefore, under 
paragraph (f)(2) of this section, there has been the sale of a 
copyrighted article rather than the grant of a lease.

    (i) Effective date--(1) General. This section applies to 
transactions occurring pursuant to contracts entered into on or after 
December 1, 1998.
    (2) Elective transition rules--(i) Contracts entered into in taxable 
years ending on or after October 2, 1998. A taxpayer may elect to apply 
this section to transactions occurring pursuant to contracts entered 
into in taxable years ending on or after October 2, 1998. A taxpayer 
that makes an election under this paragraph (i)(2)(i) must apply this 
section to all contracts entered into in taxable years ending on or 
after October 2, 1998.
    (ii) Contracts entered into before October 2, 1998. A taxpayer may 
elect to apply this section to transactions occurring in taxable years 
ending on or after October 2, 1998 pursuant to contracts entered into 
before October 2,

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1998 provided the taxpayer would not be required under this section to 
change its method of accounting as a result of such election, or the 
taxpayer would be required to change its method of accounting but the 
resulting section 481(a) adjustment would be zero. A taxpayer that makes 
an election under this paragraph (i)(2)(ii) must apply this section to 
all transactions occurring in taxable years ending on or after October 
2, 1998 pursuant to contracts entered into before October 2, 1998.
    (3) Manner of making election. Taxpayers may elect, under paragraph 
(i)(2)(i) or (i)(2)(ii) of this section, to apply this section, by 
treating the transactions in accordance with these regulations on their 
original tax return.
    (4) Examples. The following examples illustrate application of the 
transition rule of paragraph (i)(2)(ii) of this section:

    Example 1. Corp A develops computer programs for sale to third 
parties. Corp A uses an overall accrual method of accounting and files 
its tax return on a calendar-year basis. In year 1, Corp A enters into a 
contract to deliver a computer program in that year, and to provide 
updates for each of the following four years. Under the contract, the 
computer program and the updates are priced separately, and Corp A is 
entitled to receive payments for the computer program and each of the 
updates upon delivery. Assume Corp A properly accounts for the contract 
as a contract for the provision of services. Corp A properly includes 
the payments under the contract in gross income in the taxable year the 
payments are received and the computer program or updates are delivered. 
Corp A properly deducts the cost of developing the computer program and 
updates when the costs are incurred. Year 3 includes ctober 2, 1998. 
Assume under the rules of this section, the provision of updates would 
properly be accounted for as the transfer of copyrighted articles. If 
Corp A made an election under paragraph (i)(2)(ii) of this section, Corp 
A would not be required to change its method of accounting for income 
under the contract as a result of the election. Corp A would also not be 
required to change its method of accounting for the cost of developing 
the computer program and the updates under the contract as a result of 
the election. Therefore, under paragraph (i)(2)(ii) of this section, 
Corp A may elect to apply the provisions of this section to the updates 
provided in years 3, 4, and 5, because Corp A is not required to change 
from its method of accounting for the contract as a result of the 
election.
    Example 2. Corp A develops computer programs for sale to third 
parties. Corp A uses an overall accrual method of accounting and files 
its tax return on a calendar-year basis. In year 1, Corp A enters into a 
contract to deliver a computer program and to provide one update the 
following year. Under the contract, the computer program and the update 
are priced separately, and Corp A is entitled to receive payment for the 
computer program and the update upon delivery of the computer program. 
Assume Corp A properly accounts for the contract as a contract for the 
provision of services. Corp A properly includes the portion of the 
payment relating to the computer program in gross income in year 1, the 
taxable year the payment is received and the program delivered. Corp A 
properly includes the portion of the payment relating to the update in 
gross income in year 2, the taxable year the update is provided, under 
Rev. Proc. 71-21, 1971-2 CB 549 (see Sec.  601.601 (d)(2) of this 
chapter). Corp A properly deducts the cost of developing the computer 
program and update when the costs are incurred. Year 2 includes October 
2, 1998. Assume under the rules of this section, provision of the update 
would properly be accounted for as the transfer of a copyrighted 
article. If Corp A made an election under paragraph (i)(2)(ii) of this 
section, Corp A would be required to change its method of accounting for 
deferring income under its contract as a result of the election. 
However, the section 481(a) adjustment would be zero because the portion 
of the payment relating to the update would be includible in gross 
income in year 2, the taxable year the update is provided, under both 
Rev. Proc. 71-21 and Sec.  1.451-5. Corp A would not be required to 
change its method of accounting for the cost of developing the computer 
program and the update under the contract as a result of the election. 
Therefore, under paragraph (i)(2)(ii) of this section, Corp A may elect 
to apply the provisions of this section to the update in year 2, because 
the section 481(a) adjustment resulting from the change in method of 
accounting for deferring advance payments under the contract is zero, 
and because Corp A is not required to change from its method of 
accounting for the cost of developing the computer program and updates 
under the contract as a result of the election.
    Example 3. Assume the same facts as in Example 1 except that Corp A 
is entitled to receive payments for the computer program and each of the 
updates 30 days after delivery. Corp A properly includes the amounts due 
under the contract in gross income in the taxable year the computer 
program or updates are provided. Assume that Corp A properly uses the 
nonaccrual-experience method described in section 448(d)(5) and

[[Page 286]]

Sec.  1.448-2T to account for income on its contracts. If Corp A made an 
election under paragraph (i)(2)(ii) of this section, Corp A would be 
required to change from the nonaccrual-experience method for income as a 
result of the election, because the method is only available with 
respect to amounts to be received for the performance of services. 
Therefore, Corp A may not elect to apply the provisions of this section 
to the updates provided in years 3, 4, and 5, under paragraph (i)(2)(ii) 
of this section, because Corp A would be required to change from the 
nonaccrual-experience method of accounting for income on the contract as 
a result of the election.

    (j) Change in method of accounting required by this section--(1) 
Consent. A taxpayer is granted consent to change its method of 
accounting for contracts involving computer programs, to conform with 
the classification prescribed in this section. The consent is granted 
for contracts entered into on or after December 1, 1998, or in the case 
of a taxpayer making an election under paragraph (i)(2)(i) of this 
section, the consent is granted for contracts entered into in taxable 
years ending on or after October 2, 1998. In addition, a taxpayer that 
makes an election under paragraph (i)(2)(ii) of this section is granted 
consent to change its method of accounting for any contract with 
transactions subject to the election, if the taxpayer is required to 
change its method of accounting as a result of the election.
    (2) Year of change. The year of change is the taxable year that 
includes December 1, 1998, or in the case of a taxpayer making an 
election under paragraph (i)(2)(i) or (i)(2)(ii) of this section, the 
taxable year that includes October 2, 1998.
    (k) Time and manner of making change in method of accounting--(1) 
General. A taxpayer changing its method of accounting in accordance with 
this section must file a Form 3115, Application for Change in Method of 
Accounting, in duplicate. The taxpayer must type or print the following 
statement at the top of page 1 of the Form 3115: ``FILED UNDER TREASURY 
REGULATION Sec.  1.861-18.'' The original Form 3115 must be attached to 
the taxpayers original return for the year of change. A copy of the Form 
3115 must be filed with the National Office no later than when the 
original Form 3115 is filed for the year of change.
    (2) Copy of Form 3115. The copy required by this paragraph (k)(l) to 
be sent to the national office should be sent to the Commissioner of 
Internal Revenue, Attention: CC:DOM:IT&A, P.O. Box 7604, Benjamin 
Franklin Station, Washington DC 20044 (or in the case of a designated 
private delivery service: Commissioner of Internal Revenue, Attention: 
CC:DOM:IT&A, 1111 Constitution Avenue, NW., Washington, DC 20224).
    (3) Effect of consent and Internal Revenue Service review. A change 
in method of accounting granted under this section is subject to review 
by the district director and the national office and may be modified or 
revoked in accordance with the provisions of Rev. Proc. 97-37 (1997-33 
IRB 18) (or its successors) (see Sec.  601.601(d)(2) of this chapter).

[T.D. 8785, 63 FR 52977, Oct. 2, 1998; 63 FR 64868, Nov. 24, 1998]



Sec.  1.862-1  Income specifically from sources without the United States.

    (a) Gross income. (1) The following items of gross income shall be 
treated as income from sources without the United States:
    (i) Interest other than that specified in section 861(a)(1) and 
Sec.  1.861-2 as being derived from sources within the United States;
    (ii) Dividends other than those derived from sources within the 
United States as provided in section 861(a)(2) and Sec.  1.861-3;
    (iii) Compensation for labor or personal services performed without 
the United States;
    (iv) Rentals or royalties from property located without the United 
States or from any interest in such property, including rentals or 
royalties for the use of, or for the privilege of using, without the 
United States, patents, copyrights, secret processes and formulas, 
goodwill, trademarks, trade brands, franchises, and other like property;
    (v) Gains, profits, and income from the sale of real property 
located without the United States; and
    (vi) Gains, profits, and income derived from the purchase of 
personal

[[Page 287]]

property within the United States and its sale without the United 
States.
    (2) In applying subparagraph (1)(iv) of this paragraph for taxable 
years beginning after December 31, 1966, gains described in section 
871(a)(1)(D) and section 881(a)(4) from the sale or exchange after 
October 4, 1966, of patents, copyrights, and other like property shall 
be treated, as provided in section 871(e)(2), as rentals or royalties 
for the use of, or privilege of using, property or an interest in 
property. See paragraph (e) of Sec.  1.871-11.
    (3) For determining the time and place of sale of personal property 
for purposes of subparagraph (1)(vi) of this paragraph, see paragraph 
(c) of Sec.  1.861-7.
    (4) Income derived from the purchase of personal property within the 
United States and its sale within a possession of the United States 
shall be treated as derived entirely from within that possession.
    (5) If interest is paid on an obligation of a nonresident of the 
United States by a resident of the United States acting in the 
resident's capacity as a guarantor of the obligation of the nonresident, 
the interest will be treated as income from sources without the United 
States.
    (6) For rules treating certain interest as income from sources 
without the United States, see paragraph (b) of Sec.  1.861-2.
    (7) For the treatment of compensation for labor or personal services 
performed partly within the United States and partly without the United 
States, see paragraph (b) of Sec.  1.861-4.
    (b) Taxable income. The taxable income from sources without the 
United States, in the case of the items of gross income specified in 
paragraph (a) of this section, shall be determined on the same basis as 
that used in Sec.  1.861-8 for determining the taxable income from 
sources within the United States.
    (c) Income from certain property. For provisions permitting a 
taxpayer to elect to treat amounts of gross income attributable to 
certain aircraft or vessels first leased on or before December 28, 1980, 
as income from sources within the United States which would otherwise be 
treated as income from sources without the United States under paragraph 
(a) of this section, see Sec.  1.861-9. For provisions requiring amounts 
of gross income attributable to certain aircraft, vessels, or spacecraft 
first leased by the taxpayer after December 28, 1980, to be treated as 
income from sources within the United States which would otherwise be 
treated as income from sources without the United States under paragraph 
(a) of this section, see Sec.  1.861-9A.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 7378, 40 FR 45434, Oct. 2, 1975; 40 FR 48508, Oct. 16, 
1975; T.D. 7928, 48 FR 55847, Dec. 16, 1983]



Sec.  1.863-0  Table of contents.

    This section lists captions contained in Sec. Sec.  1.863-1, 1.863-
2, and 1.863-3.

     Sec.  1.863-1 Allocation of gross income under section 863(a).

    (a) In general.
    (b) Natural resources.
    (1) In general.
    (2) Additional production prior to export terminal.
    (3) Definitions.
    (i) Production activity.
    (ii) Additional production activities.
    (iii) Export terminal.
    (4) Determination of fair market value.
    (5) Determination of gross income.
    (6) Tax return disclosure.
    (7) Examples.
    (c) Determination of taxable income.
    (d) Scholarships, fellowship grants, grants, prizes and awards.
    (e) Residual interest in a REMIC.
    (1) REMIC inducement fees.
    (2) Excess inclusion income and net losses.
    (f) Effective/applicability date.

      Sec.  1.863-2 Allocation and apportionment of taxable income.

    (a) Determination of taxable income.
    (b) Determination of source of taxable income.
    (c) Effective dates.

Sec.  1.863-3 Allocation and apportionment of income from certain sales 
                              of inventory.

    (a) In general.
    (1) Scope.
    (2) Special rules.
    (b) Methods to determine income attributable to production activity 
and sales activity.
    (1) 50/50 method.
    (i) Determination of gross income.
    (ii) Example.
    (2) IFP method.
    (i) Establishing an IFP.
    (ii) Applying the IFP method.
    (iii) Determination of gross income.

[[Page 288]]

    (iv) Examples.
    (3) Books and records method.
    (c) Determination of the source of gross income from production 
activity and sales activity.
    (1) Income attributable to production activity.
    (i) Production only within the United States or only within foreign 
countries.
    (A) Source of income.
    (B) Definition of production assets.
    (C) Location of production assets.
    (ii) Production both within the United States and within foreign 
countries.
    (A) Source of income.
    (B) Adjusted basis of production assets.
    (iii) Anti-abuse rule.
    (iv) Examples.
    (2) Income attributable to sales activity.
    (d) Determination of source of taxable income.
    (e) Election and reporting rules.
    (1) Elections under paragraph (b) of this section.
    (2) Disclosure on tax return.
    (f) Income partly from sources within a possession of the United 
States.
    (g) Special rules for partnerships.
    (h) Effective dates.

[T.D. 8687, 61 FR 60545, Nov. 29, 1996, as amended by T.D. 9128, 69 FR 
26040, May 11, 2004; T.D. 9272, 71 FR 43366, Aug. 1, 2006]



Sec.  1.863-1  Allocation of gross income under section 863(a).

    (a) In general. Items of gross income other than those specified in 
section 861(a) and section 862(a) will generally be separately allocated 
to sources within or without the United States. See Sec.  1.863-2 for 
alternate methods to determine the income from sources within or without 
the United States in the case of items specified in Sec.  1.863-2(a). 
See also sections 865(b) and (e)(2). In the case of sales of property 
involving partners and partnerships, the rules of Sec.  1.863-3(g) 
apply.
    (b) Natural resources--(1) In general. Notwithstanding any other 
provision, except to the extent provided in paragraph (b)(2) of this 
section, gross receipts from the sale outside the United States of 
products derived from the ownership or operation of any farm, mine, oil 
or gas well, other natural deposit, or timber within the United States, 
must be allocated between sources within and without the United States 
based on the fair market value of the product at the export terminal (as 
defined in paragraph (b)(3)(iii) of this section). Notwithstanding any 
other provision, except to the extent provided in paragraph (b)(2) of 
this section, gross receipts from the sale within the United States of 
products derived from the ownership or operation of any farm, mine, oil 
or gas well, other natural deposit, or timber outside the United States 
must be allocated between sources within and without the United States 
based on the fair market value of the product at the export terminal. 
For place of sale, see Sec. Sec.  1.861-7(c) and 1.863-3(c)(2). The 
source of gross receipts equal to the fair market value of the product 
at the export terminal will be from sources where the farm, mine, well, 
deposit, or uncut timber is located. The source of gross receipts from 
the sale of the product in excess of its fair market value at the export 
terminal (excess gross receipts) will be determined as follows--
    (i) If the taxpayer engages in additional production activities 
subsequent to shipment from the export terminal and outside the country 
of sale, the source of excess gross receipts must be determined under 
Sec.  1.863-3. For purposes of applying Sec.  1.863-3, only production 
assets used in additional production activity subsequent to the export 
terminal are taken into account.
    (ii) In all other cases, excess gross receipts will be from sources 
within the country of sale. This paragraph (b)(1)(ii) applies to a 
taxpayer that engages in additional production activities in the country 
of sale, as well as to a taxpayer that does not engage in additional 
production activities at all.
    (2) Additional production prior to export terminal. Notwithstanding 
any other provision of this section, gross receipts from the sale of 
products derived by a taxpayer who performs additional production 
activities as defined in paragraph (b)(3)(ii) of this section before the 
relevant product is shipped from the export terminal are allocated 
between sources within and without the United States based on the fair 
market value of the product immediately prior to the additional 
production activities. The source of gross receipts equal to the fair 
market value of the product immediately prior to the additional 
production activities will be from sources where the farm, mine,

[[Page 289]]

well, deposit, or uncut timber is located. The source of gross receipts 
from the sale of the product in excess of the fair market value 
immediately prior to the additional production activities must be 
determined under Sec.  1.863-3. For purposes of applying Sec.  1.863-3, 
only production assets used in the additional production activities are 
taken into account.
    (3) Definitions--(i) Production activity. For purposes of this 
section, production activity means an activity that creates, fabricates, 
manufactures, extracts, processes, cures, or ages inventory. See Sec.  
1.864-1. Except as otherwise provided in Sec. Sec.  1.1502-13 or 1.863-
3(g)(2), only production activities conducted directly by the taxpayer 
are taken into account.
    (ii) Additional production activities. For purposes of this section, 
additional production activities are substantial production activities 
performed directly by the taxpayer in addition to activities from the 
ownership or operation of any farm, mine, oil or gas well, other natural 
deposit, or timber. Whether a taxpayer's activities constitute 
additional production activities will be determined under the principles 
of Sec.  1.954-3(a)(4). However, in no case will activities that prepare 
the natural resource itself for export, including those that are 
designed to facilitate the transportation of the natural resource to or 
from the export terminal, be considered additional production activities 
for purposes of this section.
    (iii) Export terminal. Where the farm, mine, well, deposit, or uncut 
timber is located without the United States, the export terminal will be 
the final point in a foreign country from which goods are shipped to the 
United States. If there is no such final point in a foreign country 
(e.g., the property is extracted and produced on the high seas), the 
export terminal will be the place of production. Where the farm, mine, 
well, deposit, or uncut timber is located within the United States, the 
export terminal will be the final point in the United States from which 
goods are shipped from the United States to a foreign country. The 
location of the export terminal is determined without regard to any 
contractual terms agreed to by the taxpayer and without regard to 
whether there is an actual sale of the products at the export terminal.
    (4) Determination of fair market value. For purposes of this 
section, fair market value depends on all of the facts and circumstances 
as they exist relative to a party in any particular case. Where the 
products are sold to a related party in a transaction subject to section 
482, the determination of fair market value under this section must be 
consistent with the arm's length price determined under section 482.
    (5) Determination of gross income. To determine the amount of a 
taxpayer's gross income from sources within or without the United 
States, the taxpayer's gross receipts from sources within or without the 
United States determined under this paragraph (b) must be reduced by the 
cost of goods sold properly attributable to gross receipts from sources 
within or without the United States.
    (6) Tax return disclosure. A taxpayer that determines the source of 
its income under this paragraph (b) shall attach a statement to its 
return explaining the methodology used to determine fair market value 
under paragraph (b)(4) of this section, and explaining any additional 
production activities (as defined in paragraph (b)(3)(ii) of this 
section) performed by the taxpayer. In addition, the taxpayer must 
provide such other information as is required by Sec.  1.863-3.
    (7) Examples. The following examples illustrate the rules of this 
paragraph (b):

    Example 1. No additional production. U.S. Mines, a U.S. corporation, 
operates a copper mine and mill in country X. U.S. Mines extracts 
copper-bearing rocks from the ground and transports the rocks to the 
mill where the rocks are ground and processed to produce copper-bearing 
concentrate. The concentrate is transported to a port where it is dried 
in preparation for export, stored and then shipped to purchasers in the 
United States. Because title to the property is passed in the United 
States and, under the facts and circumstances, none of U.S. Mine's 
activities constitutes additional production prior to the export 
terminal within the meaning of paragraph (b)(3)(ii) of this section, 
under paragraph (b)(1) and (b)(1)(ii) of this section, gross receipts 
equal to the fair market value of the concentrate at the export terminal 
will be from sources without the United States, and excess gross 
receipts

[[Page 290]]

will be from sources within the United States.
    Example 2. No additional production. US Gas, a U.S. corporation, 
extracts natural gas within the United States, and transports the 
natural gas to a U.S. port where it is liquified in preparation for 
shipment. The liquified natural gas is then transported via freighter 
and sold without additional production activities in a foreign country. 
Liquefaction of natural gas is not an additional production activity 
because liquefaction prepares the natural gas for transportation from 
the export terminal. Therefore, under paragraph (b)(1) and (b)(1)(ii) of 
this section, gross receipts equal to the fair market value of the 
liquefied natural gas at the export terminal will be from sources within 
the United States, and excess gross receipts will be from sources 
without the United States.
    Example 3. Sale in third country. US Gold, a U.S. corporation, mines 
gold in country X, produces gold jewelry in the United States, and sells 
the jewelry in country Y. Assume that the fair market value of the gold 
at the export terminal in country X is $40, and that US Gold ultimately 
sells the gold jewelry in country Y for $100. Under Sec.  1.863-1(b), 
$40 of US Gold's gross receipts will be allocated to sources without the 
United States. Under paragraph (b)(1)(i) of this section, the source of 
the remaining $60 of gross receipts will be determined under Sec.  
1.863-3. If US Gold applies the 50/50 method described in Sec.  1.863-3, 
$20 of cost of goods sold is properly attributable to activities 
subsequent to the export terminal, and all of US Gold's production 
assets subsequent to the export terminal are located in the United 
States, then $20 of gross income will be allocated to sources within the 
United States and $20 of gross income will be allocated to sources 
without the United States.
    Example 4. Production in country of sale. US Oil, a U.S. 
corporation, extracts oil in country X, transports the oil via pipeline 
to the export terminal in country Y, refines the oil in the United 
States, and sells the refined product in the United States to unrelated 
persons. Assume that the fair market value of the oil at the export 
terminal in country Y is $80, and that US Oil ultimately sells the 
refined product for $100. Under paragraph (b)(1) of this section, $80 of 
US Oil's gross receipts will be allocated to sources without the United 
States, and under paragraph (b)(1)(ii) of this section the remaining $20 
of gross receipts will be allocated to sources within the United States.
    Example 5. Additional production prior to export. The facts are the 
same as in Example 1, except that U.S. Mines also operates a smelter in 
country X. The concentrate output from the mill is transported to the 
smelter where it is transformed into smelted copper. The smelted copper 
is exported to purchasers in the United States. Under the facts and 
circumstances, all of the processes applied to make copper concentrate 
are considered mining. Therefore, under paragraph (b)(2) of this 
section, gross receipts equal to the fair market value of the 
concentrate at the smelter will be from sources without the United 
States. Under the facts and circumstances, the conversion of the 
concentrate into smelted copper is an additional production activity in 
a foreign country within the meaning of paragraph (b)(3)(ii) of this 
section. Therefore, the source of U.S. Mine's excess gross receipts will 
be determined pursuant to paragraph (b)(2) of this section.

    (c) Determination of taxable income. The taxpayer's taxable income 
from sources within or without the United States will be determined 
under the rules of Sec. Sec.  1.861-8 through 1.861-14T for determining 
taxable income from sources within the United States.
    (d) Scholarships, fellowship grants, grants, prizes and awards--(1) 
In general. This paragraph (d) applies to scholarships, fellowship 
grants, grants, prizes and awards. The provisions of this paragraph (d) 
do not apply to amounts paid as salary or other compensation for 
services.
    (2) Source of income. The source of income from scholarships, 
fellowship grants, grants, prizes and awards is determined as follows:
    (i) United States source income. Except as provided in paragraph 
(d)(2)(iii) of this section, scholarships, fellowship grants, grants, 
prizes and awards made by a U.S. citizen or resident, a domestic 
partnership, a domestic corporation, an estate or trust (other than a 
foreign estate or trust within the meaning of section 7701(a)(31)), the 
United States (or an instrumentality or agency thereof), a State (or any 
political subdivision thereof), or the District of Columbia shall be 
treated as income from sources within the United States.
    (ii) Foreign source income. Scholarships, fellowship grants, grants, 
prizes and awards made by a foreign government (or an instrumentality, 
agency, or any political subdivision thereof), an international 
organization (as defined in section 7701(a)(18)), or a person other than 
a U.S. person (as defined in section 7701(a)(30)) shall be treated as 
income from sources without the United States.

[[Page 291]]

    (iii) Certain activities conducted outside the United States. 
Scholarships, fellowship grants, targeted grants, and achievement awards 
received by a person other than a U.S. person (as defined in section 
7701(a)(30)) with respect to activities previously conducted (in the 
case of achievement awards) or to be conducted (in the case of 
scholarships, fellowships grants, and targeted grants) outside the 
United States shall be treated as income from sources without the United 
States.
    (3) Definitions. The following definitions apply for purposes of 
this paragraph (d):
    (i) Scholarships are defined in section 117 and the regulations 
thereunder.
    (ii) Fellowship grants are defined in section 117 and the 
regulations thereunder.
    (iii) Prizes and awards are defined in section 74 and the 
regulations thereunder.
    (iv) Grants are amounts described in subparagraph (3) of section 
4945(g) and the regulations thereunder, and are not amounts otherwise 
described in paragraphs (d)(3) (i), (ii), or (iii) of this section. For 
purposes of this paragraph (d), the reference to section 4945(g)(3) is 
applied without regard to the identity of the payor or recipient and 
without the application of the objective and nondiscriminatory basis 
test and the requirement of a procedure approved in advance.
    (v) Targeted grants are grants--
    (A) Issued by an organization described in section 501(c)(3), the 
United States (or an instrumentality or agency thereof), a State (or any 
political subdivision thereof), or the District of Columbia; and
    (B) For an activity undertaken in the public interest and not 
primarily for the private financial benefit of a specific person or 
persons or organization.
    (vi) Achievement awards are awards--
    (A) Issued by an organization described in section 501(c)(3), the 
United States (or an instrumentality or agency thereof), a State (or 
political subdivision thereof), or the District of Columbia; and
    (B) For a past activity undertaken in the public interest and not 
primarily for the private financial benefit of a specific person or 
persons or organization.
    (4) Effective dates. The following are the effective dates 
concerning this paragraph (d):
    (i) Scholarships and fellowship grants. This paragraph (d) is 
effective for scholarship and fellowship grant payments made after 
December 31, 1986. However, for scholarship and fellowship grant 
payments made after May 14, 1989, and before June 16, 1993, the 
residence of the payor rule of paragraph (d)(2) (i) and (ii) of this 
section may be applied without applying paragraph (d)(2)(iii) of this 
section.
    (ii) Grants, prizes and awards. This paragraph (d) is effective for 
payments made for grants, prizes and awards, targeted grants, and 
achievement awards after September 25, 1995. However, the taxpayer may 
elect to apply the provisions of this paragraph (d) to payments made for 
grants, prizes and awards, targeted grants, and achievement awards after 
December 31, 1986, and before September 26, 1995.
    (e) Residual interest in a REMIC--(1) REMIC inducement fees. An 
inducement fee (as defined in Sec.  1.446-6(b)(2)) shall be treated as 
income from sources within the United States.
    (2) Excess inclusion income and net losses. An excess inclusion (as 
defined in section 860E(c)) shall be treated as income from sources 
within the United States. To the extent of excess inclusion income 
previously taken into account with respect to a residual interest 
(reduced by net losses previously taken into account under this 
paragraph), a net loss (described in section 860C(b)(2)) with respect to 
the residual interest shall be allocated to the class of gross income 
and apportioned to the statutory grouping(s) or residual grouping of 
gross income to which the excess inclusion income was assigned.
    (f) Effective/applicability date. Paragraph (e)(2) of this section 
applies for taxable years ending after August 1, 2006.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 8615, 60 FR 
44275, Aug. 25, 1995; T.D. 8687, 61 FR 60545, Nov. 29, 1996; 61 FR 
65323, Dec. 12, 1996; T.D. 9128, 69 FR 26041, May 11, 2004; T.D. 9272, 
71 FR 43366, Aug. 1, 2006; T.D. 9415, 73 FR 40172, July 14, 2008]

[[Page 292]]



Sec.  1.863-2  Allocation and apportionment of taxable income.

    (a) Determination of taxable income. Section 863(b) provides an 
alternate method for determining taxable income from sources within the 
United States in the case of gross income derived from sources partly 
within and partly without the United States. Under this method, taxable 
income is determined by deducting from such gross income the expenses, 
losses, or other deductions properly apportioned or allocated thereto 
and a ratable part of any other expenses, losses, or deductions that 
cannot definitely be allocated to some item or class of gross income. 
The income to which this section applies (and that is treated as derived 
partly from sources within and partly from sources without the United 
States) will consist of gains, profits, and income
    (1) From certain transportation or other services rendered partly 
within and partly without the United States to the extent not within the 
scope of section 863(c) or other specific provisions of this title;
    (2) From the sale of inventory property (within the meaning of 
section 865(i)) produced (in whole or in part) by the taxpayer in the 
United States and sold outside the United States or produced (in whole 
or in part) by the taxpayer outside the United States and sold in the 
United States; or
    (3) Derived from the purchase of personal property within a 
possession of the United States and its sale within the United States, 
to the extent not excluded from the scope of these regulations under 
Sec.  1.936-6(a)(5),

Q&A 7.
    (b) Determination of source of taxable income. Income treated as 
derived from sources partly within and partly without the United States 
under paragraph (a) of this section may be allocated to sources within 
and without the United States pursuant to Sec.  1.863-1 or apportioned 
to such sources in accordance with the methods described in other 
regulations under section 863. To determine the source of certain types 
of income described in paragraph (a)(1) of this section, see Sec.  
1.863-4. To determine the source of gross income described in paragraph 
(a)(2) of this section, see Sec.  1.863-1 for natural resources and see 
Sec.  1.863-3 for other inventory. Taxpayers, at their election, may 
apply the principles of Sec.  1.863-3 (b)(1) and (c) to determine the 
source of taxable income (rather than gross income) from sales of 
inventory property (other than natural resources). To determine the 
source of income partly from sources within a possession of the United 
States, including income described in paragraph (a)(3) of this section, 
see Sec.  1.863-3(f).
    (c) Effective dates. This section will apply to taxable years 
beginning after December 30, 1996. However, taxpayers may apply the 
rules of this section for taxable years beginning after July 11, 1995, 
and on or before December 30, 1996. For years beginning before December 
30, 1996, see Sec.  1.863-2 (as contained in 26 CFR part 1 revised as of 
April 1, 1996).

[T.D. 8687, 61 FR 60546, Nov. 29, 1996; 61 FR 65323, Dec. 12, 1996]



Sec.  1.863-3  Allocation and apportionment of income from certain 
sales of inventory.

    (a) In general--(1) Scope. Paragraphs (a) through (e) of this 
section apply to determine the source of income derived from the sale of 
inventory property (inventory), which a taxpayer produces (in whole or 
in part) within the United States and sells outside the United States, 
or which a taxpayer produces (in whole or in part) outside the United 
States and sells within the United States (Section 863 Sales). To 
determine the source of income from sales of property produced by the 
taxpayer, when the property is either produced in whole or in part in 
space or on or under water not within the jurisdiction (as recognized by 
the United States) of a foreign country, possession of the United 
States, or the United States (in international water), or is sold in 
space or international water, the rules of Sec.  1.863-8 apply, and the 
rules of this section do not apply except to the extent provided in 
Sec.  1.863-8. A taxpayer must divide gross income from Section 863 
Sales between production activity and sales activity using one of the 
methods described in paragraph (b) of this section. The source of gross 
income from

[[Page 293]]

production activity and from sales activity must then be determined 
under paragraph (c) of this section. Taxable income from Section 863 
Sales is determined under paragraph (d) of this section. Paragraph (e) 
of this section describes the rules for electing the methods described 
in paragraph (b) of this section and the information that a taxpayer 
must disclose on a tax return. Paragraph (f) of this section applies to 
determine the source of certain income derived from a possession of the 
United States. Paragraph (g) of this section provides special rules for 
partnerships for all sales subject to Sec. Sec.  1.863-1 through 1.863-
3. Paragraph (h) of this section provides effective dates for the rules 
in this section.
    (2) Rules of application for Section 863 Sales. Once a taxpayer has 
elected a method described in paragraph (b) of this section, the 
taxpayer must separately apply that method to Section 863 Sales in the 
United States and to Section 863 Sales outside the United States. In 
addition, the taxpayer must apply the rules of paragraphs (c) and (d) of 
this section by aggregating all Section 863 Sales to which a method 
described in paragraph (b) of this section applies, after separately 
applying that method to Section 863 Sales in the United States and to 
Section 863 Sales outside the United States. See section 865(i)(1) for 
the definition of inventory property. See also section 865(e)(2). See 
Sec.  1.861-7(c) and paragraph (c)(2) of this section for the time and 
place of sale.
    (b) Methods to determine income attributable to production activity 
and sales activity--(1) 50/50 method--(i) Determination of gross income. 
Generally, gross income from Section 863 Sales will be apportioned 
between production activity and sales activity under the 50/50 method as 
described in this paragraph (b)(1). Under the 50/50 method, one-half of 
the taxpayer's gross income will be considered income attributable to 
production activity and the source of that income will be determined 
under the rules of paragraph (c)(1) of this section. The remaining one-
half of such gross income will be considered income attributable to 
sales activity and the source of that income will be determined under 
the rules of paragraph (c)(2) of this section. In lieu of the 50/50 
method, the taxpayer may elect to determine the source of income from 
Section 863 Sales under the IFP method described in paragraph (b)(2) of 
this section or, with the consent of the District Director, the books 
and records method described in paragraph (b)(3) of this section.
    (ii) Example. The following example illustrates the rules of this 
paragraph (b)(1):

    Example. 50/50 method. (i) P, a U.S. corporation, produces widgets 
in the United States. P sells the widgets for $100 to D, an unrelated 
foreign distributor, in another country. P's cost of goods sold is $40. 
Thus, P's gross income is $60.
    (ii) Pursuant to the 50/50 method, one-half of P's gross income, or 
$30, is considered income attributable to production activity, and one-
half of P's gross income, or $30, is considered income attributable to 
sales activity.

    (2) IFP method--(i) Establishing an IFP. A taxpayer may elect to 
allocate gross income earned from production activity and sales activity 
using the independent factory price (IFP) method described in this 
paragraph (b)(2) if an IFP is fairly established. An IFP is fairly 
established based on a sale by the taxpayer only if the taxpayer 
regularly sells part of its output to wholly independent distributors or 
other selling concerns in such a way as to reasonably reflect the income 
earned from production activity. A sale will not be considered to fairly 
establish an IFP if sales activity by the taxpayer with respect to that 
sale is significant in relation to all of the activities with respect to 
that product.
    (ii) Applying the IFP method. If the taxpayer elects to use the IFP 
method, the amount of the gross sales price equal to the IFP will be 
treated as attributable to production activity, and the excess of the 
gross sales price over the IFP will be treated as attributable to sales 
activity. If a taxpayer elects to use the IFP method, the IFP must be 
applied to all Section 863 Sales of inventory that are substantially 
similar in physical characteristics and function, and are sold at a 
similar level of distribution as the inventory sold in the sale fairly 
establishing an IFP. The IFP will only be applied to sales that are 
reasonably contemporaneous with the sale fairly establishing the IFP. An

[[Page 294]]

IFP cannot be applied to sales in other geographic markets if the 
markets are substantially different. If the taxpayer elects the IFP 
method, the rules of this paragraph will also apply to determine the 
division of gross receipts between production activity and sales 
activity in a Section 863 Sale that itself fairly establishes an IFP. If 
the taxpayer elects to apply the IFP method, the IFP method must be 
applied to all sales for which an IFP may be fairly established and 
applied for that taxable year and each subsequent taxable year. The 
taxpayer will apply either the 50/50 method described in paragraph 
(b)(1) of this section or the books and records method described in 
paragraph (b)(3) of this section to any other Section 863 Sale for which 
an IFP cannot be established or applied for each taxable year.
    (iii) Determination of gross income. The amount of a taxpayer's 
gross income from production activity is determined by reducing the 
amount of gross receipts from production activity by the cost of goods 
sold properly attributable to production activity. The amount of a 
taxpayer's gross income from sales activity is determined by reducing 
the amount of gross receipts from sales activity by the cost of goods 
sold (if any) properly attributable to sales activity. The source of 
gross income from production activity is determined under the rules of 
paragraph (c)(1) of this section, and the source of gross income from 
sales activity will be determined under the rules of paragraph (c)(2) of 
this section.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (b)(2):

    Example 1. IFP method. (i) P, a U.S. producer, purchases cotton and 
produces cloth in the United States. P sells cloth in country X to D, an 
unrelated foreign clothing manufacturer, for $100. Cost of goods sold 
for cloth is $80, entirely attributable to production activity. P does 
not engage in significant sales activity in relation to its other 
activities in the sales to D. Under these facts, the sale to D fairly 
establishes an IFP of $100. Assume that P elects to use the IFP method. 
Accordingly, $100 of the gross sales price is treated as attributable to 
production activity, and no amount of income from this sale is 
attributable to sales activity. After reducing the gross sales price by 
cost of goods sold, $20 of the gross income is treated as attributable 
to production activity ($100-$80).
    (ii) P also sells cloth in country X to A, an unrelated foreign 
retail outlet, for $110. Because P elected the IFP method and the cloth 
is substantially similar to the cloth sold to D, the IFP fairly 
established in the sales to D must be used to determine the amount 
attributable to production activity in the sale to A. Accordingly, $100 
of the gross sales price is treated as attributable to production 
activity and $10 ($110-$100) is attributable to sales activity. After 
reducing the gross sales price by cost of goods sold, $20 of the gross 
income is treated as attributable to production activity ($100-$80) and 
$10 is attributable to sales activity.
    Example 2. Scope of IFP Method. (i) USCo manufactures three 
dissimilar products. USCo elects to apply the IFP method. In year 1, an 
IFP can be established for sales of product X, but not for products Y 
and Z. In year 2, an IFP cannot be established for any of USCo's 
products. In year 3, an IFP can be established for products X and Y, but 
not for product Z.
    (ii) In year 1, USCo must apply the IFP method to sales of product 
X. In year 2, although USCo's IFP election remains in effect, USCo is 
not required to apply the IFP election to any products. In year 3, USCo 
is required to apply the IFP method to sales of products X and Y.

    (3) Books and records method. A taxpayer may elect to determine the 
amount of its gross income from Section 863 Sales that is attributable 
to production and sales activities for the taxable year based upon its 
books of account if it has received in advance the permission of the 
District Director having audit responsibility over its tax return. The 
taxpayer must establish to the satisfaction of the District Director 
that the taxpayer, in good faith and unaffected by considerations of tax 
liability, will regularly employ in its books of account a detailed 
allocation of receipts and expenditures which clearly reflects the 
amount of the taxpayer's income from production and sales activities. If 
a taxpayer receives permission to apply the books and records method, 
but does not comply with a material condition set forth by the District 
Director, the District Director may, in its discretion, revoke 
permission to use the books and records method. The source of gross 
income treated as attributable to production activity under this method 
may be determined under the rules of paragraph (c)(1) of this section, 
and the source of gross income attributable to

[[Page 295]]

sales activity will be determined under the rules of paragraph (c)(2) of 
this section.
    (c) Determination of the source of gross income from production 
activity and sales activity--(1) Income attributable to production 
activity--(i) Production only within the United States or only within 
foreign countries--(A) Source of income. For purposes of this section, 
production activity means an activity that creates, fabricates, 
manufactures, extracts, processes, cures, or ages inventory. See Sec.  
1.864-1. Subject to the provisions in Sec.  1.1502-13 or paragraph 
(g)(2)(ii) of this section, the only production activities that are 
taken into account for purposes of Sec. Sec.  1.863-1, 1.863-2, and this 
section are those conducted directly by the taxpayer. Where the 
taxpayer's production assets are located only within the United States 
or only outside the United States, the income attributable to production 
activity is sourced where the taxpayer's production assets are located. 
For rules regarding the source of income when production assets are 
located both within the United States and without the United States, see 
paragraph (c)(1)(ii) of this section. For rules regarding the source of 
income when production takes place, in whole or in part, in space or 
international water, the rules of Sec.  1.863-8 apply, and the rules of 
this section do not apply except to the extent provided in Sec.  1.863-
8.
    (B) Definition of production assets. Subject to the provisions of 
Sec.  1.1502-13 and paragraph (g)(2)(ii) of this section, production 
assets include only tangible and intangible assets owned directly by the 
taxpayer that are directly used by the taxpayer to produce inventory 
described in paragraph (a) of this section. Production assets do not 
include assets that are not directly used to produce inventory described 
in paragraph (a) of this section. Thus, production assets do not include 
such assets as accounts receivables, intangibles not related to 
production of inventory (e.g., marketing intangibles, including 
trademarks and customer lists), transportation assets, warehouses, the 
inventory itself, raw materials, or work-in-process. In addition, 
production assets do not include cash or other liquid assets (including 
working capital), investment assets, prepaid expenses, or stock of a 
subsidiary.
    (C) Location of production assets. For purposes of this section, a 
tangible production asset will be considered located where the asset is 
physically located. An intangible production asset will be considered 
located where the tangible production assets owned by the taxpayer to 
which it relates are located.
    (ii) Production both within the United States and within foreign 
countries--(A) Source of income. Where the taxpayer's production assets 
are located both within and without the United States, income from 
sources without the United States will be determined by multiplying the 
income attributable to the taxpayer's production activity by a fraction, 
the numerator of which is the average adjusted basis of production 
assets that are located outside the United States and the denominator of 
which is the average adjusted basis of all production assets within and 
without the United States. The remaining income is treated as from 
sources within the United States.
    (B) Adjusted basis of production assets. For purposes of paragraph 
(c)(1)(ii)(A) of this section, the adjusted basis of an asset is 
determined under section 1011. The average adjusted basis is computed by 
averaging the adjusted basis of the asset at the beginning and end of 
the taxable year, unless by reason of material changes during the 
taxable year such average does not fairly represent the average for such 
year. In this event, the average adjusted basis will be determined upon 
a more appropriate basis. If production assets are used to produce 
inventory sold in Section 863 Sales and are also used to produce other 
property during the taxable year, the portion of its adjusted basis that 
is included in the fraction described in paragraph (c)(1)(ii)(A) of this 
section will be determined under any method that reasonably reflects the 
portion of the assets that produces inventory sold in Section 863 Sales. 
For example, the portion of such an asset that is included in the 
formula may be determined by multiplying the asset's average adjusted 
basis by a fraction, the numerator of which is the gross receipts from 
sales of inventory from

[[Page 296]]

Section 863 Sales produced by the asset, and the denominator of which is 
the gross receipts from all property produced by that asset.
    (iii) Anti-abuse rule. The purpose of this paragraph (c)(1) is to 
attribute the source of the taxpayer's production income to the location 
of the taxpayer's production activity. Therefore, if the taxpayer has 
entered into or structured one or more transactions with a principal 
purpose of reducing its U.S. tax liability by manipulating the formula 
described in paragraph (c)(1)(ii)(A) of this section in a manner 
inconsistent with the purpose of this paragraph (c)(1), the District 
Director may make appropriate adjustments so that the source of the 
taxpayer's income from production activity more clearly reflects the 
source of that income.
    (iv) Examples. The following examples illustrate the rules of this 
paragraph (c)(1):

    Example 1. Source of production income. (i) A, a U.S. corporation, 
produces widgets that are sold both within the United States and within 
a foreign country. The initial manufacture of all widgets occurs in the 
United States. The second stage of production of widgets that are sold 
within a foreign country is completed within the country of sale. A's 
U.S. plant and machinery which is involved in the initial manufacture of 
the widgets has an average adjusted basis of $200. A also owns 
warehouses used to store work-in-process. A owns foreign equipment with 
an average adjusted basis of $25. A's gross receipts from all sales of 
widgets is $100, and its gross receipts from export sales of widgets is 
$25. Assume that apportioning average adjusted basis using gross 
receipts is reasonable. Assume A's cost of goods sold from the sale of 
widgets in the foreign countries is $13 and thus, its gross income from 
widgets sold in foreign countries is $12. A uses the 50/50 method to 
divide its gross income between production activity and sales activity.
    (ii) A determines its production gross income from sources without 
the United States by multiplying one-half of A's $12 of gross income 
from sales of widgets in foreign countries, or $6, by a fraction, the 
numerator of which is all relevant foreign production assets, or $25, 
and the denominator of which is all relevant production assets, or $75 
($25 foreign assets + ($200 U.S. assets x $25 gross receipts from export 
sales/$100 gross receipts from all sales)). Therefore, A's gross 
production income from sources without the United States is $2 ($6 x 
($25/$75)).
    Example 2. Location of intangible property. Assume the same facts as 
Example 1, except that A employs a patented process that applies only to 
the initial production of widgets. In computing the formula used to 
determine the source of income from production activity, A's patent, if 
it has an average adjusted basis, would be located in the United States.
    Example 3. Anti-abuse rule. (i) Assume the same facts as Example 1. 
A sells its U.S. assets to B, an unrelated U.S. corporation, with a 
principal purpose of reducing its U.S. tax liability by manipulating the 
property fraction. A then leases these assets from B. After this 
transaction, under the general rule of paragraph (c)(1)(ii) of this 
section, all of A's production income would be considered from sources 
without the United States, because all of A's relevant production assets 
are located within a foreign country. Since the leased property is not 
owned by the taxpayer, it is not included in the fraction.
    (ii) Because A has entered into a transaction with a principal 
purpose of reducing its U.S. tax liability by manipulating the formula 
described in paragraph (c)(1)(ii)(A) of this section, A's income must be 
adjusted to more clearly reflect the source of that income. In this 
case, the District Director may redetermine the source of A's production 
income by ignoring the sale-leaseback transactions.

    (2) Income attributable to sales activity. The source of the 
taxpayer's income that is attributable to sales activity will be 
determined under the provisions of Sec.  1.861-7(c). Notwithstanding any 
other provision, for rules regarding the source of income when a sale 
takes place in space or international water, the rules of Sec.  1.863-8 
apply, and the rules of this section do not apply except to the extent 
provided in Sec.  1.863-8. However, notwithstanding any other provision, 
for purposes of section 863, the place of sale will be presumed to be 
the United States if personal property is wholly produced in the United 
States and the property is sold for use, consumption, or disposition in 
the United States. See Sec.  1.864-6(b)(3)(ii) to determine the country 
of use, consumption, or disposition. Also, in applying this paragraph, 
property will be treated as wholly produced in the United States if it 
is subject to no more than packaging, repackaging, labeling, or other 
minor assembly operations outside the United States, within the meaning 
of Sec.  1.954-3(a)(4)(iii) (property manufactured or produced by a 
controlled foreign corporation). Notwithstanding any other provision, 
for rules regarding

[[Page 297]]

the source of income when a sale takes place in space or international 
water, the rules of Sec.  1.863-8 apply, and the rules of this section 
do not apply except to the extent provided in Sec.  1.863-8.
    (d) Determination of source of taxable income. Once the source of 
gross income has been determined under paragraph (c) of this section, 
the taxpayer must properly allocate and apportion separately under 
Sec. Sec.  1.861-8 through 1.861-14T the amounts of its expenses, 
losses, and other deductions to its respective amounts of gross income 
from Section 863 Sales determined separately under each method described 
in paragraph (b) of this section. In addition, if the taxpayer deducts 
expenses for research and development under section 174 that may be 
attributed to its Section 863 Sales under Sec.  1.861-8(e)(3), the 
taxpayer must separately allocate or apportion expenses, losses, and 
other deductions to its respective amounts of gross income from each 
relevant product category that the taxpayer uses in applying the rules 
of Sec.  1.861-8(e)(3)(i)(A). In the case of gross income from Section 
863 Sales determined under the IFP method or the books and records 
method, the rules of Sec. Sec.  1.861-8 through 1.861-14T must apply to 
properly allocate or apportion amounts of expenses, losses and other 
deductions allocated and apportioned to such gross income between gross 
income from sources within and without the United States. In the case of 
gross income from Section 863 Sales determined under the 50/50 method, 
the amounts of expenses, losses, and other deductions allocated and 
apportioned to such gross income must be apportioned between sources 
within and without the United States pro rata based on the relative 
amounts of gross income from sources within and without the United 
States determined under the 50/50 method. Research and experimental 
expenditures qualifying under Sec.  1.861-17 are allocated under that 
section, and are not allocated and apportioned pro rata under the 50/50 
method.
    (e) Election and reporting rules--(1) Elections under paragraph (b) 
of this section. If a taxpayer does not elect a method specified in 
paragraph (b) (2) or (3) of this section, the taxpayer must apply the 
method specified in paragraph (b)(1) of this section. The taxpayer may 
elect to apply the method specified in paragraph (b)(2) of this section 
by using the method on a timely filed original return (including 
extensions). A taxpayer may elect to apply the method specified in 
paragraph (b)(3) of this section by using the method on a timely filed 
original return (including extensions), but only if the taxpayer has 
received permission from the District Director to apply that method. 
Once a method under paragraph (b) of this section has been used, that 
method must be used in later taxable years unless the Commissioner 
consents to a change. However, if a taxpayer elects to change to or from 
the method specified in paragraph (b)(3) of this section, the taxpayer 
must obtain permission from the District Director instead of the 
Commissioner. Permission to change methods from one year to another year 
will not be withheld unless the change would result in a substantial 
distortion of the source of the taxpayer's income.
    (2) Disclosure on tax return. A taxpayer who uses one of the methods 
described in paragraph (b) of this section must fully explain in a 
statement attached to the return the methodology used, the circumstances 
justifying use of that methodology, the extent that sales are 
aggregated, and the amount of income so allocated.
    (f) Income partly from sources within a possession of the United 
States--(1) In general. This paragraph (f) relates to gains, profits, 
and income, which are treated as derived partly from sources within the 
United States and partly from sources within a possession of the United 
States (Section 863 Possession Sales). This paragraph (f) applies to 
determine the source of income derived from the sale of inventory 
produced (in whole or in part) by the taxpayer within the United States 
and sold within a possession, or produced (in whole or in part) by a 
taxpayer in a possession and sold within the United States (Possession 
Production Sales). It also applies to determine the source of income 
derived from the purchase of personal property within a possession of 
the United States and its sale within the United States (Possession 
Purchase

[[Page 298]]

Sales). A taxpayer subject to this paragraph (f) must divide gross 
income from Section 863 Possession Sales using one of the methods 
described in either paragraph (f)(2)(i) of this section (in the case of 
Possession Production Sales) or paragraph (f)(3)(i) of this section (in 
the case of Possession Purchase Sales). Once a taxpayer has elected a 
method, the taxpayer must separately apply that method to the applicable 
category of Section 863 Possession Sales in the United States and to 
those in a possession. The source of gross income from each type of 
activity must then be determined under either paragraph (f)(2)(ii) or 
(3)(ii) of this section, as appropriate. The source of taxable income 
from Section 863 Possession Sales is determined under paragraph (f)(4) 
of this section. The taxpayer must apply the rules for computing gross 
and taxable income by aggregating all Section 863 Possession Sales to 
which a method in this section applies after separately applying that 
method to Section 863 Possession Sales in the United States and to 
Section 863 Possession Sales in a possession. This section does not 
apply to determine the source of a taxpayer's gross income derived from 
a sale of inventory purchased from a corporation that has an election in 
effect under section 936, if the taxpayer's income from sales of that 
inventory is taken into account to determine benefits under section 936 
for the section 936 corporation. For rules to be applied to determine 
the source of such income, see Sec.  1.936-6(a)(5) Q&A 7a and 1.936-
6(b)(1) Q&A 13.
    (2) Allocation or apportionment for Possession Production Sales--(i) 
Methods for determining the source of gross income for Possession 
Production Sales--(A) Possession 50/50 method. Under the possession 50/
50 method, gross income from Possession Production Sales is allocated 
between production activity and business sales activity as described in 
this paragraph (f)(2)(i)(A). Under the possession 50/50 method, one-half 
of the taxpayer's gross income will be considered income attributable to 
production activity and the source of that income will be determined 
under the rules of paragraph (f)(2)(ii)(A) of this section. The 
remaining one-half of such gross income will be considered income 
attributable to business sales activity and the source of that income 
will be determined under the rules of paragraph (f)(2)(ii)(B) of this 
section.
    (B) IFP method. In lieu of the possession 50/50 method, a taxpayer 
may elect the independent factory price (IFP) method. Under the IFP 
method, gross income from Possession Production Sales is allocated to 
production activity or sales activity using the IFP method, as described 
in paragraph (b)(2) of this section, if an IFP is fairly established 
under the rules of paragraph (b)(2) of this section. See paragraphs 
(f)(2)(ii)(A) and (C) of this section for rules for determining the 
source of gross income attributable to production activity and sales 
activity.
    (C) Books and records method. A taxpayer may elect to allocate gross 
income using the books and records method described in paragraph (b)(3) 
of this section, if it has received in advance the permission of the 
District Director having audit responsibility over its return. See 
paragraph (f)(2)(ii) of this section for rules for determining the 
source of gross income.
    (ii) Determination of source of gross income from production, 
business sales, and sales activity--(A) Gross income attributable to 
production activity. The source of gross income from production activity 
is determined under the rules of paragraph (c)(1) of this section, 
except that the term possession is substituted for foreign country 
wherever it appears.
    (B) Gross income attributable to business sales activity--(1) Source 
of gross income. Gross income from the taxpayer's business sales 
activity is sourced in the possession in the same proportion that the 
amount of the taxpayer's business sales activity for the taxable year 
within the possession bears to the amount of the taxpayer's business 
sales activity for the taxable year both within the possession and 
outside the possession, with respect to Possession Production Sales. The 
remaining income is sourced in the United States.
    (2) Business sales activity. For purposes of this paragraph 
(f)(2)(ii)(B), the taxpayer's business sales activity is equal to the 
sum of--
    (i) The amounts for the taxable period paid for wages, salaries, and 
other

[[Page 299]]

compensation of employees, and other expenses attributable to Possession 
Production Sales (other than amounts that are nondeductible under 
section 263A, interest, and research and development); and
    (ii) Possession Production Sales for the taxable period.
    (3) Location of business sales activity. For purposes of determining 
the location of the taxpayer's business activity within a possession, 
the following rules apply:
    (i) Sales. Receipts from gross sales will be attributed to a 
possession under the provisions of paragraph (c)(2) of this section.
    (ii) Expenses. Expenses will be attributed to a possession under the 
rules of Sec. Sec.  1.861-8 through 1.861-14T.
    (C) Gross income attributable to sales activity. The source of the 
taxpayer's income that is attributable to sales activity, as determined 
under the IFP method or the books and records method, will be determined 
under the provisions of paragraph (c)(2) of this section.
    (3) Allocation or apportionment for Possession Purchase Sales--(i) 
Methods for determining the source of gross income for Possession 
Purchase Sales--(A) Business activity method. Gross income from 
Possession Purchase Sales is allocated in its entirety to the taxpayer's 
business activity, and is then apportioned between U.S. and possession 
sources under paragraph (f)(3)(ii) of this section.
    (B) Books and records method. A taxpayer may elect to allocate gross 
income using the books and records method described in paragraph (b)(3) 
of this section, subject to the conditions set forth in paragraph (b)(3) 
of this section. See paragraph (f)(2)(ii) of this section for rules for 
determining the source of gross income.
    (ii) Determination of source of gross income from business 
activity--(A) Source of gross income. Gross income from the taxpayer's 
business activity is sourced in the possession in the same proportion 
that the amount of the taxpayer's business activity for the taxable year 
within the possession bears to the amount of the taxpayer's business 
activity for the taxable year both within the possession and outside the 
possession, with respect to Possession Purchase Sales. The remaining 
income is sourced in the United States.
    (B) Business activity. For purposes of this paragraph (f)(3)(ii), 
the taxpayer's business activity is equal to the sum of--
    (1) The amounts for the taxable period paid for wages, salaries, and 
other compensation of employees, and other expenses attributable to 
Possession Purchase Sales (other than amounts that are nondeductible 
under section 263A, interest, and research and development);
    (2) Cost of goods sold attributable to Possession Purchase Sales 
during the taxable period; and
    (3) Possession Purchase Sales for the taxable period.
    (C) Location of business activity. For purposes of determining the 
location of the taxpayer's business activity within a possession, the 
following rules apply:
    (1) Sales. Receipts from gross sales will be attributed to a 
possession under the provisions of paragraph (c)(2) of this section.
    (2) Cost of goods sold. Payments for cost of goods sold will be 
properly attributable to gross receipts from sources within the 
possession only to the extent that the property purchased was 
manufactured, produced, grown, or extracted in the possession (within 
the meaning of section 954(d)(1)(A)).
    (3) Expenses. Expenses will be attributed to a possession under the 
rules of Sec. Sec.  1.861-8 through 1.861-14T.
    (iii) Examples. The following examples illustrate the rules of 
paragraph (f)(3)(ii) of this section relating to the determination of 
source of gross income from business activity:

    Example 1. (i) U.S. Co. purchases in a possession product X for $80 
from A. A manufactures X in the possession. Without further production, 
U.S. Co. sells X in the United States for $100. Assume U.S. Co. has 
sales and administrative expenses in the possession of $10.
    (ii) To determine the source of U.S. Co.'s gross income, the $100 
gross income from sales of X is allocated entirely to U.S. Co.'s 
business activity. Forty-seven dollars of U.S. Co.'s gross income is 
sourced in the possession. [Possession expenses ($10) plus possession 
purchases (i.e., cost of goods sold) ($80) plus possessions sales ($0), 
divided by total expenses ($10) plus total purchases ($80) plus total 
sales ($100).] The remaining $53 is sourced in the United States.

[[Page 300]]

    Example 2. (i) Assume the same facts as in Example 1, except that A 
manufactures X outside the possession.
    (ii) To determine the source of U.S. Co.'s gross income, the $100 
gross income is allocated entirely to U.S. Co.'s business activity. Five 
dollars of U.S. Co.'s gross income is sourced in the possession. 
[Possession expenses ($10) plus possession purchases ($0) plus 
possession sales ($0), divided by total expenses ($10) plus total 
purchases ($80) plus total sales ($100).] The $80 purchase is not 
included in the numerator used to determine U.S. Co.'s business activity 
in the possession, since product X was not manufactured in the 
possession. The remaining $95 is sourced in the United States.

    (4) Determination of source of taxable income. Once the source of 
gross income has been determined under paragraph (f)(2) or (3) of this 
section, the taxpayer must properly allocate and apportion separately 
under Sec. Sec.  1.861-8 through 1.861-14T the amounts of its expenses, 
losses, and other deductions to its respective amounts of gross income 
from Section 863 Possession Sales determined separately under each 
method described in paragraph (f)(2) or (3) of this section. In 
addition, if the taxpayer deducts expenses for research and development 
under section 174 that may be attributed to its Section 863 Possession 
Sales under Sec.  1.861-17, the taxpayer must separately allocate or 
apportion expenses, losses, and other deductions to its respective 
amounts of gross income from each relevant product category that the 
taxpayer uses in applying the rules of Sec.  1.861-17. Thus, in the case 
of gross income from Section 863 Possession Sales determined under the 
IFP method or books and records method, a taxpayer must apply the rules 
of Sec. Sec.  1.861-8 through 1.861-14T to properly allocate or 
apportion amounts of expenses, losses and other deductions, allocated 
and apportioned to such gross income, between gross income from sources 
within and without the United States. However, in the case of gross 
income from Possession Production Sales determined under the possessions 
50/50 method or gross income from Possession Purchase Sales computed 
under the business activity method, the amounts of expenses, losses, and 
other deductions allocated and apportioned to such gross income must be 
apportioned between sources within and without the United States pro 
rata based on the relative amounts of gross income from sources within 
and without the United States determined under those methods, except 
that the rules regarding the allocation and apportionment of research 
and experimental expenditures in Sec.  1.861-17 shall apply to such 
expenditures of taxpayers using the 50/50 method.
    (5) Special rules for partnerships. In applying the rules of this 
paragraph (f) to transactions involving partners and partnerships, the 
rules of paragraph (g) of this section apply.
    (6) Election and reporting rules--(i) Elections under paragraph 
(f)(2) or (3) of this section. If a taxpayer does not elect one of the 
methods specified in paragraph (f)(2) or (3) of this section, the 
taxpayer must apply the possession 50/50 method in the case of 
Possession Production Sales or the business activity method in the case 
of Possession Purchase Sales. The taxpayer may elect to apply a method 
specified in either paragraph (f)(2) or (3) of this section by using the 
method on a timely filed original return (including extensions). Once a 
method has been used, that method must be used in later taxable years 
unless the Commissioner consents to a change. Permission to change 
methods from one year to another year will be granted unless the change 
would result in a substantial distortion of the source of the taxpayer's 
income.
    (ii) Disclosure on tax return. A taxpayer who uses one of the 
methods described in paragraph (f)(2) or (3) of this section must fully 
explain in a statement attached to the tax return the methodology used, 
the circumstances justifying use of that methodology, the extent that 
sales are aggregated, and the amount of income so allocated.
    (g) Special rules for partnerships--(1) General rule. For purposes 
of Sec.  1.863-1 and this section, a taxpayer's production or sales 
activity does not include production and sales activities conducted by a 
partnership of which the taxpayer is a partner either directly or 
through one or more partnerships, except as otherwise provided in 
paragraph (g)(2) of this section.
    (2) Exceptions--(i) In general. For purposes of determining the 
source of the

[[Page 301]]

partner's distributive share of partnership income or determining the 
source of the partner's income from the sale of inventory property which 
the partnership distributes to the partner in kind, the partner's 
production or sales activity includes an activity conducted by the 
partnership. In addition, the production activity of a partnership 
includes the production activity of a taxpayer that is a partner either 
directly or through one or more partnerships, to the extent that the 
partner's production activity is related to inventory that the partner 
contributes to the partnership in a transaction described under section 
721.
    (ii) Attribution of production assets to or from a partnership. A 
partner will be treated as owning its proportionate share of the 
partnership's production assets only to the extent that, under paragraph 
(g)(2)(i) of this section, the partner's activity includes production 
activity conducted through a partnership. A partner's share of 
partnership assets will be determined by reference to the partner's 
distributive share of partnership income for the year attributable to 
such production assets. Similarly, to the extent a partnership's 
activities include the production activities of a partner, the 
partnership will be treated as owning the partner's production assets 
related to the inventory that is contributed in kind to the partnership. 
See paragraph (c)(1)(ii)(B) of this section for rules apportioning the 
basis of assets to Section 863 Sales.
    (iii) Basis. For purposes of this section, in those cases where the 
partner is treated as owning its proportionate share of the 
partnership's production assets, the partner's basis in production 
assets held through a partnership shall be determined by reference to 
the partnership's adjusted basis in its assets (including a partner's 
special basis adjustment, if any, under section 743). Similarly, a 
partnership's basis in a partner's production assets is determined with 
reference to the partner's adjusted basis in its assets.
    (iv) Separate application of methods. If, under paragraph (g)(2) of 
this section, a partner is treated as conducting the activity of a 
partnership, and is treated as owning its proportionate share of a 
partnership's production assets, a partner must apply the method it has 
elected under paragraph (b) of this section separately to Section 863 
Sales described in this paragraph (g) and all other Section 863 Sales.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (g):

    Example 1. Distributive share of partnership income. A, a U.S. 
corporation, forms a partnership in the United States with B, a country 
X corporation. A and B each have a 50 percent interest in the income, 
gains, losses, deductions and credits of the partnership. The 
partnership is engaged in the manufacture and sale of widgets. The 
widgets are manufactured in the partnership's plant located in the 
United States and are sold by the partnership outside the United States. 
The partnership owns the manufacturing facility and all other production 
assets used to produce the widgets. A's distributive share of 
partnership income includes 50 percent of the sales income from these 
sales. In applying the rules of section 863 to determine the source of 
its distributive share of partnership income from the export sales of 
widgets, A is treated as carrying on the activity of the partnership 
related to production of these widgets and as owning a proportionate 
share of the partnership's assets related to production of the widgets, 
based upon its distributive share of partnership income.
    Example 2. Distribution in kind. Assume the same facts as in Example 
1 except that the partnership, instead of selling the widgets, 
distributes the widgets to A and B. A then further processes the widgets 
and then sells them outside the United States. In determining the source 
of the income earned by A on the sales outside the United States, A is 
treated as conducting the activities of the partnership related to 
production of the distributed widgets. Thus, the source of gross income 
on the sale of the widgets is determined under section 863 and these 
regulations. A applies the 50/50 method described in paragraph (b)(1) of 
this section to determine the source of income from the sales. In 
applying paragraph (c)(1) of this section, A is treated as owning its 
proportionate share of the partnership's production assets based upon 
its distributive share of partnership income.

    (h) Effective dates. The rules of this section apply to taxable 
years beginning after December 30, 1996. However, taxpayers may apply 
these regulations for taxable years beginning after July 11, 1995, and 
on or before December 30, 1996. For years beginning before December 30, 
1996, see Sec. Sec.  1.863-3A and

[[Page 302]]

1.863-3AT. However, the rules of paragraph (f) of this section apply to 
taxable years beginning on or after November 13, 1998.

[T.D. 8687, 61 FR 60547, Nov. 29, 1996; 61 FR 65323, Dec. 12, 1996, as 
amended by T.D. 8786, 63 FR 55023, Oct. 14, 1998; T.D. 9305, 71 FR 
77603, Dec. 27, 2006]

   regulations applicable to taxable years prior to december 30, 1996



Sec.  1.863-3A  Income from the sale of personal property derived partly 
from within and partly from without the United States.

    (a) General--(1) Classes of income. Income from the sale of property 
to which paragraph (b) (2) and (3) of Sec.  1.863-2 applies is divided 
into two classes for purposes of this section, namely, income which is 
treated as derived partly from sources within the United States and 
partly from sources within a foreign country, and income which is 
treated as derived partly from sources within the United States and 
partly from sources within a possession of the United States.
    (2) Definition. For purposes of this section, the word ``produced'' 
includes created, fabricated, manufactured, extracted, processed, cured, 
or aged. For determining the time and place of sale of personal property 
for purposes of this section, see paragraph (c) of Sec.  1.861-7.
    (b) Income partly from sources within a foreign country--(1) 
General. This paragraph relates to gains, profits, and income derived 
from the sale of personal property produced (in whole or in part) by the 
taxpayer within the United States and sold within a foreign country, or 
produced (in whole or in part) by the taxpayer within a foreign country 
and sold within the United States. Pursuant to section 863(b) such items 
shall be treated as derived partly from sources within the United States 
and partly from sources within a foreign country.
    (2) Allocation or apportionment. The taxable income from sources 
within the United States, in the case of the items to which this 
paragraph applies, shall be determined according to the examples set 
forth in this subparagraph. For such purposes, the deductions for the 
personal exemptions shall not be taken into account, but the special 
deductions described in paragraph (c) of Sec.  1.861-8 shall be taken 
into account.

    Example 1. Where the manufacturer or producer regularly sells part 
of his output to wholly independent distributors or other selling 
concerns in such a way as to establish fairly an independent factory or 
production price--or shows to the satisfaction of the district director 
(or, if applicable, the Director of International Operations) that such 
an independent factory or production price has been otherwise 
established--unaffected by considerations of tax liability and the 
selling or distributing branch or department of the business is located 
in a different country from that in which the factory is located or the 
production carried on, the taxable income attributable to sources within 
the United States shall be computed by an accounting which treats the 
products as sold by the factory or productive department of the business 
to the distributing or selling department at the independent factory 
price so established. In all such cases the basis of the accounting 
shall be fully explained in a statement attached to the return for the 
taxable year.
    Example 2. (i)-(ii) [Reserved]. For guidance, see Sec.  863-3T(b)(2) 
Example (2)(i) and (ii).
    (iii) The term ``gross sales'', as used in this example, refers only 
to the sales of personal property produced (in whole or in part) by the 
taxpayer within the United States and sold within a foreign country or 
produced (in whole or in part) by the taxpayer within a foreign country 
and sold within the United States.
    (iv) The term ``property'', as used in this example, includes only 
the property held or used to produce income which is derived from such 
sales. Such property should be taken at its actual value, which in the 
case of property valued or appraised for purposes of inventory, 
depreciation, depletion, or other purposes of taxation shall be the 
highest amount at which so valued or appraised, and which in other cases 
shall be deemed to be its book value in the absence of affirmative 
evidence showing such value to be greater or less than the actual value. 
The average value during the taxable year or period shall be employed. 
The average value of property as above prescribed at the beginning and 
end of the taxable year or period ordinarily may be used, unless by 
reason of material changes during the taxable year or period such 
average does not fairly represent the average for such year or period, 
in which event the average shall be determined upon a monthly or daily 
basis.
    (v) Bills and accounts receivable shall (unless satisfactory reason 
for a different treatment is shown) be assigned or allocated to the 
United States when the debtor resides in the United States, unless the 
taxpayer has

[[Page 303]]

no office, branch, or agent in the United States.
    Example 3. Application for permission to base the return upon the 
taxpayer's books of account will be considered by the district director 
(or, if applicable, the Director of International Operations) in the 
case of any taxpayer who, in good faith and unaffected by considerations 
of tax liability, regularly employs in his books of account a detailed 
allocation of receipts and expenditures which reflects more clearly than 
the processes or formulas herein prescribed the taxable income derived 
from sources within the United States.

    (c) Income partly from sources within a possession of the United 
States--(1) General. This paragraph relates to gains, profits, and 
income which, pursuant to section 863(b), are treated as derived partly 
from sources within the United States and partly from sources within a 
possession of the United States. The items so treated are described in 
subparagraphs (3) and (4) of this paragraph.
    (2) Allocation or apportionment. The taxable income from sources 
within the United States, in the case of the items to which this 
paragraph applies, shall be determined according to the examples set 
forth in subparagraphs (3) and (4) of this paragraph. For such purposes, 
the deductions for the personal exemptions shall not be taken into 
account, but the special deductions described in paragraph (c) of Sec.  
1.861-8 shall be taken into account.
    (3) Personal property produced and sold. This subparagraph relates 
to gross income derived from the sale of personal property produced (in 
whole or in part) by the taxpayer within the United States and sold 
within a possession of the United States, or produced (in whole or in 
part) by the taxpayer within a possession of the United States and sold 
within the United States.

    Example 1. Same as example 1 under paragraph (b)(2) of this section.
    Example 2. (i) Where an independent factory or production price has 
not been established as provided under example 1, the taxable income 
shall first be computed by deducting from the gross income derived from 
the sale of personal property produced (in whole or in part) by the 
taxpayer within the United States and sold within a possession of the 
United States, or produced (in whole or in part) by the taxpayer within 
a possession of the United States and sold within the United States, the 
expenses, losses, or other deductions properly allocated and apportioned 
thereto in accordance with the rules set forth in Sec.  1.861-8.
    (ii) Of the amount of taxable income so determined, one-half shall 
be apportioned in accordance with the value of the taxpayer's property 
within the United States and within the possession of the United States, 
the portion attributable to sources within the United States being 
determined by multiplying such one-half by a fraction the numerator of 
which consists of the value of the taxpayer's property within the United 
States, and the denominator of which consists of the value of the 
taxpayer's property both within the United States and within the 
possession of the United States. The remaining one-half of such taxable 
income shall be apportioned in accordance with the total business of the 
taxpayer within the United States and within the possession of the 
United States, the portion attributable to sources within the United 
States being determined by multiplying such one-half by a fraction the 
numerator of which consists of the amount of the taxpayer's business for 
the taxable year or period within the United States, and the denominator 
of which consists of the amount of the taxpayer's business for the 
taxable year or period both within the United States and within the 
possession of the United States.
    (iii) ``The business of the taxpayer'', as used in this example, 
shall be measured by the amounts which the taxpayer paid out during the 
taxable year or period for wages, salaries, and other compensation of 
employees and for the purchase of goods, materials, and supplies 
consumed in the regular course of business, plus the amounts received 
during the taxable year or period from gross sales, such expenses, 
purchases, and gross sales being limited to those attributable to the 
production (in whole or in part) of personal property within the United 
States and its sale within a possession of the United States or to the 
production (in whole or in part) of personal property within a 
possession of the United States and its sale within the United States. 
The term ``property'', as used in this example, includes only the 
property held or used to produce income which is derived from such 
sales.
    Example 3. Same as example 3 under paragraph (b)(2) of this section.

    (4) Personal property purchased and sold. This subparagraph relates 
to gross income derived from the purchase of personal property within a 
possession of the United States and its sale within the United States.

    Example 1. (i) The taxable income shall first be computed by 
deducting from such

[[Page 304]]

gross income the expenses, losses, or other deductions properly 
allocated or apportioned thereto in accordance with the rules set forth 
in Sec.  1.861-8.
    (ii) The amount of taxable income so determined shall be apportioned 
in accordance with the total business of the taxpayer within the United 
States and within the possession of the United States, the portion 
attributable to sources within the United States being that percentage 
of such taxable income which the amount of the taxpayer's business for 
the taxable year or period within the United States bears to the amount 
of the taxpayer's business for the taxable year or period both within 
the United States and within the possession of the United States.
    (iii) The ``business of the taxpayer'', as that term is used in this 
example, shall be measured by the amounts which the taxpayer paid out 
during the taxable year or period for wages, salaries, and other 
compensation of employees and for the purchase of goods, materials, and 
supplies sold or consumed in the regular course of business, plus the 
amount received during the taxable year or period from gross sales, such 
expenses, purchases, and gross sales being limited to those attributable 
to the purchase of personal property within a possession of the United 
States and its sale within the United States.
    Example 2. Same as example 3 under paragraph (b)(2) of this section.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7456, 42 FR 
1214, Jan. 6, 1977; T.D. 8228, 53 FR 35506, Sept. 14, 1988. Redesignated 
by T.D. 8687, 61 FR 60545, Nov. 29, 1996]



Sec.  1.863-3AT  Income from the sale of personal property derived partly 
from within and partly from without the United States (temporary regulations).

    (a) [Reserved]
    (b) Income partly from sources within a foreign country. (1) 
[Reserved]
    (2) Allocation or apportionment.

    Example 1. [Reserved]
    Example 2. (i) Where an independent factory or production price has 
not been established as provided under Example (1), the gross income 
derived from the sale of personal property produced (in whole or in 
part) by the taxpayer within the United States and sold within a foreign 
country or produced (in whole or in part) by the taxpayer within a 
foreign country and sold within the United States shall be computed.
    (ii) Of this gross amount, one-half shall be apportioned in 
accordance with the value of the taxpayer's property within the United 
States and within the foreign country, the portion attributable to 
sources within the United States being determined by multiplying such 
one-half by a fraction, the numerator of which consists of the value of 
the taxpayer's property within the United States and the denominator of 
which consists of the value of the taxpayer's property both within the 
United States and within the foreign country. The remaining one-half of 
such gross income shall be apportioned in accordance with the gross 
sales of the taxpayer within the United States and within the foreign 
country, the portion attributable to sources within the United States 
being determined by multiplying such one-half by a fraction the 
numerator of which consists of the taxpayer's gross sales for the 
taxable year or period within the United States, and the denominator of 
which consists of the taxpayer's gross sales for the taxable year or 
period both within the United States and within the foreign country. 
Deductions from gross income that are allocable and apportionable to 
gross income described in paragraph (i) of this Example 2 shall be 
apportioned between the United States and foreign source portions of 
such income, as determined under this paragraph (ii), on a pro rata 
basis, without regard to whether the deduction relates primarily or 
exclusively to the production of property or to the sale of property.

    (b)(2) Example (2)(iii) through (c)(4) [Reserved]

[T.D. 8228, 53 FR 35506, Sept. 14, 1988. Redesignated by T.D. 8687, 61 
FR 60545, Nov. 29, 1996]



Sec.  1.863-4  Certain transportation services.

    (a) General. A taxpayer carrying on the business of transportation 
service (other than an activity giving rise to transportation income 
described in section 863(c) or to income subject to other specific 
provisions of this title) between points in the United States and points 
outside the United States derives income partly from sources within and 
partly from sources without the United States.
    (b) Gross income. The gross income from sources within the United 
States derived from such services shall be determined by taking such a 
portion of the total gross revenues therefrom as (1) the sum of the 
costs or expenses of such transportation business carried on by the 
taxpayer within the United States and a reasonable return upon the 
property used in its transportation business while within the United 
States bears to (2) the sum of the total

[[Page 305]]

costs or expenses of such transportation business carried on by the 
taxpayer and a reasonable return upon the total property used in such 
transportation business. Revenues from operations incidental to 
transportation services, such as the sale of money orders, shall be 
apportioned on the same basis as direct revenues from transportation 
services.
    (c) Allocation of costs or expenses. In allocating the total costs 
or expenses incurred in such transportation business, costs or expenses 
incurred in connection with that part of the services which was wholly 
rendered in the United States shall be assigned to the cost of 
transportation business within the United States. For example, expenses 
of loading and unloading in the United States, rentals, office expenses, 
salaries, and wages wholly incurred for services rendered to the 
taxpayer in the United States belong to this class. Costs and expenses 
incurred in connection with services rendered partly within and partly 
without the United States may be prorated on a reasonable basis between 
such services. For example, ship wages, charter money, insurance, and 
supplies chargeable to voyage expenses shall ordinarily be prorated for 
each voyage on the basis of the proportion which the number of days the 
ship was within the territorial limits of the United States bears to the 
total number of days on the voyage; and fuel consumed on each voyage may 
be prorated on the basis of the proportion which the number of miles 
sailed within the territorial limits of the United States bears to the 
total number of miles sailed on the voyage. For other expenses entering 
into the cost of services, only such expenses as are allowable 
deductions under the internal revenue laws shall be taken into account.
    (d) Items not included as costs or expenses--(1) Taxes and interest. 
Income, war profits, and excess profits taxes shall not be regarded as 
costs or expenses for the purpose of determining the proportion of gross 
income from sources within the United States; and, for such purpose, 
interest and other expenses for the use of borrowed capital shall not be 
taken into the cost of services rendered, for the reason that the return 
upon the property used measures the extent to which such borrowed 
capital is the source of the income. See paragraph (f)(2) of this 
section.
    (2) Other business activity and general expenses. If a taxpayer 
subject to this section is also engaged in a business other than that of 
providing transportation service between points in the United States and 
points outside the United States, the costs and expenses, including 
taxes, properly apportioned or allocated to such other business shall be 
excluded both from the deductions and from the apportionment process 
prescribed in paragraph (c) of this section; but, for the purpose of 
determining taxable income, a ratable part of any general expenses, 
losses, or deductions, which cannot definitely be allocated to some item 
or class of gross income, may be deducted from the gross income from 
sources within the United States after the amount of such gross income 
has been determined. Such ratable part shall ordinarily be based upon 
the ratio of gross income from sources within the United States to the 
total gross income. See paragraph (f)(3) of this section.
    (3) Personal exemptions and special deductions. The deductions for 
the personal exemptions, and the special deductions described in 
paragraph (c) of Sec.  1.861-8, shall not be taken into account for 
purposes of paragraph (c) of this section.
    (e) Property used while within the United States--(1) General. The 
value of the property used shall be determined upon the basis of cost 
less depreciation. Eight percent may ordinarily be taken as a reasonable 
rate of return to apply to such property. The property taken shall be 
the average property employed in the transportation service between 
points in the United States and points outside the United States during 
the taxable year.
    (2) Average property. For ships, the average shall be determined 
upon a daily basis for each ship, and the amount to be apportioned for 
each ship as assets employed within the United States shall be computed 
upon the proportion which the number of days the ship was within the 
territorial limits of the United States bears to the total number of 
days the ship was in service

[[Page 306]]

during the taxable period. For other assets employed in the 
transportation business, the average of the assets at the beginning and 
end of the taxable period ordinarily may be taken, but if the average so 
obtained does not, by reason of material changes during the taxable 
year, fairly represent the average for such year either for the assets 
employed in the transportation business in the United States or in 
total, the average must be determined upon a monthly or daily basis.
    (3) Current assets. Current assets shall be decreased by current 
liabilities and allocated to services between the United States and 
foreign countries and to other services. The part allocated to services 
between the United States and foreign countries shall be based on the 
proportion which the gross receipts from such services bear to the gross 
receipts from all services. The amount so allocated to services between 
the United States and foreign countries shall be further allocated to 
services rendered within the United States and to services rendered 
without the United States. The portion allocable to services rendered 
within the United States shall be based on the proportion which the 
expenses incurred within the territorial limits of the United States 
bear to the total expenses incurred in services between the United 
States and foreign countries.
    (f) Taxable income--(1) General. In computing taxable income from 
sources within the United States there shall be allowed as deductions 
from the gross income from such sources, determined in accordance with 
paragraph (b) of this section, (i) the expenses of the transportation 
business carried on within the United States (as determined under 
paragraphs (c) and (d) of this section) and (ii) the expenses and 
deductions determined in accordance with this paragraph.
    (2) Interest and taxes. Interest and income, war-profits, and excess 
profits taxes shall be excluded from the apportionment process, as 
indicated in paragraph (d) of this section; but, for the purpose of 
computing taxable income there may be deducted from the gross income 
from sources within the United States, after the amount of such gross 
income has been determined, a ratable part of all interest deductible 
under section 163 and of all income, war-profits, and excess profits 
taxes deductible under section 164, paid or accrued in respect of the 
business of transportation service between points in the United States 
and points outside the United States. The ratable part shall ordinarily 
be based upon the ratio of gross income from sources within the United 
States to the total gross income, from such transportation service.
    (3) General expenses. General expenses, losses, or deductions shall 
be deducted under this paragraph to the extent indicated in paragraph 
(d)(2) of this section.
    (4) Personal exemptions. The deductions for the personal exemptions 
shall be allowed under this paragraph to the same extent as provided by 
paragraph (b) of Sec.  1.861-8.
    (5) Special deductions. The special deductions allowed in the case 
of a corporation by sections 241, 922, and 941 shall be allowed under 
this paragraph to the same extent as provided by paragraph (c) of Sec.  
1.861-8.
    (g) Allocation based on books of account. Application for permission 
to base the return upon the taxpayer's books of account will be 
considered by the district director (or, if applicable, the Director of 
International Operations) in the case of any taxpayer subject to this 
section, who, in good faith and unaffected by considerations of tax 
liability, regularly employs in his books of account a detailed 
allocation of receipts and expenditures which more clearly reflects the 
income derived from sources within the United States than does the 
process prescribed by paragraphs (b) to (f), inclusive, of this section.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 8687, 61 FR 
60550, Nov. 29, 1996]



Sec.  1.863-6  Income from sources within a foreign country.

    The principles applied in sections 861 through 863 and section 865 
and the regulations thereunder for determining the gross and the taxable 
income from sources within and without the United States shall generally 
be applied in determining the gross and the taxable income from sources 
within and without

[[Page 307]]

a particular foreign country when such a determination must be made 
under any provision of Subtitle A of the Internal Revenue Code, 
including section 952(a)(5). This section shall not apply, however, to 
the extent it is determined by applying Sec.  1.863-3 that a portion of 
the taxable income is from sources within the United States and the 
balance of the taxable income is from sources within a foreign country. 
In the application of this section, the name of the particular foreign 
country shall be used instead of the term United States, and the term 
domestic shall be construed to mean created or organized in such foreign 
country. In applying section 861 and the regulations thereunder for 
purposes of this section, references to sections 243 and 245 shall be 
excluded, and the exception in section 861(a)(3) shall not apply. In the 
case of any item of income, the income from sources within a foreign 
country shall not exceed the amount which, by applying any provision of 
sections 861 through 863 and section 865 and the regulations thereunder 
without reference to this section, is treated as income from sources 
without the United States. See Sec.  1.937-2T for rules for determining 
income from sources within a possession of the United States.

[T.D. 9194, 70 FR 18928, Apr. 11, 2005]



Sec.  1.863-7  Allocation of income attributable to certain notional 
principal contracts under section 863(a).

    (a) Scope--(1) Introduction. This section provides rules relating to 
the source and, in certain cases, the character of notional principal 
contract income. However, this section does not apply to income from a 
section 988 transaction within the meaning of section 988 and the 
regulations thereunder, relating to the treatment of certain 
nonfunctional currency transactions. Further, this section does not 
apply to a dividend equivalent described in section 871(m) and the 
regulations thereunder. Notional principal contract income is income 
attributable to a notional principal contract as defined in Sec.  1.446-
3(c). An agreement between a taxpayer and a qualified business unit (as 
defined in section 989(a)) of the taxpayer, or among qualified business 
units of the same taxpayer, is not a notional principal contract, 
because a taxpayer cannot enter into a contract with itself.
    (2) Effective/applicability date.This section applies to notional 
principal contract income includible in income on or after February 13, 
1991. However, any taxpayer desiring to apply paragraph (b)(2)(iv) of 
this section to notional principal contract income includible in income 
prior to February 13, 1991, in lieu of temporary Income Tax Regulations 
Sec.  1.863-7T(b)(2)(iv) may (on a consistent basis) so choose. See 
paragraph (c) of this section for an election to apply the rules of this 
section to notional principal contract income includible in income 
before December 24, 1986. With respect to a dividend equivalent 
described in section 871(m) and the regulations thereunder, this section 
applies to payments made on or after January 23, 2012.
    (b) Source of notional principal contract income--(1) General rule. 
Unless paragraph (b) (2) or (3) of this section applies, the source of 
notional principal contract income shall be determined by reference to 
the residence of the taxpayer as determined under section 
988(a)(3)(B)(i).
    (2) Qualified business unit exception. The source of notional 
principal contract income shall be determined by reference to the 
residence of a qualified business unit of a taxpayer if--
    (i) The taxpayer's residence, determined under section 
988(a)(3)(B)(i), is the United States;
    (ii) The qualified business unit's residence, determined under 
section 988(a)(3)(B)(ii), is outside the United States;
    (iii) The qualified business unit is engaged in the conduct of a 
trade or business where it is a resident as determined under section 
988(a)(3)(B)(ii); and
    (iv) The notional principal contract is properly reflected on the 
books of the qualified business unit. Whether a notional principal 
contract is properly reflected on the books of such qualified business 
unit is a question of fact. The degree of participation in the 
negotiation and acquisition of a notional principal contract shall be 
considered in this determination. Participation in

[[Page 308]]

connection with the negotiation or acquisition of a notional principal 
contract may be disregarded if the district director determines that a 
purpose for such participation was to affect the source of notional 
principal contract income.
    (3) Effectively connected notional principal contract income. 
Notional principal contract income that under principles similar to 
those set forth in Sec.  1.864-4(c) arises from the conduct of a United 
States trade or business shall be sourced in the United States and such 
income 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).
    (c) Election--(1) Eligibility and effect. A taxpayer described in 
paragraph (b)(2)(i) of this section may make an election to apply the 
rules of this section to all, but not part, of the taxpayer's income 
attributable to notional principal contracts for all taxable years (or 
portion thereof) beginning before December 24, 1986, for which the 
period of limitations for filing a claim for refund under section 
6511(a) has not expired. A taxpayer not described in paragraph (b)(2)(i) 
of this section that is engaged in trade or business within the United 
States may make an election to apply the rules of this section to all, 
but not part, of the taxpayer's income described in paragraph (b)(3) of 
this section for all taxable years (or portion thereof) beginning before 
December 24, 1986, for which the period of limitations for filing a 
claim for refund under section 6511(a) has not expired. If a taxpayer 
makes an election pursuant to this paragraph (c)(1) in the time and 
manner provided in paragraph (c) (2) and (3) of this section, then, with 
respect to such taxable years (or portion thereof), no tax shall be 
deducted or withheld under sections 1441 and 1442 with respect to 
payments made by the taxpayer pursuant to a notional principal contract 
the income attributable to which is subject to such election. The 
election may be revoked only with the consent of the Commissioner.
    (2) Time for making election. The election specified in paragraph 
(c)(1) of this section shall be made by May 14, 1991.
    (3) Manner of making election. The election described in paragraph 
(c)(1) of this section shall be made by attaching a statement to the tax 
return or an amended tax return for each taxable year beginning before 
December 24, 1986, in which the taxpayer accrued or received notional 
principal contract income. The statement shall--
    (i) Contain the name, address, and taxpayer identifying number of 
the electing taxpayer;
    (ii) Identify the election as a ``Notional Principal Contract 
Election under Sec.  1.863-7''; and
    (iii) Specify each taxable year described in paragraph (c)(1) of 
this section in which payments were made.
    (d) Example. The operation of this section is illustrated by the 
following example:

    Example. (1) On January 1, 1990, X, a calendar year domestic 
corporation, entered into an interest rate swap contract with FZ, an 
unrelated foreign corporation. X does not have a qualified business unit 
outside the United States. Under the contract, X is required to pay FZ 
fixed rate dollar amounts, and FZ is required to pay X floating rate 
dollar amounts, each determined solely by reference to a notional dollar 
denominated principal amount specified under the contract. The contract 
is a notional principal contract under Sec.  1.863-7(a) because the 
contract provides for the payment of amounts at specified intervals 
calculated by reference to a specified index upon a notional principal 
amount in exchange for a promise to pay similar amounts.
    (2) Assume that during 1990 X had notional principal contract income 
of $100 in connection with the notional principal contract described in 
(1) above. Also assume that the contract provides that payments more 
than 30 days late give rise to a $5 fee, and that X receives such a fee 
in 1990. Under paragraph (b)(1) of this section, the source of X's $100 
of income attributable to the swap agreement is domestic. The $5 fee is 
not notional principal contract income.

    (e) Cross references. See Sec.  1.861-9T(b) for the allocation of 
expense to certain notional principal contracts. For rules relating to 
the source of income from nonfunctional currency notional principal 
contracts, see Sec.  1.9 88-4T. For rules relating to the taxable amount 
of notional principal contract income allocable under this section to 
sources

[[Page 309]]

inside or outside the United States, see Sec.  1.863-1(c).

[T.D. 8330, 56 FR 1362, Jan. 14, 1991, as amended by T.D. 9572, 77 FR 
3109, Jan. 23, 2012; T.D. 9648, 78 FR 73080, Dec. 5, 2013]



Sec.  1.863-8  Source of income derived from space and ocean activity 
under section 863(d).

    (a) In general. Income of a United States or a foreign person 
derived from space and ocean activity (space and ocean income) is 
sourced under the rules of this section, notwithstanding any other 
provision, including sections 861, 862, 863, and 865. A taxpayer will 
not be considered to derive income from space or ocean activity, as 
defined in paragraph (d) of this section, if such activity is performed 
by another person, subject to the rules for the treatment of 
consolidated groups in Sec.  1.1502-13.
    (b) Source of gross income from space and ocean activity--(1) Space 
and ocean income derived by a United States person. Space and ocean 
income derived by a United States person is income from sources within 
the United States. However, space and ocean income derived by a United 
States person is income from sources without the United States to the 
extent the income, based on all the facts and circumstances, is 
attributable to functions performed, resources employed, or risks 
assumed in a foreign country or countries.
    (2) Space and ocean income derived by a foreign person--(i) In 
general. Space and ocean income derived by a person other than a United 
States person is income from sources without the United States, except 
as otherwise provided in this paragraph (b)(2).
    (ii) Space and ocean income derived by a controlled foreign 
corporation. Space and ocean income derived by a controlled foreign 
corporation within the meaning of section 957 (CFC) is income from 
sources within the United States. However, space and ocean income 
derived by a CFC is income from sources without the United States to the 
extent the income, based on all the facts and circumstances, is 
attributable to functions performed, resources employed, or risks 
assumed in a foreign country or countries.
    (iii) Space and ocean income derived by foreign persons engaged in a 
trade or business within the United States. Space and ocean income 
derived by a foreign person (other than a CFC) engaged in a trade or 
business within the United States is income from sources within the 
United States to the extent the income, based on all the facts and 
circumstances, is attributable to functions performed, resources 
employed, or risks assumed within the United States.
    (3) Source rules for income from certain sales of property--(i) 
Sales of purchased property. When a taxpayer sells purchased property in 
space or international water, the source of gross income from the sale 
generally will be determined under paragraph (b)(1) or (2) of this 
section, as applicable. However, if such property is inventory property 
within the meaning of section 1221(a)(1) (inventory property) and is 
sold for use, consumption, or disposition outside space and 
international water, the source of income from the sale will be 
determined under Sec.  1.861-7(c).
    (ii) Sales of property produced by the taxpayer--(A) General. If the 
taxpayer both produces property and sells such property, the taxpayer 
must allocate gross income from such sales between production activity 
and sales activity under the 50/50 method. Under the 50/50 method, one-
half of the taxpayer's gross income will be considered income allocable 
to production activity, and the source of that income will be determined 
under paragraph (b)(3)(ii)(B) or (C) of this section. The remaining one-
half of such gross income will be considered income allocable to sales 
activity, and the source of that income will be determined under 
paragraph (b)(3)(ii)(D) of this section.
    (B) Production only in space or international water, or only outside 
space and international water. When production occurs only in space or 
international water, income allocable to production activity is sourced 
under paragraph (b)(1) or (2) of this section, as applicable. When 
production occurs only outside space and international water, income 
allocable to production activity is sourced under Sec.  1.863-3(c)(1).

[[Page 310]]

    (C) Production both in space or international water and outside 
space and international water. When property is produced both in space 
or international water and outside space and international water, gross 
income allocable to production activity must be allocated to production 
occurring in space or international water and production occurring 
outside space and international water. Such gross income is allocated to 
production activity occurring in space or international water to the 
extent the income, based on all the facts and circumstances, is 
attributable to functions performed, resources employed, or risks 
assumed in space or international water. The balance of such gross 
income is allocated to production activity occurring outside space and 
international water. The source of gross income allocable to production 
activity in space or international water is determined under paragraph 
(b)(1) or (2) of this section, as applicable. The source of gross income 
allocated to production activity occurring outside space and 
international water is determined under Sec.  1.863-3(c)(1).
    (D) Source of income allocable to sales activity. When property 
produced by the taxpayer is sold outside space and international water, 
the source of gross income allocable to sales activity will be 
determined under Sec. Sec.  1.861-7(c) and 1.863-3(c)(2). When property 
produced by the taxpayer is sold in space or international water, the 
source of gross income allocable to sales activity generally will be 
determined under paragraph (b)(1) or (2) of this section, as applicable. 
However, if such property is inventory property within the meaning of 
section 1221(a)(1) and is sold in space or international water for use, 
consumption, or disposition outside space, international water, and the 
United States, the source of gross income allocable to sales activity 
will be determined under Sec. Sec.  1.861-7(c) and 1.863-3(c)(2).
    (4) Special rule for determining the source of gross income from 
services. To the extent a transaction characterized as the performance 
of a service constitutes a space or ocean activity, as determined under 
paragraph (d)(2)(ii) of this section, the source of gross income derived 
from such transaction is determined under paragraph (b)(1) or (2) of 
this section.
    (5) Special rule for determining source of income from 
communications activity (other than income from international 
communications activity). Space and ocean activity, as defined in 
paragraph (d) of this section, includes activity that occurs in space or 
international water that is characterized as a communications activity 
as defined in Sec.  1.863-9(h)(1) (other than international 
communications activity). The source of space and ocean income that is 
also communications income as defined in Sec.  1.863-9(h)(2) (but not 
space/ocean communications income as defined in Sec.  1.863-9(h)(3)(v)) 
is determined under the rules of Sec.  1.863-9(c), (d), and (f), as 
applicable, rather than under paragraph (b) of this section. The source 
of space and ocean income that is also space/ocean communications income 
as defined in Sec.  1.863-9(h)(3)(v) is determined under the rules of 
paragraph (b) of this section. See Sec.  1.863-9(e).
    (c) Taxable income. When a taxpayer allocates gross income under 
paragraph (b)(1), (b)(2), (b)(3)(ii)(C), or (b)(4) of this section, the 
taxpayer must allocate expenses, losses, and other deductions as 
prescribed in Sec. Sec.  1.861-8 through 1.861-14T to the class or 
classes of gross income that include the income so allocated in each 
case. A taxpayer must then apply the rules of Sec. Sec.  1.861-8 through 
1.861-14T to apportion properly amounts of expenses, losses, and other 
deductions so allocated to such gross income between gross income from 
sources within the United States and gross income from sources without 
the United States.
    (d) Space and ocean activity--(1) Definition--(i) Space activity. In 
general, space activity is any activity conducted in space. For purposes 
of this section, space means any area not within the jurisdiction (as 
recognized by the United States) of a foreign country, possession of the 
United States, or the United States, and not in international water. For 
purposes of determining space activity, the Commissioner may separate 
parts of a single transaction into separate transactions or combine 
separate transactions as part of a single transaction. Paragraph

[[Page 311]]

(d)(3) of this section lists specific exceptions to the general 
definition of space activity. Activities that constitute space activity 
include but are not limited to--
    (A) Performance and provision of services in space, as defined in 
paragraph (d)(2)(ii) of this section;
    (B) Leasing of equipment located in space, including spacecraft (for 
example, satellites) or transponders located in space;
    (C) Licensing of technology or other intangibles for use in space;
    (D) Production, processing, or creation of property in space, as 
defined in paragraph (d)(2)(i) of this section;
    (E) Activity occurring in space that is characterized as 
communications activity (other than international communications 
activity) under Sec.  1.863-9(h)(1);
    (F) Underwriting income from the insurance of risks on activities 
that produce space income; and
    (G) Sales of property in space (see Sec.  1.861-7(c)).
    (ii) Ocean activity. In general, ocean activity is any activity 
conducted on or under water not within the jurisdiction (as recognized 
by the United States) of a foreign country, possession of the United 
States, or the United States (collectively, in international water). For 
purposes of determining ocean activity, the Commissioner may separate 
parts of a single transaction into separate transactions or combine 
separate transactions as part of a single transaction. Paragraph (d)(3) 
of this section lists specific exceptions to the general definition of 
ocean activity. Activities that constitute ocean activity include but 
are not limited to--
    (A) Performance and provision of services in international water, as 
defined in paragraph (d)(2)(ii) of this section;
    (B) Leasing of equipment located in international water, including 
underwater cables;
    (C) Licensing of technology or other intangibles for use in 
international water;
    (D) Production, processing, or creation of property in international 
water, as defined in paragraph (d)(2)(i) of this section;
    (E) Activity occurring in international water that is characterized 
as communications activity (other than international communications 
activity) under Sec.  1.863-9(h)(1);
    (F) Underwriting income from the insurance of risks on activities 
that produce ocean income;
    (G) Sales of property in international water (see Sec.  1.861-7(c));
    (H) Any activity performed in Antarctica;
    (I) The leasing of a vessel that does not transport cargo or persons 
for hire between ports-of-call (for example, the leasing of a vessel to 
engage in research activities in international water); and
    (J) The leasing of drilling rigs, extraction of minerals, and 
performance and provision of services related thereto, except as 
provided in paragraph (d)(3)(ii) of this section.
    (2) Determining a space or ocean activity--(i) Production of 
property in space or international water. For purposes of this section, 
production activity means an activity that creates, fabricates, 
manufactures, extracts, processes, cures, or ages property within the 
meaning of section 864(a) and Sec.  1.864-1.
    (ii) Special rule for performance of services--(A) General. Except 
as provided in paragraph (d)(2)(ii)(B) of this section, if a transaction 
is characterized as the performance of a service, then such service will 
be treated as a space or ocean activity in its entirety when any part of 
the service is performed in space or international water. Services are 
performed in space or international water if functions are performed, 
resources are employed, or risks are assumed in space or international 
water, regardless of whether performed by personnel, equipment, or 
otherwise.
    (B) Exception to the general rule. If the taxpayer can demonstrate 
the value of the service attributable to performance occurring in space 
or international water, and the value of the service attributable to 
performance occurring outside space and international water, then such 
service will be treated as space or ocean activity only to the extent of 
the activity performed in space or international water. The value of

[[Page 312]]

the service is attributable to performance occurring in space or 
international water to the extent the performance of the service, based 
on all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed in space or 
international water. In addition, if the taxpayer can demonstrate, based 
on all the facts and circumstances, that the value of the service 
attributable to performance in space and international water is de 
minimis, such service will not be treated as space or ocean activity.
    (3) Exceptions to space or ocean activity. Space or ocean activity 
does not include the following types of activities:
    (i) Any activity giving rise to transportation income as defined in 
section 863(c).
    (ii) Any activity with respect to mines, oil and gas wells, or other 
natural deposits, to the extent the mines, wells, or natural deposits 
are located within the jurisdiction (as recognized by the United States) 
of any country, including the United States and its possessions.
    (iii) Any activity giving rise to international communications 
income as defined in Sec.  1.863-9(h)(3)(ii).
    (e) Treatment of partnerships. This section is applied at the 
partner level.
    (f) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Space activity--activity occurring on land and in space. 
(i) Facts. S, a United States person, owns satellites in orbit. S leases 
one of its satellites to A. S, as lessor, will not operate the 
satellite. Part of S's performance as lessor in this transaction occurs 
on land. Assume that the combination of S's activities is characterized 
as the lease of equipment.
    (ii) Analysis. Because the leased equipment is located in space, the 
transaction is defined in its entirety as space activity under paragraph 
(d)(1)(i) of this section. Income derived from the lease will be sourced 
under paragraph (b)(1) of this section. Under paragraph (b)(1) of this 
section, S's space income is sourced outside the United States to the 
extent the income, based on all the facts and circumstances, is 
attributable to functions performed, resources employed, or risks 
assumed in a foreign country or countries.
    Example 2. Space activity. (i) Facts. X is an Internet service 
provider. X offers a service that permits a customer (C) to connect to 
the Internet via a telephone call, initiated by the modem of C's 
personal computer, to a control center. X transmits information 
requested by C to C's personal computer, in part using satellite 
capacity leased by X from S. X performs the uplink and downlink 
functions. X charges its customers a flat monthly fee. Assume that 
neither X nor S derive international communications income within the 
meaning of Sec.  1.863-9(h)(3)(ii). In addition, assume that X is able 
to demonstrate, pursuant to paragraph (d)(2)(ii)(B) of this section, the 
extent to which the value of the service is attributable to functions 
performed, resources employed, and risks assumed in space.
    (ii) Analysis. Under paragraph (d)(2)(ii) of this section, the 
service performed by X constitutes space activity to the extent the 
value of the service is attributable to functions performed, resources 
employed, and risks assumed in space. To the extent the service 
performed by X constitutes space activity, the source of X's income from 
the service transaction is determined under paragraph (b) of this 
section. To the extent the service performed by X does not constitute 
space or ocean activity, the source of X's income from the service is 
determined under sections 861, 862, and 863, as applicable. To the 
extent that X derives space and ocean income that is also communications 
income within the meaning of Sec.  1.863-9(h)(2), the source of X's 
income is determined under paragraph (b) of this section and Sec.  
1.863-9(c), (d), and (f), as applicable, as provided in paragraph (b)(5) 
of this section. S derives space and ocean income that is also 
communications income within the meaning of Sec.  1.863-9(h)(2), and the 
source of S's income is therefore determined under paragraph (b) of this 
section and Sec.  1.863-9(c), (d), and (f), as applicable, as provided 
in paragraph (b)(5) of this section.
    Example 3. Services as space activity--de minimis value attributable 
to performance occurring in space. (i) Facts. R owns a retail outlet in 
the United States. R engages S to provide a security system for R's 
premises. S operates its security system by transmitting images from R's 
premises directly to a satellite, and from the satellite to a group of S 
employees located in Country B, who monitor the premises by viewing the 
transmitted images. The satellite is used as a medium of delivery and 
not as a method of surveillance. O provides S with transponder capacity 
on O's satellite, which S uses to transmit those images. Assume that S's 
transaction with R is characterized as the performance of a service. 
Assume that O's provision of transponder capacity is also viewed as the 
provision of a service. Assume also that S is able to demonstrate, 
pursuant to Sec.  1.863-9(h)(1), that the value of the transaction with 
R attributable to communications activities is de minimis.

[[Page 313]]

    (ii) Analysis. S derives income from providing monitoring services. 
S can demonstrate, pursuant to paragraph (d)(2)(ii) of this section, 
that based on all the facts and circumstances, the value of S's service 
transaction attributable to performance in space is de minimis. Thus, S 
is not treated as engaged in a space activity, and none of S's income 
from the service transaction is space income. In addition, because S 
demonstrates that the value of the transaction with R attributable to 
communications activities is de minimis, S is not required under Sec.  
1.863-9(h)(1)(ii) to treat the transaction as separate communications 
and non-communications transactions, and none of S's gross income from 
the transaction is treated as communications income within the meaning 
of Sec.  1.863-9(h)(2). O's provision of transponder capacity is viewed 
as the provision of a service. Based on all the facts and circumstances, 
the value of O's service transaction attributable to performance in 
space is not de minimis. Thus, O's activity will be considered space 
activity, pursuant to paragraph (d)(2)(ii) of this section, to the 
extent the value of the services transaction is attributable to 
performance in space (unless O's activity in space is international 
communications activity). To the extent that O derives communications 
income, the source of such income is determined under paragraph (b) of 
this section and Sec.  1.863-9(b), (c), (d), and (f), as applicable, as 
provided in paragraph (b)(5) of this section. R does not derive any 
income from space activity.
    Example 4. Space activity. (i) Facts. L, a domestic corporation, 
offers programming and certain other services to customers located both 
in the United States and in foreign countries. Assume that L's provision 
of programming and other services in this Example 4 is characterized as 
the provision of a service, and that no part of the service transaction 
occurs in space or international water. Assume that the delivery of the 
programming constitutes a separate transaction also characterized as the 
performance of a service. L uses satellite capacity acquired from S to 
deliver the programming service directly to customers' television sets. 
L performs the uplink and downlink functions, so that part of the value 
of the delivery transaction derives from functions performed and 
resources employed in space. Assume that these contributions to the 
value of the delivery transaction occurring in space are not considered 
de minimis under paragraph (d)(2)(ii)(B) of this section. Customer C 
pays L to provide and deliver programming to C's residence in the United 
States. Assume S's provision of satellite capacity in this Example 4 is 
viewed as the provision of a service, and also that S does not derive 
international communications income within the meaning of Sec.  1.863-
9(h)(3)(ii).
    (ii) Analysis. S's activity will be considered space activity. To 
the extent that S derives space and ocean income that is also 
communications income under Sec.  1.863-9(h)(2), the source of S's 
income is determined under paragraph (b) of this section and Sec.  
1.863-9(c), (d), and (f), as applicable, as provided in paragraph (b)(5) 
of this section. On these facts, L's activities are treated as two 
separate service transactions: the provision of programming (and other 
services), and the delivery of programming. L's income derived from 
provision of programming and other services is not income derived from 
space activity. L's delivery of programming and other services is 
considered space activity, pursuant to paragraph (d)(2)(ii) of this 
section, to the extent the value of the delivery transaction is 
attributable to performance in space. To the extent that the delivery of 
programming is treated as a space activity, the source of L's income 
derived from the delivery transaction is determined under paragraph 
(b)(1) of this section, as provided in paragraph (b)(4) of this section. 
To the extent that L derives space and ocean income that is also 
communications income within the meaning of Sec.  1.863-9(h)(2), the 
source of such income is determined under paragraph (b) of this section 
and Sec.  1.863-9(b), (c), (d), (e), and (f), as applicable, as provided 
in paragraph (b)(5) of this section.
    Example 5. Space activity. (i) Facts. The facts are the same as in 
Example 4, except that L does not deliver the programming service 
directly but instead engages R, a domestic corporation specializing in 
content delivery, to deliver by transmission its programming. For all 
portions of a transmission which require satellite capacity, R, in turn, 
contracts out such functions to S. S performs the uplink and downlink 
functions, so that part of the value of the delivery transaction derives 
from functions performed and resources employed in space.
    (ii) Analysis. L's activity will not be considered space activity 
because none of L's activity occurs in space. Thus, L does not derive 
any space and ocean income. L does, however, derive communications 
income within the meaning of Sec.  1.863-9(h)(2). This is the case even 
though L does not perform the transmission function because L is paid by 
Customer C to transmit, and bears the risk of transmitting, the 
communications or data. To the extent that L's activity consists in part 
of non-de minimis communications and non-de minimis non-communications 
activity, each part of the transaction must be treated as a separate 
transaction and gross income is allocated accordingly under Sec.  1.863-
9(h)(1)(ii). In addition, L must also allocate expenses, losses, and 
other deductions, for example, payments to R, to the class or classes of 
gross income that include the income so allocated. R's activity will not 
be considered space activity. Since R contracts

[[Page 314]]

out all of the functions involving satellite capacity to S, no part of 
R's activity occurs in space. Thus, R does not derive any space and 
ocean income. R does, however, derive communications income within the 
meaning of Sec.  1.863-9(h)(2). This is the case even though R does not 
perform the transmission function because R is paid by L to transmit, 
and bears the risk of transmitting, the communications or data. S's 
activity will be considered space activity. To the extent that S derives 
space and ocean income that is also communications income within the 
meaning of Sec.  1.863-9(h)(2), the source of such income is determined 
under paragraph (b) of this section and Sec.  1.863-9(b), (c), (d), (e), 
and (f), as applicable, as provided in paragraph (b)(5) of this section.
    Example 6. Space activity--treatment of land activity. (i) Facts. S, 
a United States person, offers remote imaging products and services to 
its customers. In year 1, S uses its satellite's remote sensors to 
gather data on certain geographical terrain. In year 3, C, a 
construction development company, contracts with S to obtain a satellite 
image of an area for site development work. S pulls data from its 
archives and transfers to C the images gathered in year 1, in a 
transaction that is characterized as a sale of the data. S's rights, 
title, and interest in the data pass to C in the United States. Before 
transferring the images to C, S uses computer software in its land-based 
office to enhance the images so that the images can be used.
    (ii) Analysis. The collection of data and creation of images in 
space is characterized as the creation of property in space. Because S 
both produces and sells the data, S must allocate gross income from the 
sale of the data between production activity and sales activity under 
the 50/50 method of paragraph (b)(3)(ii)(A). The source of S's income 
allocable to production activity is determined under paragraph 
(b)(3)(ii)(C) of this section because production activities occur both 
in space and on land. The source of S's income attributable to sales 
activity is determined under paragraph (b)(3)(ii)(D) of this section (by 
reference to Sec.  1.863-3(c)(2)) as U.S. source income because S's 
rights, title, and interest in the data pass to C in the United States.
    Example 7. Use of intangible property in space. (i) Facts. X 
acquires a license to use a particular satellite slot or orbit, which X 
sublicenses to C. C pays X a royalty.
    (ii) Analysis. Because the royalty is paid for the right to use 
intangible property in space, the source of the royalty paid by C to X 
is determined under paragraph (b) of this section.
    Example 8. Performance of services. (i) Facts. E, a domestic 
corporation, operates satellites with sensing equipment that can 
determine how much heat and light particular plants emit and reflect. 
Based on the data, E will provide F, a U.S. farmer, a report analyzing 
the data, which F will use in growing crops. E analyzes the data from 
offices located in the United States. Assume that E's combined 
activities are characterized as the performance of services.
    (ii) Analysis. Based on all the facts and circumstances, the value 
of E's service transaction attributable to performance in space is not 
de minimis. Thus, E's activities will be considered space activities, 
pursuant to paragraph (d)(2)(ii) of this section, to the extent the 
value of E's service transaction is attributable to performance in 
space. To the extent E's service transaction constitutes a space 
activity, the source of E's income derived from the service transaction 
will be determined under paragraph (b)(4) of this section, by reference 
to paragraph (b)(1) of this section. To the extent that E's service 
transaction does not constitute a space or ocean activity, the source of 
E's income derived from the service transaction is determined under 
sections 861, 862, and 863, as applicable.
    Example 9. Separate transactions. (i) Facts. The same facts as 
Example 8, except that E provides the raw data to F in a transaction 
characterized as a sale of a copyrighted article. In addition, E 
provides an analysis in the form of a report to F. The price F pays E 
for the raw data is separately stated.
    (ii) Analysis. To the extent that the provision of raw data and the 
analysis of the data are each treated as separate transactions, the 
source of income from the production and sale of data is determined 
under paragraph (b)(3)(ii) of this section. The provision of services 
would be analyzed in the same manner as in Example 8.
    Example 10. Sale of property in international water. (i) Facts. T 
purchased and owns transatlantic cable that lies in international water. 
T sells the cable to B, with T's rights, title, and interest in the 
cable passing to B in international water. Assume that the transatlantic 
cable is not inventory property within the meaning of section 
1221(a)(1).
    (ii) Analysis. Because T's rights, title, and interest in the 
property pass to B in international water, the sale takes place in 
international water under Sec.  1.861-7(c), and the sale transaction is 
ocean activity under paragraph (d)(1)(ii) of this section. The source of 
T's sales income is determined under paragraph (b)(3)(i) of this 
section, by reference to paragraph (b)(1) or (2) of this section.
    Example 11. Sale of property in space. (i) Facts. S, a United States 
person, manufactures a satellite in the United States and sells it to a 
customer who is not a United States person. S's rights, title, and 
interest in the satellite pass to the customer in space.
    (ii) Analysis. Because S's rights, title, and interest in the 
satellite pass to the customer in space, the sale takes place in space 
under Sec.  1.861-7(c), and the sale transaction is space

[[Page 315]]

activity under paragraph (d)(1)(i) of this section. The source of income 
derived from the sale of the satellite in space is determined under 
paragraph (b)(3)(ii) of this section, with the source of income 
allocable to production activity determined under paragraphs 
(b)(3)(ii)(A) and (B) of this section, and the source of income 
allocable to sales activity determined under paragraphs (b)(3)(ii)(A) 
and (D) of this section. Under paragraph (b)(1) of this section, S's 
space income is sourced outside the United States to the extent the 
income, based on all the facts and circumstances, is attributable to 
functions performed, resources employed, or risks assumed in a foreign 
country or countries.
    Example 12. Sale of property in space. (i) Facts. S has a right to 
operate from a particular position (satellite slot or orbit) in space. S 
sells the right to operate from that position to P. Assume that the sale 
of the satellite slot is characterized as a sale of property and that 
S's rights, title, and interest in the satellite slot pass to P in 
space.
    (ii) Analysis. The sale of the satellite slot takes place in space 
under Sec.  1.861-7(c) because S's rights, title, and interest in the 
satellite slot pass to P in space. The sale of the satellite slot is 
space activity under paragraph (d)(1)(i) of this section, and income or 
gain from the sale is sourced under paragraph (b)(3)(i) of this section, 
by reference to paragraph (b)(1) or (2) of this section.
    Example 13. Source of income of a foreign person. (i) Facts. FP, a 
foreign corporation that is not a CFC, derives income from the operation 
of satellites. FP operates ground stations in the United States and in 
foreign Country FC. Assume that FP is considered engaged in a trade or 
business within the United States based on FP's operation of the ground 
station in the United States.
    (ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP's 
space income is sourced in the United States to the extent the income, 
based on all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed within the United 
States.
    Example 14. Source of income of a foreign person. (i) Facts. FP, a 
foreign corporation that is not a CFC, operates remote sensing 
satellites in space to collect data and images for its customers. FP 
uses an independent agent, A, in the United States who provides 
marketing, order-taking, and other customer service functions. Assume 
that FP is considered engaged in a trade or business within the United 
States based on A's activities on FP's behalf in the United States.
    (ii) Analysis. Under paragraph (b)(2)(iii) of this section, FP's 
space income is sourced in the United States to the extent the income, 
based on all the facts and circumstances, is attributable to functions 
performed, resources employed, or risks assumed within the United 
States.

    (g) Reporting and documentation requirements--(1) In general. A 
taxpayer making an allocation of gross income under paragraph (b)(1), 
(b)(2), (b)(3)(ii)(C), or (b)(4) of this section must satisfy the 
requirements in paragraphs (g)(2), (3), and (4) of this section.
    (2) Required documentation. In all cases, a taxpayer must prepare 
and maintain documentation in existence when its return is filed 
regarding the allocation of gross income and allocation and 
apportionment of expenses, losses, and other deductions, the 
methodologies used, and the circumstances justifying use of those 
methodologies. The taxpayer must make available such documentation 
within 30 days upon request.
    (3) Access to software. If the taxpayer or any third party used any 
computer software, within the meaning of section 7612(d), to allocate 
gross income, or to allocate or apportion expenses, losses, and other 
deductions, the taxpayer must make available upon request--
    (i) Any computer software executable code, within the meaning of 
section 7612(d), used for such purposes, including an executable copy of 
the version of the software used in the preparation of the taxpayer's 
return (including any plug-ins, supplements, etc.) and a copy of all 
related electronic data files. Thus, if software subsequently is 
upgraded or supplemented, a separate executable copy of the version used 
in preparing the taxpayer's return must be retained;
    (ii) Any related computer software source code, within the meaning 
of section 7612(d), acquired or developed by the taxpayer or a related 
person, or primarily for internal use by the taxpayer or such person 
rather than for commercial distribution; and
    (iii) In the case of any spreadsheet software or similar software, 
any formulae or links to supporting worksheets.
    (4) Use of allocation methodology. In general, when a taxpayer 
allocates gross income under paragraph (b)(1), (b)(2), (b)(3)(ii)(C), or 
(b)(4) of this section, it does so by making the allocation on a timely 
filed original return

[[Page 316]]

(including extensions). However, a taxpayer will be permitted to make 
changes to such allocations made on its original return with respect to 
any taxable year for which the statute of limitations has not closed as 
follows:
    (i) In the case of a taxpayer that has made a change to such 
allocations prior to the opening conference for the audit of the taxable 
year to which the allocation relates or who makes such a change within 
90 days of such opening conference, if the IRS issues a written 
information document request asking the taxpayer to provide the 
documents and such other information described in paragraphs (g)(2) and 
(3) of this section with respect to the changed allocations and the 
taxpayer complies with such request within 30 days of the request, then 
the IRS will complete its examination, if any, with respect to the 
allocations for that year as part of the current examination cycle. If 
the taxpayer does not provide the documents and information described in 
paragraphs (g)(2) and (3) of this section within 30 days of the request, 
then the procedures described in paragraph (g)(4)(ii) of this section 
shall apply.
    (ii) If the taxpayer changes such allocations more than 90 days 
after the opening conference for the audit of the taxable year to which 
the allocations relate or the taxpayer does not provide the documents 
and information with respect to the changed allocations as requested in 
accordance with paragraphs (g)(2) and (3) of this section, then the IRS 
will, in a separate cycle, determine whether an examination of the 
taxpayer's allocations is warranted and complete any such examination. 
The separate cycle will be worked as resources are available and may not 
have the same estimated completion date as the other issues under 
examination for the taxable year. The IRS may ask the taxpayer to extend 
the statute of limitations on assessment and collection for the taxable 
year to permit examination of the taxpayer's method of allocation, 
including an extension limited, where appropriate, to the taxpayer's 
method of allocation.
    (h) Effective date. This section applies to taxable years beginning 
on or after December 27, 2006.

[T.D. 9305, 71 FR 77603, Dec. 27, 2006]



Sec.  1.863-9  Source of income derived from communications activity 
under section 863(a), (d), and (e).

    (a) In general. Income of a United States or a foreign person 
derived from each type of communications activity, as defined in 
paragraph (h)(3) of this section, is sourced under the rules of this 
section, notwithstanding any other provision including sections 861, 
862, 863, and 865. Notwithstanding that a communications activity would 
qualify as space or ocean activity under section 863(d) and the 
regulations thereunder, the source of income derived from such 
communications activity is determined under this section, and not under 
section 863(d) and the regulations thereunder, except to the extent 
provided in Sec.  1.863-8(b)(5).
    (b) Source of international communications income--(1) International 
communications income derived by a United States person. Income derived 
from international communications activity (international communications 
income) by a United States person is one-half from sources within the 
United States and one-half from sources without the United States.
    (2) International communications income derived by foreign persons--
(i) In general. International communications income derived by a person 
other than a United States person is, except as otherwise provided in 
this paragraph (b)(2), wholly from sources without the United States.
    (ii) International communications income derived by a controlled 
foreign corporation. International communications income derived by a 
controlled foreign corporation within the meaning of section 957 (CFC) 
is one-half from sources within the United States and one-half from 
sources without the United States.
    (iii) International communications income derived by foreign persons 
with a fixed place of business in the United States. International 
communications income derived by a foreign person, other than a CFC, 
that is attributable to an office or other fixed place of business of 
the foreign person in the United States is from sources within the 
United States. The principles of section 864(c)(5) apply in determining 
whether a foreign person has an office or fixed

[[Page 317]]

place of business in the United States. See Sec.  1.864-7. International 
communications income is attributable to an office or other fixed place 
of business to the extent of functions performed, resources employed, or 
risks assumed by the office or other fixed place of business.
    (iv) International communications income derived by foreign persons 
engaged in a trade or business within the United States. International 
communications income derived by a foreign person (other than a CFC) 
engaged in a trade or business within the United States is income from 
sources within the United States to the extent the income, based on all 
the facts and circumstances, is attributable to functions performed, 
resources employed, or risks assumed within the United States.
    (c) Source of U.S. communications income. Income derived by a United 
States or foreign person from U.S. communications activity is from 
sources within the United States.
    (d) Source of foreign communications income. Income derived by a 
United States or foreign person from foreign communications activity is 
from sources without the United States.
    (e) Source of space/ocean communications income. The source of 
income derived by a United States or foreign person from space/ocean 
communications activity is determined under section 863(d) and the 
regulations thereunder.
    (f) Source of communications income when taxpayer cannot establish 
the two points between which the taxpayer is paid to transmit the 
communication. Income derived by a United States or foreign person from 
communications activity, when the taxpayer cannot establish the two 
points between which the taxpayer is paid to transmit the communication 
as required in paragraph (h)(3)(i) of this section, is from sources 
within the United States.
    (g) Taxable income. When a taxpayer allocates gross income under 
paragraph (b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section, the 
taxpayer must allocate expenses, losses, and other deductions as 
prescribed in Sec. Sec.  1.861-8 through 1.861-14T to the class or 
classes of gross income that include the income so allocated in each 
case. A taxpayer must then apply the rules of Sec. Sec.  1.861-8 through 
1.861-14T properly to apportion amounts of expenses, losses, and other 
deductions so allocated to such gross income between gross income from 
sources within the United States and gross income from sources without 
the United States. For amounts of expenses, losses, and other deductions 
allocated to gross income derived from international communications 
activity, when the source of income is determined under the 50/50 method 
of paragraph (b)(1) or (b)(2)(ii) of this section, taxpayers generally 
must apportion expenses, losses, and other deductions between sources 
within the United States and sources without the United States pro rata 
based on the relative amounts of gross income from sources within the 
United States and gross income from sources without the United States. 
However, the preceding sentence shall not apply to research and 
experimental expenditures qualifying under Sec.  1.861-17, which are to 
be allocated and apportioned under the rules of that section.
    (h) Communications activity and income derived from communications 
activity--(1) Communications activity--(i) General rule. For purposes of 
this part, communications activity consists solely of the delivery by 
transmission of communications or data (communications). Delivery of 
communications other than by transmission (for example, by delivery of 
physical packages and letters) is not communications activity within the 
meaning of this section. Communications activity also includes the 
provision of capacity to transmit communications. Provision of content 
or any other additional service provided along with, or in connection 
with, a non-de minimis communications activity must be treated as a 
separate non-communications activity unless de minimis. Communications 
activity or non-communications activity will be treated as de minimis to 
the extent, based on the facts and circumstances, the value attributable 
to such activity is de minimis.
    (ii) Separate transaction. To the extent that a taxpayer's 
transaction consists in part of non-de minimis communications activity 
and in part of non-de minimis non-communications activity, each such 
part of the transaction must

[[Page 318]]

be treated as a separate transaction. Gross income is allocated to each 
such communications activity transaction and non-communications activity 
transaction to the extent the income, based on all the facts and 
circumstances, is attributable to functions performed, resources 
employed, or risks assumed in each such activity.
    (2) Income derived from communications activity. Income derived from 
communications activity (communications income) is income derived from 
the delivery by transmission of communications, including income derived 
from the provision of capacity to transmit communications. Income may be 
considered derived from a communications activity even if the taxpayer 
itself does not perform the transmission function, but in all cases, the 
taxpayer derives communications income only if the taxpayer is paid to 
transmit, and bears the risk of transmitting, the communications.
    (3) Determining the type of communications activity--(i) In general. 
Whether income is derived from international communications activity, 
U.S. communications activity, foreign communications activity, or space/
ocean communications activity is determined by identifying the two 
points between which the taxpayer is paid to transmit the communication. 
The taxpayer must establish the two points between which the taxpayer is 
paid to transmit, and bears the risk of transmitting, the communication. 
Whether the taxpayer contracts out part or all of the transmission 
function is not relevant. A taxpayer may satisfy the requirement that 
the taxpayer establish the two points between which the taxpayer is paid 
to transmit, and bears the risk of transmitting, the communication by 
using any consistently applied reasonable method to establish one or 
both endpoints. In evaluating the reasonableness of such method, 
consideration will be given to all the facts and circumstances, 
including whether the endpoints would otherwise be identifiable absent 
this reasonable method provision and the reliability of the data. 
Depending on the facts and circumstances, methods based on, for example, 
records of port or transport charges, customer billing records, a 
satellite footprint, or records of termination fees made pursuant to an 
international settlement agreement may be reasonable. In addition, 
practices used by taxpayers to classify or categorize certain 
communications activity in connection with preparation of statements and 
analyses for the use of management, creditors, minority shareholders, 
joint ventures, or other parties or governmental agencies in interest 
may be reliable indicators of the reasonableness of the method chosen, 
but need not be accorded conclusive weight by the Commissioner. In all 
cases, the method chosen to establish the two points between which the 
taxpayer is paid to transmit, and bears the risk of transmitting, the 
communication must be supported by sufficient documentation to permit 
verification by the Commissioner.
    (ii) Income derived from international communications activity. 
Income derived by a taxpayer from international communications activity 
(international communications income) is income derived from 
communications activity, as defined in paragraph (h)(2) of this section, 
when the taxpayer is paid to transmit--
    (A) Between a point in the United States and a point in a foreign 
country (or a possession of the United States); or
    (B) Foreign-originating communications (communications with a 
beginning point in a foreign country or a possession of the United 
States) from a point in space or international water to a point in the 
United States.
    (iii) Income derived from U.S. communications activity. Income 
derived by a taxpayer from U.S. communications activity (U.S. 
communications income) is income derived from communications activity, 
as defined in paragraph (h)(2) of this section, when the taxpayer is 
paid to transmit--
    (A) Between two points in the United States; or
    (B) Between the United States and a point in space or international 
water, except as provided in paragraph (h)(3)(ii)(B) of this section.
    (iv) Income derived from foreign communications activity. Income 
derived by a taxpayer from foreign communications activity (foreign 
communications income)

[[Page 319]]

is income derived from communications activity, as defined in paragraph 
(h)(2) of this section, when the taxpayer is paid to transmit--
    (A) Between two points in a foreign country or countries (or a 
possession or possessions of the United States);
    (B) Between a foreign country and a possession of the United States; 
or
    (C) Between a foreign country (or a possession of the United States) 
and a point in space or international water.
    (v) Income derived from space/ocean communications activity. Income 
derived by a taxpayer from space/ocean communications activity (space/
ocean communications income) is income derived from communications 
activity, as defined in paragraph (h)(2) of this section, when the 
taxpayer is paid to transmit between a point in space or international 
water and another point in space or international water.
    (i) Treatment of partnerships. This section is applied at the 
partner level.
    (j) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Income derived from non-communications activity--remote 
data base access. (i) Facts. D provides its customers in various foreign 
countries with access to its data base, which contains information on 
certain individuals' health care insurance coverage. Customer C obtains 
access to D's data base by placing a call to D's telephone number. 
Assume that C's telephone service, used to access D's data base, is 
provided by a third party, and that D assumes no responsibility for the 
transmission of the information via telephone.
    (ii) Analysis. D is not paid to transmit communications and does not 
derive income from communications activity within the meaning of 
paragraph (h)(2) of this section. Rather, D derives income from 
provision of content or provision of services to its customers. 
Therefore, the rules of this section do not apply to determine the 
source of D's income.
    Example 2. Income derived from U.S. communications activity--U.S. 
portion of international communication. (i) Facts. TC, a local telephone 
company, receives an access fee from an international carrier for 
picking up a call from a local telephone customer and delivering the 
call to a U.S. point of presence (POP) of the international carrier. The 
international carrier picks up the call from its U.S. POP and delivers 
the call to a foreign country.
    (ii) Analysis. TC is not paid to carry the transmission between the 
United States and a foreign country. TC is paid to transmit a 
communication between two points in the United States. TC derives U.S. 
communications income as defined in paragraph (h)(3)(iii) of this 
section, which is sourced under paragraph (c) of this section as U.S. 
source income.
    Example 3. Income derived from international communications 
activity--underwater cable. (i) Facts. TC, a domestic corporation, owns 
an underwater fiber optic cable. Pursuant to contracts, TC makes 
available to its customers capacity to transmit communications via the 
cable. TC's customers then solicit telephone customers and arrange to 
transmit the telephone customers' calls. The cable runs in part through 
U.S. waters, in part through international waters, and in part through 
foreign country waters.
    (ii) Analysis. TC derives international communications income as 
defined in paragraph (h)(3)(ii) of this section because TC is paid to 
make available capacity to transmit communications between the United 
States and a foreign country. Because TC is a United States person, TC's 
international communications income is sourced under paragraph (b)(1) of 
this section as one-half from sources within the United States and one-
half from sources without the United States.
    Example 4. Income derived from international communications 
activity--satellite. (i) Facts. S, a United States person, owns 
satellites in orbit and uplink facilities in Country X, a foreign 
country. B, a resident of Country X, pays S to deliver B's programming 
from S's uplink facility, located in Country X, to a downlink facility 
in the United States owned by C, a customer of B.
    (ii) Analysis. S derives international communications income under 
paragraph (h)(3)(ii) of this section because S is paid to transmit the 
communications between a beginning point in a foreign country and an 
endpoint in the United States. Because S is a United States person, the 
source of S's international communications income is determined under 
paragraph (b)(1) of this section as one-half from sources within the 
United States and one-half from sources without the United States.
    Example 5. The paid-to-do rule--foreign communications via domestic 
route. (i) Facts. TC is paid to transmit communications from Toronto, 
Canada, to Paris, France. TC transmits the communications from Toronto 
to New York. TC pays another communications company, IC, to transmit the 
communications from New York to Paris.
    (ii) Analysis. Under the paid-to-do rule of paragraph (h)(3)(i) of 
this section, TC derives foreign communications income under paragraph 
(h)(3)(iv) of this section because TC is paid to transmit communications 
between two points in foreign countries, Toronto and Paris. Under 
paragraph (h)(3)(i) of this section, the character of TC's 
communications

[[Page 320]]

activity is determined without regard to the fact that TC pays IC to 
transmit the communications for some portion of the delivery path. IC 
has international communications income under paragraph (h)(3)(ii) of 
this section because IC is paid to transmit the communications between a 
point in the United States and a point in a foreign country.
    Example 6. The paid-to-do rule--domestic communication via foreign 
route. (i) Facts. TC is paid to transmit a call between two points in 
the United States, but routes the call through Canada.
    (ii) Analysis. Under paragraph (h)(3)(i) of this section, the 
character of income derived from communications activity is determined 
by the two points between which the taxpayer is paid to transmit, and 
bears the risk of transmitting, the communications, without regard to 
the path of the transmission between those two points. Thus, under 
paragraph (h)(3)(iii) of this section, TC derives income from U.S. 
communications activity because it is paid to transmit the 
communications between two U.S. points.
    Example 7. The paid-to-do rule--foreign-originating communications. 
(i) Facts. Under an international settlement agreement, G, a Country X 
international carrier, pays T to receive all calls originating in 
Country X that are bound for the United States and to terminate such 
calls in the United States. Due to Country X legal restrictions, the 
international settlement agreement specifies that G carries the 
transmission to a point outside the territory of Country X and that T 
carries the foreign-originating transmission from such point to the 
destined point in the United States. T, in turn, contracts out with 
another communications company, S, to transmit the U.S. portion of the 
communications. Tracing and identifying the endpoints of each 
transmission is not possible or practical. T does, however, keep records 
of termination fees received from G for terminating the foreign-
originating calls.
    (ii) Analysis. T derives communications income as defined in 
paragraph (h)(2) of this section. Based on all the facts and 
circumstances, T can establish that T is paid to transmit, and bears the 
risk of transmitting, foreign-originating calls from a point in space or 
international water to a point in the United States using a reasonable 
method to establish the endpoints, assuming that this method is 
consistently applied. In this case, T can reasonably establish that T is 
paid to receive foreign-originating calls and terminate such calls in 
the United States based on the records of termination fees pursuant to 
an international settlement agreement. Under paragraph (h)(3)(ii)(B) of 
this section, a taxpayer derives income from international 
communications activity when the taxpayer is paid to transmit foreign-
originating communications from space or international water to the 
United States. Thus, under paragraph (h)(3)(ii)(B) of this section, T 
derives income from international communications. If, based on all the 
facts and circumstances, T could reasonably trace and identify the 
endpoints, then T would have to directly establish that each call 
originated in a foreign country. Assuming T is able to do so, the rest 
of the analysis in this Example 7 remains the same. Under paragraph 
(h)(3)(iii) of this section, S derives income from U.S. communications 
activity because S is paid to transmit the communications between two 
U.S. points.
    Example 8. Indeterminate endpoints--prepaid telephone calling cards. 
(i) Facts. S purchases capacity from TC to transmit telephone calls. S 
sells prepaid telephone calling cards that give customers access to TC's 
telephone lines for a certain number of minutes. Assume that S cannot 
establish the endpoints of its customers' telephone calls, even under 
the reasonable method rule of paragraph (h)(3) of this section.
    (ii) Analysis. S derives communications income as defined in 
paragraph (h)(2) of this section because S makes capacity to transmit 
communications available to its customers. In this case, S cannot 
establish the two points between which the communications are 
transmitted. Therefore, S's communications income is U.S. source income, 
as provided by paragraph (f) of this section.
    Example 9. Reasonable methods--minutes of use data on long distance 
calling plans. (i)Facts. B provides both domestic and international long 
distance services in a calling plan for a limited number of minutes for 
a set amount each month. Tracing and identifying the endpoints of each 
transmission is not possible or practical. B is, however, able to 
establish that the calling plan generated $10,000 of revenue for 25,000 
minutes based on reports derived from customer billing records. Based on 
minutes of use data in these reports, B is able to establish that of the 
total 25,000 minutes, 60 percent or 15,000 minutes were for U.S. long 
distance calls and 40 percent or 10,000 minutes were for international 
calls.
    (ii) Analysis. B derives communications income as defined in 
paragraph (h)(2) of this section. Based on all the facts and 
circumstances, B can establish the two points between which B is paid to 
transmit, and bears the risk of transmitting, the communications using a 
reasonable method to establish the endpoints, assuming that this method 
is consistently applied. In this case, B can reasonably establish that 
60 percent of the income derived from the long distance calling plan is 
U.S. communications income and 40 percent is international 
communications income based on the minutes of use data derived from 
customer billing records

[[Page 321]]

to establish the endpoints of the communications. If, based on all the 
facts and circumstances, B could reasonably trace and identify the 
endpoints, then B would have to directly identify the endpoints between 
which B is paid to transmit the communications.
    Example 10. Reasonable methods--system design. (i) Facts. D operates 
satellites which are designed to transmit signals through two separate 
ranges of signal frequencies (bands). Due to technological limitations, 
requirements, and practicalities, one band is designed to only transmit 
signals within the United States. The other band is designed to transmit 
signals between foreign countries and the United States. D cannot trace 
and identify the endpoints of each individual transmission. D does, 
however, track the total transmission through each band and the total 
income derived from transmitting signals through each band.
    (ii) Analysis. D derives communications income as defined in 
paragraph (h)(2) of this section. Based on all the facts and 
circumstances, D can establish the two points between which D is paid to 
transmit, and bears the risk of transmitting, the communications using a 
reasonable method to establish endpoints, assuming that this method is 
consistently applied. In this case, D can reasonably establish that 
income derived from transmissions through the first band is U.S. 
communications income and income derived from transmissions through the 
second band is international communications income based on the design 
of the bands to establish the endpoints of the communications.
    Example 11. Reasonable methods--port locations. (i) Facts. X 
provides its customer, C, with a virtual private network (VPN) so that 
C's U.S. headquarter office can connect and communicate with offices in 
the United States, Country X, Country Y, and Country Z. Assume that the 
VPN is only for communications with the U.S. headquarter office. X 
cannot trace and identify the endpoints of each transmission. C pays X a 
set amount each month for the entire service, regardless of the 
magnitude of the usage or the geographic points between which C uses the 
service.
    (ii) Analysis. X derives communications income as defined in 
paragraph (h)(2) of this section. Based on the facts and circumstances, 
X can establish the two points between which X is paid to transmit, and 
bears the risk of transmitting, the communications using a reasonable 
method to establish endpoints, assuming that this method is consistently 
applied. In this case, X can reasonably establish that one-fourth of the 
income derived from the VPN service is U.S. communications income and 
three-fourths is international communications income based on the 
location of the VPN ports to establish the endpoints of the 
communications.
    Example 12. Indeterminate endpoints--Internet access. (i) Facts. B, 
a domestic corporation, is an Internet service provider. B charges its 
customer, C, a monthly lump sum for Internet access. C accesses the 
Internet via a telephone call, initiated by the modem of C's personal 
computer, to one of B's control centers, which serves as C's portal to 
the Internet. B transmits data sent by C from B's control center in 
France to a recipient in England, over the Internet. B does not maintain 
records as to the beginning and endpoints of the transmission.
    (ii) Analysis. B derives communications income as defined in 
paragraph (h)(2) of this section. The source of B's communications 
income is determined under paragraph (f) of this section as income from 
sources within the United States because B cannot establish the two 
points between which it is paid to transmit the communications.
    Example 13. De minimis non-communications activity. (i) Facts. The 
same facts as in Example 12.
    Assume in addition that B replicates frequently requested sites on 
B's own servers, solely to speed up response time. Assume that B's 
replication of frequently requested sites would be considered a de 
minimis non-communications activity under this section.
    (ii) Analysis. On these facts, because B's replication of frequently 
requested sites would be considered a de minimis non-communications 
activity, B is not required to treat the replication activity as a 
separate non-communications activity transaction under paragraph (h)(1) 
of this section. B derives communications income under paragraph (h)(2) 
of this section. The character and source of B's communications income 
are determined by demonstrating the points between which B is paid to 
transmit the communications, under paragraph (h)(3)(i) of this section.
    Example 14. Income derived from communications and non-
communications activity--bundled services. (i) Facts. A, a domestic 
corporation, offers customers local and long distance phone service, 
video, and Internet services. Customers pay a flat monthly fee plus 10 
cents a minute for all long-distance calls, including international 
calls.
    (ii) Analysis. Under paragraph (h)(1)(ii) of this section, to the 
extent that A's transaction with its customer consists in part of non-de 
minimis communications activity and in part of non-de minimis non-
communications activity, each such part of the transaction must be 
treated as a separate transaction. A's gross income from the transaction 
is allocated to each such communications activity transaction and non-
communications activity transaction in accordance with paragraph 
(h)(1)(ii) of this section. To the extent A can establish that it

[[Page 322]]

derives international communications income as defined in paragraph 
(h)(3)(ii) of this section, A would determine the source of such income 
under paragraph (b)(1) of this section. If A cannot establish the points 
between which it is paid to transmit communications, as required by 
paragraph (h)(3)(i) of this section, A's communications income is from 
sources within the United States, as provided by paragraph (f) of this 
section.
    Example 15. Income derived from communications and non-
communications activity. (i) Facts. B, a domestic corporation, is paid 
by D, a cable system operator in Foreign Country, to provide television 
programs and to transmit the television programs to Foreign Country. 
Using its own satellite transponder, B transmits the television programs 
from the United States to downlink facilities owned by D in Foreign 
Country. D receives the transmission, unscrambles the signals, and 
distributes the broadcast to D's customers in Foreign Country. Assume 
that B's provision of television programs is a non-de minimis non-
communications activity, and that B's transmission of television 
programs is a non-de minimis communications activity.
    (ii) Analysis. Under paragraph (h)(1)(ii) of this section, B must 
treat its communications and non-communications activities as separate 
transactions. B's gross income is allocated to each such separate 
communications and non-communications activity transaction in accordance 
with paragraph (h)(1)(ii) of this section. Income derived by B from the 
transmission of television programs to D's Foreign Country downlink 
facility is international communications income as defined in paragraph 
(h)(3)(ii) of this section because B is paid to transmit communications 
from the United States to a foreign country.
    Example 16. Income derived from foreign communications activity. (i) 
Facts. STS provides satellite capacity to B, a broadcaster located in 
Australia. B beams programming from Australia to the satellite. S's 
satellite picks the communications up in space and beams the programming 
over a footprint covering Southeast Asia.
    (ii) Analysis. S derives communications income as defined in 
paragraph (h)(2) of this section. S's income is characterized as foreign 
communications income under paragraph (h)(3)(iv) of this section because 
S picks up the communication in space, and beams it to a footprint 
entirely covering a foreign area. Under paragraph (d) of this section, 
S's foreign communications income is from sources without the United 
States. If S were beaming the programming over a satellite footprint 
that covered area both in the United States and outside the United 
States, S would be required to allocate the income derived from the 
different types of communications activity.

    (k) Reporting and documentation requirements--(1) In general. A 
taxpayer making an allocation of gross income under paragraph 
(b)(2)(iii), (b)(2)(iv), or (h)(1)(ii) of this section must satisfy the 
requirements in paragraphs (k)(2), (3), and (4) of this section.
    (2) Required documentation. In all cases, a taxpayer must prepare 
and maintain documentation in existence when its return is filed 
regarding the allocation of gross income, and allocation and 
apportionment of expenses, losses, and other deductions, the 
methodologies used, and the circumstances justifying use of those 
methodologies. The taxpayer must make available such documentation 
within 30 days upon request.
    (3) Access to software. If the taxpayer or any third party used any 
computer software, within the meaning of section 7612(d), to allocate 
gross income, or to allocate or apportion expenses, losses, and other 
deductions, the taxpayer must make available upon request--
    (i) Any computer software executable code, within the meaning of 
section 7612(d), used for such purposes, including an executable copy of 
the version of the software used in the preparation of the taxpayer's 
return (including any plug-ins, supplements, etc.) and a copy of all 
related electronic data files. Thus, if software subsequently is 
upgraded or supplemented, a separate executable copy of the version used 
in preparing the taxpayer's return must be retained;
    (ii) Any related computer software source code, within the meaning 
of section 7612(d), acquired or developed by the taxpayer or a related 
person, or primarily for internal use by the taxpayer or such person 
rather than for commercial distribution; and
    (iii) In the case of any spreadsheet software or similar software, 
any formulae or links to supporting worksheets.
    (4) Use of allocation methodology. In general, when a taxpayer 
allocates gross income under paragraph (b)(2)(iii), (b)(2)(iv), or 
(h)(1)(ii) of this section, it does so by making the allocation on a 
timely filed original return (including extensions). However, a taxpayer 
will be permitted to make

[[Page 323]]

changes to such allocations made on its original return with respect to 
any taxable year for which the statute of limitations has not closed as 
follows:
    (i) In the case of a taxpayer that has made a change to such 
allocations prior to the opening conference for the audit of the taxable 
year to which the allocation relates or who makes such a change within 
90 days of such opening conference, if the IRS issues a written 
information document request asking the taxpayer to provide the 
documents and such other information described in paragraphs (k)(2) and 
(3) of this section with respect to the changed allocations and the 
taxpayer complies with such request within 30 days of the request, then 
the IRS will complete its examination, if any, with respect to the 
allocations for that year as part of the current examination cycle. If 
the taxpayer does not provide the documents and information described in 
paragraphs (k)(2) and (3) of this section within 30 days of the request, 
then the procedures described in paragraph (k)(4)(ii) of this section 
shall apply.
    (ii) If the taxpayer changes such allocations more than 90 days 
after the opening conference for the audit of the taxable year to which 
the allocations relate or the taxpayer does not provide the documents 
and information with respect to the changed allocations as requested in 
accordance with paragraphs (k)(2) and (3) of this section, then the IRS 
will, in a separate cycle, determine whether an examination of the 
taxpayer's allocations is warranted and complete any such examination. 
The separate cycle will be worked as resources are available and may not 
have the same estimated completion date as the other issues under 
examination for the taxable year. The IRS may ask the taxpayer to extend 
the statute of limitations on assessment and collection for the taxable 
year to permit examination of the taxpayer's method of allocation, 
including an extension limited, where appropriate, to the taxpayer's 
method of allocation.
    (l) Effective date. This section applies to taxable years beginning 
on or after December 27, 2006.

[T.D. 9305, 71 FR 77603, Dec. 27, 2006; 72 FR 3490, Jan. 25, 2007]



Sec.  1.863-10  Source of income from a qualified fails charge.

    (a) In general. Except as provided in paragraphs (b) and (c) of this 
section, the source of income from a qualified fails charge shall be 
determined by reference to the residence of the taxpayer as determined 
under section 988(a)(3)(B)(i).
    (b) Qualified business unit exception. The source of income from a 
qualified fails charge shall be determined by reference to the residence 
of a qualified business unit (as defined in section 989) of a taxpayer 
if--
    (1) The taxpayer's residence, determined under section 
988(a)(3)(B)(i), is the United States;
    (2) The qualified business unit's residence, determined under 
section 988(a)(3)(B)(ii), is outside the United States;
    (3) The qualified business unit is engaged in the conduct of a trade 
or business in the country where it is a resident; and
    (4) The transaction to which the qualified fails charge relates is 
attributable to the qualified business unit. A transaction will be 
treated as attributable to a qualified business unit if it satisfies the 
principles of Sec.  1.864-4(c)(5)(iii) (substituting ``qualified 
business unit'' for ``U.S. office'').
    (c) Effectively connected income exception. Qualified fails charge 
income that arises from a transaction any income from which is (or would 
be if the transaction produced income) effectively connected with a 
United States trade or business pursuant to Sec.  1.864-4(c) is treated 
as from sources within the United States, and the income from the 
qualified fails charge is treated as effectively connected to the 
conduct of a United States trade or business.
    (d) Qualified fails charge. For purposes of this section, a 
qualified fails charge is a payment that--
    (1) Compensates a party to a transaction that provides for delivery 
of a designated security (as defined in paragraph (e) of this section) 
in exchange for the payment of cash (delivery-versus-payment settlement) 
for another party's failure to deliver the specified designated security 
on the settlement date specified in the relevant agreement; and

[[Page 324]]

    (2) Is made pursuant to--
    (i) A trading practice or similar guidance approved or adopted by 
either an agency of the United States government or the Treasury Market 
Practices Group, or
    (ii) Any trading practice, program, policy or procedure approved by 
the Commissioner in guidance published in the Internal Revenue Bulletin.
    (e) Designated security. For purposes of this section, a designated 
security means any--
    (i) Debt instrument (as defined in Sec.  1.1275-1(d)) issued by the 
United States Treasury Department, the Federal National Mortgage 
Association, the Federal Home Loan Mortgage Corporation, or any Federal 
Home Loan Bank; or
    (ii) Pass-through mortgage-backed security guaranteed by the Federal 
National Mortgage Association, the Federal Home Loan Mortgage 
Corporation, or the Government National Mortgage Association.
    (g) Effective/applicability date. This section is effective on 
February 21, 2012. This section applies to a qualified fails charge paid 
or accrued on or after December 8, 2010.

[T.D. 9579, 77 FR 9847, Feb. 21, 2012]



Sec.  1.864-1  Meaning of sale, etc.

    For purposes of Sec. Sec.  1.861 through 1.864-7, the word ``sale'' 
includes ``exchange''; the word ``sold'' includes ``exchanged''; the 
word ``produced'' includes ``created'', ``fabricated'', 
``manufactured'', ``extracted'', ``processed'', ``cured'', and ``aged''.

[T.D. 6948, 33 FR 5090, Mar. 28, 1968]



Sec.  1.864-2  Trade or business within the United States.

    (a) In general. As used in part I (section 861 and following) and 
part II (section 871 and following), subchapter N, chapter 1 of the 
Code, and chapter 3 (section 1441 and following) of the Code, and the 
regulations thereunder, the term ``engaged in trade or business within 
the United States'' does not include the activities described in 
paragraphs (c) and (d) of this section, but includes the performance of 
personal services within the United States at any time within the 
taxable year except to the extent otherwise provided in this section.
    (b) Performance of personal services for foreign employer--(1) 
Excepted services. For purposes of paragraph (a) of this section, the 
term ``engaged in trade or business within the United States'' does not 
include the performance of personal services--
    (i) For a nonresident alien individual, foreign partnership, or 
foreign corporation, not engaged in trade or business within the United 
States at any time during the taxable year, or
    (ii) For an office or place of business maintained in a foreign 
country or in a possession of the United States by an individual who is 
a citizen or resident of the United States or by a domestic partnership 
or a domestic corporation, by a nonresident alien individual who is 
temporarily present in the United States for a period or periods not 
exceeding a total of 90 days during the taxable year and whose 
compensation for such services does not exceed in the aggregate gross 
amount of $3,000.
    (2) Rules of application. (i) As a general rule, the term ``day'', 
as used in subparagraph (1) of this paragraph, means a calendar day 
during any portion of which the nonresident alien individual is 
physically present in the United States.
    (ii) Solely for purposes of applying this paragraph, the nonresident 
alien individual, foreign partnership, or foreign corporation for which 
the nonresident alien individual is performing personal services in the 
United States shall not be considered to be engaged in trade or business 
in the United States by reason of the performance of such services by 
such individual.
    (iii) In applying subparagraph (1) of this paragraph it is 
immaterial whether the services performed by the nonresident alien 
individual are performed as an employee for his employer or under any 
form of contract with the person for whom the services are performed.
    (iv) In determining for purposes of subparagraph (1) of this 
paragraph whether compensation received by the nonresident alien 
individual exceeds in the aggregate a gross amount of $3,000, any 
amounts received by the individual

[[Page 325]]

from an employer as advances or reimbursements for travel expenses 
incurred on behalf of the employer shall be omitted from the 
compensation received by the individual, to the extent of expenses 
incurred, where he was required to account and did account to his 
employer for such expenses and has met the tests for such accounting 
provided in Sec.  1.162-17 and paragraph (e)(4) of Sec.  1.274-5. If 
advances or reimbursements exceed such expenses, the amount of the 
excess shall be included as compensation for personal services for 
purposes of such subparagraph. Pensions and retirement pay attributable 
to personal services performed in the United States are not to be taken 
into account for purposes of subparagraph (1) of this paragraph.
    (v) See section 7701(a)(5) and Sec.  301.7701-5 of this chapter 
(Procedure and Administration Regulations) for the meaning of 
``foreign'' when applied to a corporation or partnership.
    (vi) As to the source of compensation for personal services, see 
Sec. Sec.  1.861-4 and 1.862-1.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. During 1967, A, a nonresident alien individual, is 
employed by the London office of a domestic partnership. A, who uses the 
calendar year as his taxable year, is temporarily present in the United 
States during 1967 for 60 days performing personal service in the United 
States for the London office of the partnership and is paid by that 
office a total gross salary of $2,600 for such services. During 1967, A 
is not engaged in trade or business in the United States solely by 
reason of his performing such personal services for the London office of 
the domestic partnership.
    Example 2. The facts are the same as in example 1, except that A's 
total gross salary for the services performed in the United States 
during 1967 amounts to $3,500, of which $2,625 is received in 1967 and 
$875 is received in 1968. During 1967, is engaged in trade or business 
in the United States by reason of his performance of personal services 
in the United States.

    (c) Trading in stocks or securities. For purposes of paragraph (a) 
of this section--
    (1) In general. The term ``engaged in trade or business within the 
United States'' does not include the effecting of transactions in the 
United States in stocks or securities through a resident broker, 
commission agent, custodian, or other independent agent. This 
subparagraph shall apply to any taxpayer, including a broker or dealer 
in stocks or securities, except that it shall not apply if at any time 
during the taxable year the taxpayer has an office or other fixed place 
of business in the United States through which, or by the direction of 
which, the transactions in stocks or securities are effected. The volume 
of stock or security transactions effected during the taxable year shall 
not be taken into account in determining under this subparagraph whether 
the taxpayer is engaged in trade or business within the United States.
    (2) Trading for taxpayer's own account--(i) In general. The term 
``engaged in trade or business within the United States'' does not 
include the effecting of transactions in the United States in stocks or 
securities for the taxpayer's own account, irrespective of whether such 
transactions are effected by or through--
    (a) The taxpayer himself while present in the United States,
    (b) Employees of the taxpayer, whether or not such employees are 
present in the United States while effecting the transactions, or
    (c) A broker, commission agent, custodian, or other agent of the 
taxpayer, whether or not such agent while effecting the transactions is 
(1) dependent or independent, or (2) resident, nonresident, or present, 
in the United States, and irrespective of whether any such employee or 
agent has discretionary authority to make decisions in effecting such 
transactions. For purposes of this paragraph, the term ``securities'' 
means any note, bond, debenture, or other evidence of indebtedness, or 
any evidence of an interest in or right to subscribe to or purchase any 
of the foregoing; and the effecting of transactions in stocks or 
securities includes buying, selling (whether or not by entering into 
short sales), or trading in stocks, securities, or contracts or options 
to buy or sell stocks or securities, on margin or otherwise, for the 
account and risk of the taxpayer, and any other activity closely related 
thereto (such as obtaining credit for

[[Page 326]]

the purpose of effectuating such buying, selling, or trading). The 
volume of stock of security transactions effected during the taxable 
year shall not be taken into account in determining under this 
subparagraph whether the taxpayer is engaged in trade or business within 
the United States. The application of this subdivision may be 
illustrated by the following example:

    Example. A, a nonresident alien individual who is not a dealer in 
stocks or securities, authorizes B, an individual resident of the United 
States, as his agent to effect transactions in the United States in 
stocks and securities for the account of A. B is empowered with complete 
authority to trade in stocks and securities for the account of A and to 
use his own discretion as to when to buy or sell for A's account. This 
grant of discretionary authority from A to B is also communicated in 
writing by A to various domestic brokerage firms through which A 
ordinarily effects transactions in the United States in stocks or 
securities. Under the agency arrangement B has the authority to place 
orders with the brokers, and all confirmations are to be made by the 
brokers to B, subject to his approval. The brokers are authorized by A 
to make payments to B and to charge such payments to the account of A. 
In addition, B is authorized to obtain and advance the necessary funds, 
if any, to maintain credits with the brokerage firms. Pursuant to his 
authority B carries on extensive trading transactions in the United 
States during the taxable year through the various brokerage firms for 
the account of A. During the taxable year A makes several visits to the 
United States in order to discuss with B various aspects of his trading 
activities and to make necessary changes in his trading policy. A is not 
engaged in trade or business within the United States during the taxable 
year solely because of the effecting by B of transactions in the United 
States in stocks or securities during such year for the account of A.

    (ii) Partnerships. A nonresident alien individual, foreign 
partnership, foreign estate, foreign trust, or foreign corporation shall 
not be considered to be engaged in trade or business within the United 
States solely because such person is a member of a partnership (whether 
domestic or foreign) which, pursuant to discretionary authority granted 
to such partnership by such person, effects transactions in the United 
States in stocks or securities for the partnership's own account or 
solely because an employee of such partnership, or a broker, commission 
agent, custodian, or other agent, pursuant to discretionary authority 
granted by such partnership, effects transactions in the United States 
in stocks or securities for the account of such partnership. This 
subdivision shall not apply, however, to any member of (a) a partnership 
which is a dealer in stocks or securities or (b) a partnership (other 
than a partnership in which, at any time during the last half of its 
taxable year, more than 50 percent of either the capital interest or the 
profits interest is owned, directly or indirectly, by five or fewer 
partners who are individuals) the principal business of which is trading 
in stocks or securities for its own account, if the principal office of 
such partnership is in the United States at any time during the taxable 
year. The principles of subdivision (iii) of this subparagraph for 
determining whether a foreign corporation has its principal office in 
the United States shall apply in determining under this subdivision 
whether a partnership has its principal office in the United States. See 
section 707(b)(3) and paragraph (b)(3) of Sec.  1.707-1 for rules for 
determining the extent of the ownership by a partner of a capital 
interest or profits interest in a partnership. The application of this 
subdivision may be illustrated by the following examples:

    Example 1. B, a nonresident alien individual, is a member of 
partnership X, the members of which are U.S. citizens, nonresident alien 
individuals, and foreign corporations. The principal business of 
partnership X is trading in stocks or securities for its own account. 
Pursuant to discretionary authority granted by B, partnership X effects 
transactions in the United States in stocks or securities for its own 
account. Partnership X is not a dealer in stocks or securities, and more 
than 50 percent of either the capital interest or the profits interest 
in partnership X is owned throughout its taxable year by five or fewer 
partners who are individuals. B is not engaged in trade or business 
within the United States solely by reason of such effecting of 
transactions in the United States in stocks or securities by partnership 
X for its own account.
    Example 2. The facts are the same as in example 1, except that not 
more than 50 percent of either the capital interest or the profits 
interest in partnership X is owned throughout the taxable year by five 
or fewer

[[Page 327]]

partners who are individuals. However, partnership X does not maintain 
its principal office in the United States at any time during the taxable 
year. B is not engaged in trade or business within the United States 
solely by reason of the trading in stocks or securities by partnership X 
for its own account.
    Example 3. The facts are the same as in example 1, except that, 
pursuant to discretionary authority granted by partnership X, domestic 
broker D effects transactions in the United States in stocks or 
securities for the account of partnership X. B is not engaged in trade 
or business in the United States solely by reason of such trading in 
stocks or securities for the account of partnership X.

    (iii) Dealers in stocks or securities and certain foreign 
corporations. This subparagraph shall not apply to the effecting of 
transactions in the United States for the account of (a) a dealer in 
stocks or securities or (b) a foreign corporation (other than a 
corporation which is, or but for section 542(c)(7) or 543(b)(1)(C) would 
be, a personal holding company) the principal business of which is 
trading in stocks or securities for its own account, if the principal 
office of such corporation is in the United States at any time during 
the taxable year. Whether a foreign corporation's principal office is in 
the United States for this purpose is to be determined by comparing the 
activities (other than trading in stocks or securities) which the 
corporation conducts from its office or other fixed place of business 
located in the United States with the activities it conducts from its 
offices or other fixed places of business located outside the United 
States. For purposes of this subdivision, a foreign corporation is 
considered to have only one principal office, and an office of such 
corporation will not be considered to be its principal office merely 
because it is a statutory office of such corporation. For example, a 
foreign corporation which carries on most or all of its investment 
activities in the United States but maintains a general business office 
or offices outside the United States in which its management is located 
will not be considered as having its principal office in the United 
States if all or a substantial portion of the following functions is 
carried on at or from an office or offices located outside the United 
States:
    (1) Communicating with its shareholders (including the furnishing of 
financial reports),
    (2) Communicating with the general public,
    (3) Soliciting sales of its own stock,
    (4) Accepting the subscriptions of new stockholders,
    (5) Maintaining its principal corporate records and books of 
account,
    (6) Auditing its books of account,
    (7) Disbursing payments of dividends, legal fees, accounting fees, 
and officers' and directors' salaries,
    (8) Publishing or furnishing the offering and redemption price of 
the shares of stock issued by it,
    (9) Conducting meetings of its shareholders and board of directors, 
and
    (10) Making redemptions of its own stock.

The application of this subdivision may be illustrated by the following 
examples:

    Example 1. (a) Foreign corporation X (not a corporation which is, or 
but for section 542(c)(7) or 543(b)(1)(C) would be, a personal holding 
company) was organized to sell its shares to nonresident alien 
individuals and foreign corporations and to invest the proceeds from the 
sale of such shares in stocks or securities in the United States. 
Foreign corporation X is engaged primarily in the business of investing, 
reinvesting, and trading in stocks or securities for its own account.
    (b) For a period of three years, foreign corporation X irrevocably 
authorizes domestic corporation Y to exercise its discretion in 
effecting transactions in the United States in stocks or securities for 
the account and risk of foreign corporation X. Foreign corporation X 
issues a prospectus in which it is stated that its funds will be 
invested pursuant to an investment advisory contract with domestic 
corporation Y and otherwise advertises its services. Shares of foreign 
corporation X are sold to nonresident aliens and foreign corporations 
who are customers of the United States brokerage firms unrelated to 
domestic corporation Y or foreign corporation X. The principal functions 
performed for foreign corporation X by domestic corporation Y are the 
rendering of investment advice and the effecting of transactions in the 
United States in stocks or securities for the account of foreign 
corporation X. Moreover, domestic corporation Y occasionally 
communicates with prospective foreign investors in foreign corporation X 
(through speaking engagements abroad by management of domestic 
corporation Y, and otherwise) for the purpose of explaining the 
investment techniques

[[Page 328]]

and policies used by domestic corporation Y in investing the funds of 
foreign corporation X. However, domestic corporation Y does not 
participate in the day-to-day conduct of other business activities of 
foreign corporation X.
    (c) Foreign corporation X maintains a general business office or 
offices outside the United States in which its management is permanently 
located and from which it carries on, except to the extent noted 
heretofore, the functions enumerated in (b)(1) through (10) of this 
subdivision. The management of foreign corporation X at all times 
retains the independent power to cancel the investment advisory contract 
with domestic corporation Y subject to the contractual limitations 
contained therein and is in all other respects independent of the 
management of domestic corporation Y. The managing personnel of foreign 
corporation X communicate on a regular basis with domestic corporation 
Y, and periodically visit the offices of domestic corporation Y, in 
connection with the business activities of foreign corporation X.
    (d) The principal office of foreign corporation X will not be 
considered to be in the United States; and, therefore, foreign 
corporation X is not engaged in trade or business within the United 
States solely by reason of its relationship with domestic corporation Y.
    Example 2. The facts are the same as in example 1 except that, in 
lieu of having the investment advisory contract with domestic 
corporation Y, foreign corporation X has an office in the United States 
in which its employees perform the same functions as are performed by 
domestic corporation Y in example 1. Foreign corporation X is not 
engaged in trade or business within the United States during the taxable 
year solely because the employees located in its United States office 
effect transactions in the United States in stocks or securities for the 
account of that corporation.

    (iv) Definition of dealer in stocks or securities--(a) In general. 
For purposes of this subparagraph, a dealer in stocks or securities is a 
merchant of stocks or securities, with an established place of business, 
regularly engaged as a merchant in purchasing stocks or securities and 
selling them to customers with a view to the gains and profits that may 
be derived therefrom. Persons who buy and sell, or hold, stocks or 
securities for investment or speculation, irrespective of whether such 
buying or selling constitutes the carrying on of a trade or business, 
and officers of corporations, members of partnerships, or fiduciaries, 
who in their individual capacities buy and sell, or hold, stocks or 
securities for investment or speculation are not dealers in stocks or 
securities within the meaning of this subparagraph solely by reason of 
that activity. In determining under this subdivision whether a person is 
a dealer in stocks or securities such person's transactions in stocks or 
securities effected both in and outside the United States shall be taken 
into account.
    (b) Underwriting syndicates and dealers trading for others. A 
foreign person who otherwise may be considered a dealer in stocks or 
securities under (a) of this subdivision shall not be considered a 
dealer in stocks or securities for purposes of this subparagraph--
    (1) Solely because he acts as an underwriter, or as a selling group 
member, for the purpose of making a distribution of stocks or securities 
of a domestic issuer to foreign purchasers of such stocks or securities, 
irrespective of whether other members of the selling group distribute 
the stocks or securities of the domestic issuer to domestic purchasers, 
or
    (2) Solely because of transactions effected in the United States in 
stocks or securities pursuant to his grant of discretionary authority to 
make decisions in effecting those transactions, if he can demonstrate to 
the satisfaction of the Commissioner that the broker, commission agent, 
custodian, or other agent through whom the transactions were effected 
acted pursuant to his written representation that the funds in respect 
of which such discretion was granted were the funds of a customer who is 
neither a dealer in stocks or securities, a partnership described in 
subdivision (ii)(b) of this subparagraph, or a foreign corporation 
described in subdivision (iii)(b) of this subparagraph.


For purposes of this (b), a foreign person includes a nonresident alien 
individual, a foreign corporation, or a partnership any member of which 
is a nonresident alien individual or a foreign corporation. This (b) 
shall apply only if the foreign person at no time during the taxable 
year has an office or other fixed place of business in the United States 
through which, or by the direction of which, the transactions in stocks 
or securities are effected.

[[Page 329]]

    (c) Illustrations. The application of this subdivision may be 
illustrated by the following examples:

    Example 1. Foreign corporation X is a member of an underwriting 
syndicate organized to distribute stock issued by domestic corporation 
Y. Foreign corporation X distributes the stock of domestic corporation Y 
to foreign purchasers only. Domestic corporation M is syndicate manager 
of the underwriting syndicate and, pursuant to the terms of the 
underwriting agreement, reserves the right to sell certain quantities of 
the underwritten stock on behalf of all the members of the syndicate so 
as to engage in stabilizing transactions and to take certain other 
actions which may result in the realization of profit by all members of 
the underwriting syndicate. Foreign corporation X is not engaged in 
trade or business within the United States solely by reason of its 
participation as a member of such underwriting syndicate for the purpose 
of distributing the stock of domestic corporation Y to foreign 
purchasers or by reason of the exercise by M corporation of its 
discretionary authority as manager of such syndicate.
    Example 2. Foreign corporation Y, a calendar year taxpayer, is a 
bank which trades in stocks or securities both for its own account and 
for the account of others. During 1967 foreign corporation Y authorizes 
domestic corporation M, a broker, to exercise its discretion in 
effecting transactions in the United States in stocks or securities for 
the account of B, a nonresident alien individual who has a trading 
account with foreign corporation Y. Foreign corporation Y furnishes a 
written representation to domestic corporation M to the effect that the 
funds in respect of which foreign corporation Y has authorized domestic 
corporation M to use its discretion in trading in the United States in 
stocks or securities are not funds in respect of which foreign 
corporation Y is trading for its own account but are the funds of one of 
its customers who is neither a dealer in stocks or securities, a 
partnership described in subdivision (ii)(b) of this subparagraph, or a 
foreign corporation described in subdivision (iii)(b) of this 
subparagraph. Pursuant to the discretionary authority so granted, 
domestic corporation M effects transactions in the United States during 
1967 in stocks or securities for the account of the customer of foreign 
corporation Y. At no time during 1967 does foreign corporation Y have an 
office or other fixed place of business in the United States through 
which, or by the direction of which, such transactions in stocks or 
securities are effected by domestic corporation M. During 1967 foreign 
corporation Y is not engaged in trade or business within the United 
States solely by reason of such trading in stocks or securities during 
such year by domestic corporation M for the account of the customer of 
foreign corporation Y. Copies of the written representations furnished 
to domestic corporation M should be retained by foreign corporation Y 
for inspection by the Commissioner, if inspection is requested.

    (d) Trading in commodities. For purposes of paragraph (a) of this 
section--
    (1) In general. The term ``engaged in trade or business within the 
United States'' does not include the effecting of transactions in the 
United States in commodities (including hedging transactions) through a 
resident broker, commission agent, custodian, or other independent agent 
if (i) the commodities are of a kind customarily dealt in on an 
organized commodity exchange, such as a grain futures or a cotton 
futures market, (ii) the transaction is of a kind customarily 
consummated at such place, and (iii) the taxpayer at no time during the 
taxable year has an office or other fixed place of business in the 
United States through which, or by the direction of which, the 
transactions in commodities are effected. The volume of commodity 
transactions effected during the taxable year shall not be taken into 
account in determining under this subparagraph whether the taxpayer is 
engaged in trade or business in the United States.
    (2) Trading for taxpayer's own account--(i) In general. The term 
``engaged in trade or business within the United States'' does not 
include the effecting of transactions in the United States in 
commodities (including hedging transactions) for the taxpayer's own 
account if the commodities are of a kind customarily dealt in on an 
organized commodity exchange and if the transaction is of a kind 
customarily consummated at such place. This rule shall apply 
irrespective of whether such transactions are effected by or through--
    (a) The taxpayer himself while present in the United States,
    (b) Employees of the taxpayer, whether or not such employees are 
present in the United States while effecting the transactions, or
    (c) A broker, commission, agent, custodian, or other agent of the 
taxpayer, whether or not such agent while effecting the transactions is 
(1) dependent or independent, or (2) resident, nonresident, or present, 
in the United

[[Page 330]]

States, and irrespective of whether any such employee or agent has 
discretionary authority to make decisions in effecting such 
transactions. The volume of commodity transactions effected during the 
taxable year shall not be taken into account in determining under this 
subparagraph whether the taxpayer is engaged in trade or business within 
the United States. This subparagraph shall not apply to the effecting of 
transactions in the United States for the account of a dealer in 
commodities.
    (ii) Partnerships. A nonresident alien individual, foreign 
partnership, foreign estate, foreign trust, or foreign corporation shall 
not be considered to be engaged in trade or business within the United 
States solely because such person is a member of a partnership (whether 
domestic or foreign) which, pursuant to discretionary authority granted 
to such partnership by such person, effects transactions in the United 
States in commodities for the partnership's account or solely because an 
employee of such partnership, or a broker, commission agent, custodian, 
or other agent, pursuant to discretionary authority granted by such 
partnership, effects transactions in the United States in commodities 
for the account of such partnership. This subdivision shall not apply to 
any member of a partnership which is a dealer in commodities.
    (iii) Illustration. The application of this subparagraph may be 
illustrated by the following example:

    Example. Foreign corporation X, a calendar year taxpayer, is engaged 
as a merchant in the business of purchasing grain in South America and 
selling such cash grain outside the United States under long-term 
contracts for delivery in foreign countries. Foreign corporation X 
consummates a sale of 100,000 bushels of cash grain in February 1967 for 
July delivery to Sweden. Because foreign corporation X does not actually 
own such grain at the time of the sales transaction, such corporation 
buys as a hedge a July ``futures contract'' for delivery of 100,000 
bushels of grain, in order to protect itself from loss by reason of a 
possible rise in the price of grain between February and July. The 
``futures contract'' is ordered through domestic corporation Y, a 
futures commission merchant registered under the Commodity Exchange Act. 
Foreign corporation X is not engaged in trade or business within the 
United States during 1967 solely by reason of its effecting of such 
futures contract for its own account through domestic corporation Y.

    (3) Definition of commodity. For purposes of section 864(b)(2)(B) 
and this paragraph the term ``commodities'' does not include goods or 
merchandise in the ordinary channels of commerce.
    (e) Other rules. The fact that a person is not determined by reason 
of this section to be not engaged in trade or business with the United 
States is not to be considered a determination that such person is 
engaged in trade or business within the United States. Whether or not 
such person is engaged in trade or business within the United States 
shall be determined on the basis of the facts and circumstances in each 
case. For other rules relating to the determination of whether a 
taxpayer is engaged in trade or business in the United States see 
section 875 and the regulations thereunder.
    (f) Effective date. The provisions of this section shall apply only 
in the case of taxable years beginning after December 31, 1966.

[T.D. 6948, 33 FR 5090, Mar. 28, 1968, as amended by T.D. 7378, 40 FR 
45435, Oct. 2, 1975]



Sec.  1.864-3  Rules for determining income effectively connected 
with U.S. business of nonresident aliens or foreign corporations.

    (a) In general. For purposes of the Internal Revenue Code, in the 
case of a nonresident alien individual or a foreign corporation that is 
engaged in a trade or business in the United States at any time during 
the taxable year, the rules set forth in Sec. Sec.  1.864-4 through 
1.864-7 and this section shall apply in determining whether income, 
gain, or loss shall be treated as effectively connected for a taxable 
year beginning after December 31, 1966, with the conduct of a trade or 
business in the United States. Except as provided in sections 871 (c) 
and (d) and 882 (d) and (e), and the regulations thereunder, in the case 
of a nonresident alien individual or a foreign corporation that is at no 
time during the taxable year engaged in a trade or business in the 
United States, no income, gain, or loss shall be treated as effectively 
connected for the taxable year with the conduct of a trade or business 
in the

[[Page 331]]

United States. The general rule prescribed by the preceding sentence 
shall apply even though the income, gain, or loss would have been 
treated as effectively connected with the conduct of a trade or business 
in the United States if such income or gain had been received or 
accrued, or such loss had been sustained, in an earlier taxable year 
when the taxpayer was engaged in a trade or business in the United 
States. In applying Sec. Sec.  1.864-4 through 1.864-7 and this section, 
the determination whether an item of income, gain, or loss is 
effectively connected with the conduct of a trade or business in the 
United States shall not be controlled by any administrative, judicial, 
or other interpretation made under the laws of any foreign country.
    (b) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. During 1967 foreign corporation N, which uses the 
calendar year as the taxable year, is engaged in the business of 
purchasing and selling household equipment on the installment plan. 
During 1967 N is engaged in business in the United States by reason of 
the sales activities it carries on in the United States for the purpose 
of selling therein some of the equipment which it has purchased. During 
1967 N receives installment payments of $800,000 on sales it makes that 
year in the United States, and the income from sources within the United 
States for 1967 attributable to such payments is $200,000. By reason of 
section 864(c)(3) and paragraph (b) of Sec.  1.864-4 this income of 
$200,000 is effectively connected for 1967 with the conduct of a trade 
or business in the United States by N. In December of 1967, N 
discontinues its efforts to make any further sales of household 
equipment in the United States, and at no time during 1968 is N engaged 
in a trade or business in the United States. During 1968 N receives 
installment payments of $500,000 on the sales it made in the United 
States during 1967, and the income from sources within the United States 
for 1968 attributable to such payments is $125,000. By reason of section 
864(c)(1)(B) and this section, this income of $125,000 is not 
effectively connected for 1968 with the conduct of a trade or business 
in the United States by N, even though such amount, if it had been 
received by N during 1967, would have been effectively connected for 
1967 with the conduct of a trade or business in the United States by 
that corporation.
    Example 2. R, a foreign holding company, owns all of the voting 
stock in five corporations, two of which are domestic corporations. All 
of the subsidiary corporations are engaged in the active conduct of a 
trade or business. R has an office in the United States where its chief 
executive officer, who is also the chief executive officer of one of the 
domestic corporations, spends a substantial portion of the taxable year 
supervising R's investment in its operating subsidiaries and performing 
his function as chief executive officer of the domestic operating 
subsidiary. R is not considered to be engaged in a trade or business in 
the United States during the taxable year by reason of the activities 
carried on in the United States by its chief executive officer in the 
supervision of its investment in its operating subsidiary corporations. 
Accordingly, the dividends from sources within the United States 
received by R during the taxable year from its domestic subsidiary 
corporations are not effectively connected for that year with the 
conduct of a trade or business in the United States by R.
    Example 3. During the months of June through December 1971, B, a 
nonresident alien individual who uses the calendar year as the taxable 
year and the cash receipts and disbursements method of accounting, is 
employed in the United States by domestic corporation M for a salary of 
$2,000 per month, payable semimonthly. During 1971, B receives from M 
salary payments totaling $13,000, all of which income by reason of 
section 864(c)(2) and paragraph (c)(6)(ii) of Sec.  1.864-4, is 
effectively connected for 1971 with the conduct of a trade or business 
in the United States by B. On December 31, 1971, B terminates his 
employment with M and departs from the United States. At no time during 
1972 is B engaged in a trade or business in the United States. In 
January of 1972, B receives from M salary of $1,000 for the last half of 
December 1971, and a bonus of $1,000 in consideration of the services B 
performed in the United States during 1971 for that corporation. By 
reason of section 864(c)(1)(B) and this section, the $2,000 received by 
B during 1972 from sources within the United States is not effectively 
connected for that year with the conduct of a trade or business in the 
United States, even though such amount, if it had been received by B 
during 1971, would have been effectively connected for 1971 with the 
conduct of a trade or business in the United States by B.

[T.D. 7216, 37 FR 23424, Nov. 3, 1972]



Sec.  1.864-4  U.S. source income effectively connected with U.S. business.

    (a) In general. This section applies only to a nonresident alien 
individual or a foreign corporation that is engaged in a trade or 
business in the United States at some time during a taxable year 
beginning after December

[[Page 332]]

31, 1966, and to the income, gain, or loss of such person from sources 
within the United States. If the income, gain, or loss of such person 
for the taxable year from sources within the United States consists of 
(1) gain or loss from the sale or exchange of capital assets or (2) 
fixed or determinable annual or periodical gains, profits, and income or 
certain other gains described in section 871(a)(1) or 881(a), certain 
factors must be taken into account, as prescribed by section 864(c)(2) 
and paragraph (c) of this section, in order to determine whether the 
income, gain, or loss is effectively connected for the taxable year with 
the conduct of a trade or business in the United States by that person. 
All other income, gain, or loss of such person for the taxable year from 
sources within the United States shall be treated as effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by that person, as prescribed by section 864(c)(3) 
and paragraph (b) of this section.
    (b) Income other than fixed or determinable income and capital 
gains. All income, gain, or loss for the taxable year derived by a 
nonresident alien individual or foreign corporation engaged in a trade 
or business in the United States from sources within the United States 
which does not consist of income, gain, or loss described in section 
871(a)(1) or 881(a), or of gain or loss from the sale or exchange of 
capital assets, shall, for purposes of paragraph (a) of this section, be 
treated as effectively connected for the taxable year with the conduct 
of a trade or business in the United States. This income, gain, or loss 
shall be treated as effectively connected for the taxable year with the 
conduct of a trade or business in the United States, whether or not the 
income, gain, or loss is derived from the trade or business being 
carried on in the United States during the taxable year. The application 
of this paragraph may be illustrated by the following examples:

    Example 1. M, a foreign corporation which uses the calendar year as 
the taxable year, is engaged in the business of manufacturing machine 
tools in a foreign country. It establishes a branch office in the United 
States during 1968 which solicits orders from customers in the United 
States for the machine tools manufactured by that corporation. All 
negotiations with respect to such sales are carried on in the United 
States. By reason of its activity in the United States M is engaged in 
business in the United States during 1968. The income or loss from 
sources within the United States from such sales during 1968 is treated 
as effectively connected for that year with the conduct of a business in 
the United States by M. Occasionally, during 1968 the customers in the 
United States write directly to the home office of M, and the home 
office makes sales directly to such customers without routing the 
transactions through its branch office in the United States. The income 
or loss from sources within the United States for 1968 from these 
occasional direct sales by the home office is also treated as 
effectively connected for that year with the conduct of a business in 
the United States by M.
    Example 2. The facts are the same as in example 1 except that during 
1967 M was also engaged in the business of purchasing and selling office 
machines and that it used the installment method of accounting for the 
sales made in this separate business. During 1967 M was engaged in 
business in the United States by reason of the sales activities it 
carried on in the United States for the purpose of selling therein a 
number of the office machines which it had purchased. Although M 
discontinued this business activity in the United States in December of 
1967, it received in 1968 some installment payments on the sales which 
it had made in the United States during 1967. The income of M for 1968 
from sources within the United States which is attributable to such 
installment payments is effectively connected for 1968 with the conduct 
of a business in the United States, even though such income is not 
connected with the business carried on in the United States during 1968 
through its sales office located in the United States for the 
solicitation of orders for the machine tools it manufactures.
    Example 3. Foreign corporation S, which uses the calendar year as 
the taxable year, is engaged in the business of purchasing and selling 
electronic equipment. The home office of such corporation is also 
engaged in the business of purchasing and selling vintage wines. During 
1968, S establishes a branch office in the United States to sell 
electronic equipment to customers, some of whom are located in the 
United States and the balance, in foreign countries. This branch office 
is not equipped to sell, and does not participate in sales of, wine 
purchased by the home office. Negotiations for the sales of the 
electronic equipment take place in the United States. By reason of the 
activity of its branch office in the United States, S is engaged in 
business in the United States during 1968. As a result of advertisements 
which the home office of S places in periodicals

[[Page 333]]

sold in the United States, customers in the United States frequently 
place orders for the purchase of wines with the home office in the 
foreign country, and the home office makes sales of wine in 1968 
directly to such customers without routing the transactions through its 
branch office in the United States. The income or loss from sources 
within the United States for 1968 from sales of electronic equipment by 
the branch office, together with the income or loss from sources within 
the United States for that year from sales of wine by the home office, 
is treated as effectively connected for that year with the conduct of a 
business in the United States by S.

    (c) Fixed or determinable income and capital gains--(1) Principal 
factors to be taken into account--(i) In general. In determining for 
purposes of paragraph (a) of this section whether any income for the 
taxable year from sources within the United States which is described in 
section 871(a)(1) or 881(a), relating to fixed or determinable annual or 
periodical gains, profits, and income and certain other gains, or 
whether gain or loss from sources within the United States for the 
taxable year from the sale or exchange of capital assets, is effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States, the principal tests to be applied are (a) the 
asset-use test, that is, whether the income, gain, or loss is derived 
from assets used in, or held for use in, the conduct of the trade or 
business in the United States, and (b) the business-activities test, 
that is, whether the activities of the trade or business conducted in 
the United States were a material factor in the realization of the 
income, gain, or loss.
    (ii) Special rule relating to interest on certain deposits. For 
purposes of determining under section 861(a)(1)(A) (relating to interest 
on deposits with banks, savings and loan associations, and insurance 
companies paid or credited before January 1, 1976) whether the interest 
described therein is effectively connected for the taxable year with the 
conduct of a trade or business in the United States, such interest shall 
be treated as income from sources within the United States for purposes 
of applying this paragraph and Sec.  1.864-5. If by reason of the 
application of this paragraph such interest is determined to be income 
which is not effectively connected for the taxable year with the conduct 
of a trade or business in the United States, it shall then be treated as 
interest from sources without the United States which is not subject to 
the application of Sec.  1.864-5.
    (2) Application of the asset-use test--(i) In general. For purposes 
of subparagraph (1) of this paragraph, the asset-use test ordinarily 
shall apply in making a determination with respect to income, gain, or 
loss of a passive type where the trade or business activities as such do 
not give rise directly to the realization of the income, gain, or loss. 
However, even in the case of such income, gain, or loss, any activities 
of the trade or business which materially contribute to the realization 
of such income, gain, or loss shall also be taken into account as a 
factor in determining whether the income, gain, or loss is effectively 
connected with the conduct of a trade or business in the United States. 
The asset-use test is of primary significance where, for example, 
interest income is derived from sources within the United States by a 
nonresident alien individual or foreign corporation that is engaged in 
the business of manufacturing or selling goods in the United States. See 
also subparagraph (5) of this paragraph for rules applicable to 
taxpayers conducting a banking, financing, or similar business in the 
United States.
    (ii) Cases where applicable. Ordinarily, an asset shall be treated 
as used in, or held for use in, the conduct of a trade or business in 
the United States if the asset is--
    (a) Held for the principal purpose of promoting the present conduct 
of the trade or business in the United States; or
    (b) Acquired and held in the ordinary course of the trade or 
business conducted in the United States, as, for example, in the case of 
an account or note receivable arising from that trade or business; or
    (c) Otherwise held in a direct relationship to the trade or business 
conducted in the United States, as determined under paragraph (c)(2)(iv) 
of this section.
    (iii) Application of asset-use test to stock--(a) In general. Except 
as provided

[[Page 334]]

in paragraph (c)(2)(iii)(b) of this section, stock of a corporation 
(whether domestic or foreign) shall not be treated as an asset used in, 
or held for use in, the conduct of a trade or business in the United 
States.
    (b) Stock held by foreign insurance companies. This paragraph 
(c)(2)(iii) shall not apply to stock of a corporation (whether domestic 
or foreign) held by a foreign insurance company unless the foreign 
insurance company owns 10 percent or more of the total voting power or 
value of all classes of stock of such corporation. For purposes of this 
section, section 318(a) shall be applied in determining ownership, 
except that in applying section 318(a)(2)(C), the phrase ``10 percent'' 
is used instead of the phrase ``50 percent.''
    (iv) Direct relationship between holding of asset and trade or 
business--(a) In general. In determining whether an asset is held in a 
direct relationship to the trade or business conducted in the United 
States, principal consideration shall be given to whether the asset is 
needed in that trade or buisness. An asset shall be considered needed in 
a trade or business, for this purpose, only if the asset is held to meet 
the present needs of that trade or business and not its anticipated 
future needs. An asset shall be considered as needed in the trade or 
business conducted in the United States if, for example, the asset is 
held to meet the operating expenses of that trade or business. 
Conversely, an asset shall be considered as not needed in the trade or 
business conducted in the United States if, for example, the asset is 
held for the purpose of providing for (1) future diversification into a 
new trade or business, (2) expansion of trade or business activities 
conducted outside of the United States, (3) future plant replacement, or 
(4) future business contingencies.
    (b) Presumption of direct relationship. Generally, an asset will be 
treated as held in a direct relationship to the trade or business if (1) 
the asset was acquired with funds generated by that trade or business, 
(2) the income from the asset is retained or reinvested in that trade or 
business, and (3) personnel who are present in the United States and 
actively involved in the conduct of that trade or business exercise 
significant management and control over the investment of such asset.
    (v) Illustration. The application of paragraph (iv) may be 
illustrated by the following examples:

    Example 1. M, a foreign corporation which uses the calendar year as 
the taxable year, is engaged in industrial manufacturing in a foreign 
country. M maintains a branch in the United States which acts as 
importer and distributor of the merchandise it manufactures abroad; by 
reason of these branch activities. M is engaged in business in the 
United States during 1968. The branch in the United States is required 
to hold a large current cash balance for business purposes, but the 
amount of the cash balance so required varies because of the fluctuating 
seasonal nature of the branch's business. During 1968 at a time when 
large cash balances are not required the branch invests the surplus 
amount in U.S. Treasury bills. Since these Treasury bills are held to 
meet the present needs of the business conducted in the United States 
they are held in a direct relationship to that business, and the 
interest for 1968 on these bills is effectively connected for that year 
with the conduct of the business in the United States by M.
    Example 2. Foreign corporation M, which uses the calendar year as 
the taxable year, has a branch office in the United States where it 
sells to customers located in the United States various products which 
are manufactured by that corporation in a foreign country. By reason of 
this activity M is engaged in business in the United States during 1997. 
The U.S. branch establishes in 1997 a fund to which are periodically 
credited various amounts which are derived from the business carried on 
at such branch. The amounts in this fund are invested in various 
securities issued by domestic corporations by the managing officers of 
the U.S. branch, who have the responsibility for maintaining proper 
investment diversification and investment of the fund. During 1997, the 
branch office derives from sources within the United States interest on 
these securities, and gains and losses resulting from the sale or 
exchange of such securities. Since the securities were acquired with 
amounts generated by the business conducted in the United States, the 
interest is retained in that business, and the portfolio is managed by 
personnel actively involved in the conduct of that business, the 
securities are presumed under paragraph (c)(2)(iv)(b) of this section to 
be held in a direct relationship to that business. However, M is able to 
rebut this presumption by demonstrating that the fund was established to 
carry out a program of future expansion and not to meet the present 
needs of the business conducted in the United States. Consequently, the 
income,

[[Page 335]]

gains, and losses from the securities for 1997 are not effectively 
connected for that year with the conduct of a trade or business in the 
United States by M.

    (3) Application of the business-activities test--(i) In general. For 
purposes of subparagraph (1) of this paragraph, the business-activities 
test shall ordinarily apply in making a determination with respect to 
income, gain, or loss which, even though generally of the passive type, 
arises directly from the active conduct of the taxpayer's trade or 
business in the United States. The business-activities test is of 
primary significance, for example, where (a) dividends or interest are 
derived by a dealer in stocks or securities, (b) gain or loss is derived 
from the sale or exchange of capital assets in the active conduct of a 
trade or business by an investment company, (c) royalties are derived in 
the active conduct of a business consisting of the licensing of patents 
or similar intangible property, or (d) service fees are derived in the 
active conduct of a servicing business. In applying the business-
activities test, activities relating to the management of investment 
portfolios shall not be treated as activities of the trade or business 
conducted in the United States unless the maintenance of the investments 
constitutes the principal activity of that trade or business. See also 
subparagraph (5) of this paragraph for rules applicable to taxpayers 
conducting a banking, financing, or similar business in the United 
States.
    (ii) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation S is a foreign investment company 
organized for the purpose of investing in stocks and securities. S is 
not a personal holding company or a corporation which would be a 
personal holding company but for section 542(c)(7) or 543(b)(1)(C). Its 
investment portfolios consist of common stocks issued by both foreign 
and domestic corporations and a substantial amount of high grade bonds. 
The business activity of S consists of the management of its portfolios 
for the purpose of investing, reinvesting, or trading in stocks and 
securities. During the taxable year 1968, S has its principal office in 
the United States within the meaning of paragraph (c)(2)(iii) of Sec.  
1.864-2 and, by reason of its trading in the United States in stocks and 
securities, is engaged in business in the United States. The dividends 
and interest derived by S during 1968 from sources within the United 
States, and the gains and losses from sources within the United States 
for such year from the sale of stocks and securities from its investment 
portfolios, are effectively connected for 1968 with the conduct of the 
business in the United States by that corporation, since its activities 
in connection with the management of its investment portfolios are 
activities of that business and such activities are a material factor in 
the realization of such income, gains, and losses.
    Example 2. N, a foreign corporation which uses the calendar year as 
the taxable year, has a branch in the United States which acts as an 
importer and distributor of merchandise; by reason of the activities of 
that branch, N is engaged in business in the United States during 1968. 
N also carries on a business in which it licenses patents to unrelated 
persons in the United States for use in the United States. The 
businesses of the licensees in which these patents are used have no 
direct relationship to the business carried on in N's branch in the 
United States, although the merchandise marketed by the branch is 
similar in type to that manufactured under the patents. The negotiations 
and other activities leading up to the consummation of these licenses 
are conducted by employees of N who are not connected with the U.S. 
branch of that corporation, and the U.S. branch does not otherwise 
participate in arranging for the licenses. Royalties received by N 
during 1968 from these licenses are not effectively connected for that 
year with the conduct of its business in the United States because the 
activities of that business are not a material factor in the realization 
of such income.

    (4) Method of accounting as a factor. In applying the asset-use test 
or the business-activities test described in subparagraph (1) of this 
paragraph, due regard shall be given to whether or not the asset, or the 
income, gain, or loss, is accounted for through the trade or business 
conducted in the United States, that is, whether or not the asset, or 
the income, gain, or loss, is carried on books of account separately 
kept for that trade or business, but this accounting test shall not by 
itself be controlling. In applying this subparagraph, consideration 
shall be given to whether the accounting treatment of an item reflects 
the consistent application of generally accepted accounting principles 
in a particular trade or business in accordance with accepted conditions 
or practices in that trade or

[[Page 336]]

business and whether there is a consistent accounting treatment of that 
item from year to year by the taxpayer.
    (5) Special rules relating to banking, financing, or similar 
business activity--(i) Definition of banking, financing, or similar 
business. A nonresident alien individual or a foreign corporation shall 
be considered for purposes of this section and paragraph (b)(2) of Sec.  
1.864-5 to be engaged in the active conduct of a banking, financing, or 
similar business in the United States if at some time during the taxable 
year the taxpayer is engaged in business in the United States and the 
activities of such business consist of any one or more of the following 
activities carried on, in whole or in part, in the United States in 
transactions with persons situated within or without the United States:
    (a) Receiving deposits of funds from the public,
    (b) Making personal, mortgage, industrial, or other loans to the 
public,
    (c) Purchasing, selling, discounting, or negotiating for the public 
on a regular basis, notes, drafts, checks, bills of exchange, 
acceptances, or other evidences of indebtedness,
    (d) Issuing letters of credit to the public and negotiating drafts 
drawn thereunder,
    (e) Providing trust services for the public, or
    (f) Financing foreign exchange transactions for the public.


Although the fact that the taxpayer is subjected to the banking and 
credit laws of a foreign country shall be taken into account in 
determining whether he is engaged in the active conduct of a banking, 
financing, or similar business, the character of the business actually 
carried on during the taxable year in the United States shall determine 
whether the taxpayer is actively conducting a banking, financing, or 
similar business in the United States. A foreign corporation which acts 
merely as a financing vehicle for borrowing funds for its parent 
corporation or any other person who would be a related person within the 
meaning of section 954(d)(3) if such foreign corporation were a 
controlled foreign corporation shall not be considered to be engaged in 
the active conduct of a banking, financing, or similar business in the 
United States.
    (ii) Effective connection of income from stocks or securities with 
active conduct of a banking, financing, or similar business. 
Notwithstanding the rules in subparagraphs (2) and (3) of this paragraph 
with respect to the asset-use test and the business-activities test, any 
dividends or interest from stocks or securities, or any gain or loss 
from the sale or exchange of stocks or securities which are capital 
assets, which is from sources within the United States and derived by a 
nonresident alien individual or a foreign corporation in the active 
conduct during the taxable year of a banking, financing, or similar 
business in the United States shall be treated as effectively connected 
for such year with the conduct of that business only if the stocks or 
securities giving rise to such income, gain, or loss are attributable to 
the U.S. office through which such business is carried on and--
    (a) Were acquired--
    (1) As a result of, or in the course of making loans to the public,
    (2) In the course of distributing such stocks or securities to the 
public, or
    (3) For the purpose of being used to satisfy the reserve 
requirements, or other requirements similar to reserve requirements, 
established by a duly constituted banking authority in the United 
States, or
    (b) Consist of securities (as defined in subdivision (v) of this 
subparagraph) which are--
    (1) Payable on demand or at a fixed maturity date not exceeding 1 
year from the date of acquisition,
    (2) Issued by the United States, or any agency or instrumentality 
thereof, or
    (3) Not described in (a) or in (1) or (2) of this (b).


However, the amount of interest from securities described in (b)(3) of 
this subdivision (ii) which shall be treated as effectively connected 
for the taxable year with the active conduct of a banking, financing, or 
similar business in the United States shall be an amount (but not in 
excess of the entire interest

[[Page 337]]

for the taxable year from sources within the United States from such 
securities) determined by multiplying the entire interest for the 
taxable year from sources within the United States from such securities 
by a fraction the numerator of which is 10 percent and the denominator 
of which is the same percentage, determined on the basis of a monthly 
average for the taxable year, as the book value of the total of such 
securities held by the U.S. office through which such business is 
carried on bears to the book value of the total assets of such office. 
The amount of gain or loss, if any, for the taxable year from the sale 
or exchange of such securities which shall be treated as effectively 
connected for the taxable year with the active conduct of a banking, 
financing, or similar business in the United States shall be an amount 
(but not in excess of the entire gain or loss for the taxable year from 
sources within the United States from the sale or exchange of such 
securities) determined by multiplying the entire gain or loss for the 
taxable year from sources within the United States from the sale or 
exchange of such securities by the fraction described in the immediately 
preceding sentence. The percentage of the denominator of the limiting 
fraction for such purposes shall be the percentage obtained by 
separately adding the book value of such securities and such total 
assets held at the close of each month in the taxable year, dividing 
each such sum by 12, and then dividing the amount of securities so 
obtained by the amount of assets so obtained. This subdivision does not 
apply to dividends from stock owned by a foreign corporation in a 
domestic corporation of which more than 50 percent of the total combined 
voting power of all classes of stock entitled to vote is owned by such 
foreign corporation and which is engaged in the active conduct of a 
banking business in the United States. The application of this 
subdivision may be illustrated by the following example:

    Example. Foreign corporation M, created under the laws of foreign 
country Y, has in the United States a branch, B, which during the 
taxable year is engaged in the active conduct of the banking business in 
the United States within the meaning of subdivision (i) of this 
subparagraph. During the taxable year M derives from sources within the 
United States through the activities carried on through B, $7,500,000 
interest from securities described in subdivision (b)(3) of this 
subdivision (ii) and $7,500,000 gain from the sale or exchange of such 
securities. The monthly average, determined as of the last day of each 
month in the taxable year, of such securities held by B divided by the 
monthly average, as so determined, of the total assets held by B equals 
15 percent. Under this subdivision, the amount of interest income from 
such securities that shall be treated as effectively connected for the 
taxable year with the active conduct by M of a banking business in the 
United States is $5 million ($7,500,000 interest x 10% / 15%), and the 
amount of gain from the sale or exchange of such securities that shall 
be treated as effectively connected for such year with the active 
conduct of such business is $5 million ($7,500,000 gain x 10% / 15%).

    (iii) Stocks or securities attributable to U.S. office--(a) In 
general. For purposes of paragraph (c)(5)(ii) of this section, a stock 
or security shall be deemed to be attributable to a U.S. office only if 
such office actively and materially participated in soliciting, 
negotiating, or performing other activities required to arrange the 
acquisition of the stock or security. The U.S. office need not have been 
the only active participant in arranging the acquisition of the stock or 
security.
    (b) Exceptions. A stock or security shall not be deemed to be 
attributable to a U.S. office merely because such office conducts one or 
more of the following activities:
    (1) Collects or accounts for the dividends, interest, gain, or loss 
from such stock or security,
    (2) Exercises general supervision over the activities of the persons 
directly responsible for carrying on the activities described in 
paragraph (c)(5)(iii)(a) of this section,
    (3) Performs merely clerical functions incident to the acquisition 
of such stock or security,
    (4) Exercises final approval over the execution of the acquisition 
of such stock or security, or
    (5) Holds such stock or security in the United States or records 
such stock or security on its books or records as having been acquired 
by such office or for its account.
    (c) Effective date. This paragraph (c)(5)(iii) shall be effective 
for income

[[Page 338]]

includible in taxable years beginning on or after June 18, 1984, except 
that 26 CFR 1.864-4 (c)(5)(iii) as it appeared in the Code of Federal 
Regulations revised as of April 1, 1983, shall apply to income received 
or accured under a loan made by the taxpayer on or before May 18, 1984, 
or pursuant to a written binding commitment entered into on or before 
May 18, 1984.
    (iv) Acquisitions in course of making loans to the public. For 
purposes of subdivision (ii) of this subparagraph--
    (a) A stock or security shall be considered to have been acquired in 
the course of making a loan to the public where, for example, such stock 
or security was acquired as additional consideration for the making of 
the loan,
    (b) A stock or security shall be considered to have been acquired as 
a result of making a loan to the public if, for example, such stock or 
security was acquired by foreclosure upon a bona fide default of the 
loan and is held as an ordinary and necessary incident to the active 
conduct of the banking, financing, or similar business in the United 
States, and
    (c) A stock or security acquired on a stock exchange or organized 
over-the-counter market shall be considered not to have been acquired as 
a result of, or in the course of, making loans to the public.
    (v) Security defined. For purposes of this subparagraph, a security 
is any bill, note, bond, debenture, or other evidence of indebtedness, 
or any evidence of an interest in, or right to subscribe to or purchase, 
any of the foregoing items.
    (vi) Limitations on application of subparagraph--(a) Other business 
activity. This subparagraph provides rules for determining when certain 
income from stocks or securities is effectively connected with the 
active conduct of a banking, financing, or similar business in the 
United States. Any dividends, interest, gain, or loss from sources 
within the United States which by reason of the application of 
subdivision (ii) of this subparagraph is not effectively connected with 
the active conduct by a nonresident alien individual or a foreign 
corporation of a banking, financing, or similar business in the United 
States may be effectively connected for the taxable year, under 
subparagraph (2) or (3) of this paragraph with the conduct by such 
taxpayer of another trade or business in the United States, such as, for 
example, the business of selling or manufacturing goods or merchandise 
or of trading in stocks or securities for the taxpayer's own account.
    (b) Other income. For rules relating to income, gain, or loss from 
sources within the United States (other than dividends or interest from, 
or gain or loss from the sale or exchange of, stocks or securities 
referred to in subdivision (ii) of this subparagraph) derived in the 
active conduct of a banking, financing, or similar business in the 
United States, see subparagraphs (2) and (3) of this paragraph and 
paragraph (b) of this section.
    (vii) Illustrations. The application of this subparagraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation F, which is created under the laws of 
foreign country X and engaged in the active conduct of the banking 
business in country X and a number of other foreign countries, has in 
the United States a branch, B, which during the taxable year is engaged 
in the active conduct of the banking business in the United States 
within the meaning of subdivision (i) of this subparagraph. In the 
course of its banking business in foreign countries, F receives at its 
branches located in country X and other foreign countries substantial 
deposits in U.S. dollars which are transferred to the accounts of B in 
the United States. During the taxable year, B actively participates in 
negotiating loans to residents of the United States, such as call loans 
to U.S. brokers, which are financed from the U.S. dollar deposits 
transferred to B by F. In addition, B actively participates in 
purchasing on the New York Stock Exchange and over-the-counter markets 
long-term bonds and notes issued by the U.S. Government, U.S. Treasury 
bills, and long-term interest-bearing bonds issued by domestic 
corporations and having a maturity date of less than 1 year from the 
date of acquisition, all of which are purchased from the deposits 
transferred to B by F. All of the securities so acquired are held by B 
and recorded on its books in the United States. Pursuant to subdivision 
(ii) of this subparagraph, the interest received by F during the taxable 
year on these loans, bonds, notes, and bills is effectively connected 
for such year with the active conduct by F of a banking business in the 
United States.

[[Page 339]]

    Example 2. The facts are the same as in example 1 except that B also 
actively participates in using part of the U.S. dollar deposits, which 
are transferred to it by F, to purchase on the New York Stock Exchange 
shares of common stock issued by various domestic corporations. All of 
the shares so purchased are considered to be capital assets within the 
meaning of section 1221 and are recorded on B's books in the United 
States. None of the shares so purchased were acquired for the purpose of 
meeting reserve or other similar requirements. During the taxable year 
some of the shares are sold by B on the stock exchange. Pursuant to 
subdivision (ii) of this subparagraph, the dividends and gains received 
by F during the taxable year on these shares of stock are not 
effectively connected with the active conduct by F of a banking, 
financing, or similar business in the United States.
    Example 3. The facts are the same as in example 1 except that B also 
uses part of the U.S. dollar deposits, which are transferred to it by F, 
to make a loan to domestic corporation M. As part of the consideration 
for the loan, M gives to B a number of shares of common stock issued by 
M. All of these shares of stock are considered to be capital assets 
within the meaning of section 1221 and are recorded on B's books in the 
United States. During the taxable year one-half of these shares of stock 
is sold by B on the New York Stock Exchange. Pursuant to subdivision 
(ii) of this subparagraph, the dividends and gains received by F during 
the taxable year on these shares of stock are effectively connected for 
such year with the active conduct by F of a banking business in the 
United States.
    Example 4. The facts are the same as in example 1 except that during 
the taxable year the home office of F in country X actively participates 
in negotiating loans to residents of the United States, such as call 
loans to U.S. brokers, which are financed by the U.S. dollar deposits 
received at the home office and are recorded on the books of the home 
office. B does not participate in negotiating these loans. Pursuant to 
subdivision (ii) of this subparagraph the interest received by F during 
the taxable year on these loans made by the home office in country X is 
not effectively connected with the active conduct by F of a banking, 
financing, or similar business in the United States.
    Example 5. Foreign corporation Y, which is created under the laws of 
foreign country X and is engaged in the active conduct of a banking 
business in country X and other foreign countries, has a branch, C, in 
the United States that is engaged in the active conduct of a banking 
business in the United States, within the meaning of paragraph (c)(5)(i) 
of this section, during the taxable year. C handles the negotiation and 
acquisition of securities involved in loans made by Y to U.S. persons. C 
also presents interest coupons with respect to such securities for 
payment, presents all such securities for payment at maturity, and 
maintains compete photocopy files with respect to such securities. The 
activities of the office of Y in country X with respect to these 
securities consist of giving pro forma approval of the loans, storing 
the original securities, and recording the securities on the books of 
the country X office. Pursuant to paragraphs (c)(5)(ii) and (c)(5)(iii) 
of this section, the U.S. source interest income received by Y during 
the taxable year on these securities is effectively connected for such 
year with the active conduct by Y of a banking business in the United 
States.

    (6) Income related to personal services of an individual--(i) 
Income, gain, or loss from assets. Income or gains from sources within 
the United States described in section 871(a)(1) and derived from an 
asset, and gain or loss from sources within the United States from the 
sale or exchange of capital assets, realized by a nonresident alien 
individual engaged in a trade or business in the United States during 
the taxable year solely by reason of his performing personal services in 
the United States shall not be treated as income, gain, or loss which is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States, unless there is a direct economic 
relationship between his holding of the asset from which the income, 
gain, or loss results and his trade or business of performing the 
personal services.
    (ii) Wages, salaries, and pensions. Wages, salaries, fees, 
compensations, emoluments, or other remunerations, including bonuses, 
received by a nonresident alien individual for performing personal 
services in the United States which, under paragraph (a) of Sec.  1.864-
2, constitute engaging in a trade or business in the United States, and 
pensions and retirement pay attributable to such personal services, 
constitute income which is effectively connected for the taxable year 
with the conduct of a trade or business in the United States by that 
individual if he is engaged in a trade or business in the United States 
at some time during the taxable year in which such income is received.
    (7) Effective date. Paragraphs (c)(2) and (c)(6)(i) of this section 
are effective

[[Page 340]]

for taxable years beginning on or after June 6, 1996.

[T.D. 7216, 37 FR 23425, Nov. 3, 1972, as amended by T.D. 7332, 39 FR 
44232, Dec. 23, 1974; T.D. 79-58, 49 FR 21052, May 18, 1984; T.D. 8657, 
61 FR 9337, Mar. 8, 1996; T.D. 9226, 70 FR 57510, Oct. 3, 2005]



Sec.  1.864-5  Foreign source income effectively connected with U.S. business.

    (a) In general. This section applies only to a nonresident alien 
individual or a foreign corporation that is engaged in a trade or 
business in the United States at some time during a taxable year 
beginning after December 31, 1966, and to the income, gain, or loss of 
such person from sources without the United States. The income, gain, or 
loss of such person for the taxable year from sources without the United 
States which is specified in paragraph (b) of this section shall be 
treated as effectively connected for the taxable year with the conduct 
of a trade or business in the United States, only if he also has in the 
United States at some time during the taxable year, but not necessarily 
at the time the income, gain, or loss is realized, an office or other 
fixed place of business, as defined in Sec.  1.864-7, to which such 
income, gain, or loss is attributable in accordance with Sec.  1.864-6. 
The income of such person for the taxable year from sources without the 
United States which is specified in paragraph (c) of this section shall 
be treated as effectively connected for the taxable year with the 
conduct of a trade or business in the United States when derived by a 
foreign corporation carrying on a life insurance business in the United 
States. Except as provided in paragraphs (b) and (c) of this section, no 
income, gain, or loss of a nonresident alien individual or a foreign 
corporation for the taxable year from sources without the United States 
shall be treated as effectively connected for the taxable year with the 
conduct of a trade or business in the United States by that person. Any 
income, gain, or loss described in paragraph (b) or (c) of this section 
which, if it were derived by the taxpayer from sources within the United 
States for the taxable year, would not be treated under Sec.  1.864-4 as 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States shall not be treated under this section 
as effectively connected for the taxable year with the conduct of a 
trade or business in the United States.
    (b) Income other than income attributable to U.S. life insurance 
business. Income, gain, or loss from sources without the United States 
other than income described in paragraph (c) of this section shall be 
taken into account pursuant to paragraph (a) of this section in applying 
Sec. Sec.  1.864-6 and 1.864-7 only if it consists of--
    (1) Rents, royalties, or gains on sales of intangible property. (i) 
Rents or royalties for the use of, or for the privilege of using, 
intangible personal property located outside the United States or from 
any interest in such property, including rents or royalties for the use, 
or for the privilege of using, outside the United States, patents, 
copyrights, secret processes and formulas, good will, trademarks, trade 
brands, franchises, and other like properties, if such rents or 
royalties are derived in the active conduct of the trade or business in 
the United States.
    (ii) Gains or losses on the sale or exchange of intangible personal 
property located outside the United States or from any interest in such 
property, including gains or losses on the sale or exchange of the 
privilege of using, outside the United States, patents, copyrights, 
secret processes and formulas, good will, trademarks, trade brands, 
franchises, and other like properties, if such gains or losses are 
derived in the active conduct of the trade or business in the United 
States.
    (iii) Whether or not such an item of income, gain, or loss is 
derived in the active conduct of a trade or business in the United 
States shall be determined from the facts and circumstances of each 
case. The frequency with which a nonresident alien individual or a 
foreign corporation enters into transactions of the type from which the 
income, gain, or loss is derived shall not of itself determine that the 
income, gain, or loss is derived in the active conduct of a trade or 
business.
    (iv) This subparagraph shall not apply to rents or royalties for the 
use of, or for the privilege of using, real property or tangible 
personal property,

[[Page 341]]

or to gain or loss from the sale or exchange of such property.
    (2) Dividends or interest, or gains or loss from sales of stocks or 
securities--(i) In general. Dividends or interests from any transaction, 
or gains or losses on the sale or exchange of stocks or securities, 
realized by (a) a nonresident alien individual or a foreign corporation 
in the active conduct of a banking, financing, or similar business in 
the United States or (b) a foreign corporation engaged in business in 
the United States whose principal business is trading in stocks or 
securities for its own account. Whether the taxpayer is engaged in the 
active conduct of a banking, financing, or similar business in the 
United States for purposes of this subparagraph shall be determined in 
accordance with the principles of paragraph (c)(5)(i) of Sec.  1.864-4.
    (ii) Substitute payments. For purposes of this paragraph (b)92), a 
substitute interest payment (as defined in Sec.  1.861-2(a)(7)) received 
by a foreign person subject to tax under this paragraph (b) pursuant to 
a securities lending transaction or a sale-repurchase transaction (as 
defined in Sec.  1.861-2(a)(7)) with respect to a security (as defined 
in Sec.  1.864-6(b)(2)(ii)(c)) shall have the same character as interest 
income paid or accrued with respect to the terms of the transferred 
security. Similarly, for purposes of this paragraph (b)(2), a substitute 
dividend payment (as defined in Sec.  1.861-3(a)(6)) received by a 
foreign person pursuant to a securities lending transaction or a sale-
repurchase transaction (as defined in Sec.  1.861-3(a)(6)) with respect 
to a stock shall have the same character as a distribution with respect 
to the transferred security. This paragraph (b)(2)(ii) is applicable to 
payments made after November 13, 1997.
    (iii) Incidental investment activity. This subparagraph shall not 
apply to income, gain, or loss realized by a nonresident alien 
individual or foreign corporation on stocks or securities held, sold, or 
exchanged in connection with incidental investment activities carried on 
by that person. Thus, a foreign corporation which is primarily a holding 
company owning significant percentages of the stocks or securities 
issued by other corporations shall not be treated under this 
subparagraph as a corporation the principal business of which is trading 
in stocks or securities for its own account, solely because it engages 
in sporadic purchases or sales of stocks or securities to adjust its 
portfolio. The application of this subdivision may be illustrated by the 
following example:

    Example. F, a foreign corporation, owns voting stock in foreign 
corporations M, N, and P, its holdings in such corporations constituting 
15, 20, and 100 percent, respectively, of all classes of their 
outstanding voting stock. Each of such stock holdings by F represents 
approximately 20 percent of its total assets. The remaining 40 percent 
of F's assets consist of other investments, 20 percent being invested in 
securities issued by foreign governments and in stocks and bonds issued 
by other corporations in which F does not own a significant percentage 
of their outstanding voting stock, and 20 percent being invested in 
bonds issued by N. None of the assets of F are held primarily for sale; 
but if the officers of that corporation were to decide that other 
investments would be preferable to its holding of such assets, F would 
sell the stocks and securities and reinvest the proceeds therefrom in 
other holdings. Any income, gain, or loss which F may derive from this 
investment activity is not considered to be realized by a foreign 
corporation described in subdivision (i) of this subparagraph.

    (3) Sale of goods or merchandise through U.S. office. (i) Income, 
gain, or loss from the sale of inventory items or of property held 
primarily for sale to customers in the ordinary course of business, as 
described in section 1221(1), where the sale is outside the United 
States but through the office or other fixed place of business which the 
nonresident alien or foreign corporation has in the United States, 
irrespective of the destination to which such property is sent for use, 
consumption, or disposition.
    (ii) This subparagraph shall not apply to income, gain, or loss 
resulting from a sales contract entered into on or before February 24, 
1966. See section 102(e)(1) of the Foreign Investors Tax Act of 1966 (80 
Stat. 1547). Thus, for example, the sales office in the United States of 
a foreign corporation enters into negotiations for the sale of 500,000 
industrial bearings which the corporation produces in a foreign country 
for consumption in the Western Hemisphere. These negotiations culminate

[[Page 342]]

in a binding agreement entered into on January 1, 1966. By its terms 
delivery under the contract is to be made over a period of 3 years 
beginning in March of 1966. Payment is due upon delivery. The income 
from sources without the United States resulting from this sale 
negotiated by the U.S. sales office of the foreign corporation shall not 
be taken into account under this subparagraph for any taxable year.
    (iii) This subparagraph shall not apply to gains or losses on the 
sale or exchange of intangible personal property to which subparagraph 
(1) of this paragraph applies or of stocks or securities to which 
subparagraph (2) of this paragraph applies.
    (c) Income attributable to U.S. life insurance business. (1) All of 
the income for the taxable year of a foreign corporation described in 
subparagraph (2) of this paragraph from sources without the United 
States, which is attributable to its U.S. life insurance business, shall 
be treated as effectively connected for the taxable year with the 
conduct of a trade or business in the United States by that corporation. 
Thus, in determining its life insurance company taxable income from its 
U.S. business for purposes of section 802, the foreign corporation shall 
include all of its items of income from sources without the United 
States which would appropriately be taken into account in determining 
the life insurance company taxable income of a domestic corporation. The 
income to which this subparagraph applies shall be taken into account 
for purposes of paragraph (a) of this section without reference to 
Sec. Sec.  1.864-6 and 1.864-7.
    (2) A foreign corporation to which subparagraph (1) of this 
paragraph applies is a foreign corporation carrying on an insurance 
business in the United States during the taxable year which--
    (i) Without taking into account its income not effectively connected 
for that year with the conduct of any trade or business in the United 
States, would qualify as a life insurance company under part I (section 
801 and following) of subchapter L, chapter 1 of the Code, if it were a 
domestic corporation, and
    (ii) By reason of section 842 is taxable under that part on its 
income which is effectively connected for that year with its conduct of 
any trade or business in the United States.
    (d) Excluded foreign source income. Notwithstanding paragraphs (b) 
and (c) of this section, no income from sources without the United 
States shall be treated as effectively connected for any taxable year 
with the conduct of a trade or business in the United States by a 
nonresident alien individual or a foreign corporation if the income 
consists of--
    (1) Dividends, interest, or royalties paid by a related foreign 
corporation. Dividends, interest, or royalties paid by a foreign 
corporation in which the nonresident alien individual or the foreign 
corporation described in paragraph (a) of this section owns, within the 
meaning of section 958(a), or is considered as owning, by applying the 
ownership rules of section 958(b), at the time such items are paid more 
than 50 percent of the total combined voting power of all classes of 
stock entitled to vote.
    (2) Subpart F income of a controlled foreign corporation. Any income 
of the foreign corporation described in paragraph (a) of this section 
which is subpart F income for the taxable year, as determined under 
section 952(a), even though part of the income is attributable to 
amounts which, if distributed by the foreign corporation, would be 
distributed with respect to its stock which is owned by shareholders who 
are not U.S. shareholders within the meaning of section 951(b). This 
subparagraph shall not apply to any income of the foreign corporation 
which is excluded in determining its subpart F income for the taxable 
year for purposes of section 952(a). Thus, for example, this 
subparagraph shall not apply to--
    (i) Foreign base company shipping income which is excluded under 
section 954(b)(2),
    (ii) Foreign base company income amounting to less than 10 percent 
(30 percent in the case of taxable years of foreign corporations ending 
before January 1, 1976) of gross income which by reason of section 
954(b)(3)(A) does not become subpart F income for the taxable year,
    (iii) Any income excluded from foreign base company income under 
section 954(b)(4), relating to exception for

[[Page 343]]

foreign corporations not availed of to reduce taxes,
    (iv) Any income derived in the active conduct of a trade or business 
which is excluded under section 954(c)(3), or
    (v) Any income received from related persons which is excluded under 
section 954(c)(4).


This subparagraph shall apply to the foreign corporation's entire 
subpart F income for the taxable year determined under section 952(a), 
even though no amount is included in the gross income of a U.S. 
shareholder under section 951(a) with respect to that subpart F income 
because of the minimum distribution provisions of section 963(a) or 
because of the reduction under section 970(a) with respect to an export 
trade corporation. This subparagraph shall apply only to a foreign 
corporation which is a controlled foreign corporation within the meaning 
of section 957 and the regulations thereunder. The application of this 
subparagraph may be illustrated by the following examples:

    Example 1. Controlled foreign corporation M, incorporated under the 
laws of foreign country X, is engaged in the business of purchasing and 
selling merchandise manufactured in foreign country Y by an unrelated 
person. M negotiates sales, through its sales office in the United 
States, of its merchandise for use outside of country X. These sales are 
made outside the United States, and the merchandise is sold for use 
outside the United States. No office maintained by M outside the United 
States participates materially in the sales made through its U.S. sales 
office. These activities constitute the only activities of M. During the 
taxable year M derives $100,000 income from these sales made through its 
U.S. sales office, and all of such income is foreign base company sales 
income by reason of section 954(d)(2) and paragraph (b) of Sec.  1.954-
3. The entire $100,000 is also subpart F income, determined under 
section 952(a). In addition, all of this income would, without reference 
to section 864(c)(4)(D)(ii) and this subparagraph, be treated as 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by M. Through its entire taxable year 
60 percent of the one class of stock of M is owned within the meaning of 
section 958(a) by U.S. shareholders, as defined in section 951(b), and 
40 percent of its one class of stock is owned within the meaning of 
section 958(a) by persons who are not U.S. shareholders, as defined in 
section 951(b). Although only $60,000 of the subpart F income of M for 
the taxable year is includible in the income of the U.S. shareholders 
under section 951(a), the entire subpart F income of $100,000 
constitutes income which, by reason of section 864(c)(4)(D)(ii) and this 
subparagraph, is not effectively connected for the taxable year with the 
conduct of a trade or business in the United States by M.
    Example 2. The facts are the same as in example 1 except that the 
foreign base company sales income amounts to $150,000 determined in 
accordance with paragraph (d)(3)(i) of Sec.  1.954-1, and that M also 
has gross income from sources without the United States of $50,000 from 
sales, through its sales office in the United States, of merchandise for 
use in country X. These sales are made outside the United States. All of 
this income would, without reference to section 864(c)(4)(D)(ii) and 
this subparagraph, be treated as effectively connected for the taxable 
year with the conduct of a trade or business in the United States by M. 
Since the foreign base company income of $150,000 amounts to 75 percent 
of the entire gross income of $200,000, determined as provided in 
paragraph (d)(3)(ii) of Sec.  1.954-1, the entire $200,000 constitutes 
foreign base company income under section 954(b)(3)(B). Assuming that M 
has no amounts to be taken into account under paragraphs (1), (2), (4), 
and (5) of section 954(b), the $200,000 is also subpart F income, 
determined under section 952(a). This subpart F income of $200,000 
constitutes income which, by reason of section 864(c)(4)(D)(ii) and this 
subparagraph, is not effectively connected for the taxable year with the 
conduct of a trade or business in the United States by M.

    (3) Interest on certain deposits. Interest which, by reason of 
section 861(a)(1)(A) (relating to interest on deposits with banks, 
savings and loan associations, and insurance companies paid or credited 
before January 1, 1976) and paragraph (c) of Sec.  1.864-4, is 
determined to be income from sources without the United States because 
it is not effectively connected for the taxable year with the conduct of 
a trade or business in the United States by the nonresident alien 
individual or foreign corporation.

[T.D. 7216, 37 FR 23429, Nov. 3, 1972, as amended by T.D. 7893, 48 FR 
22507, May 19, 1983; T.D. 8735, 62 FR 53501, Oct. 14, 1997]

[[Page 344]]



Sec.  1.864-6  Income, gain, or loss attributable to an office 
or other fixed place of business in the United States.

    (a) In general. Income, gain, or loss from sources without the 
United States which is specified in paragraph (b) of Sec.  1.864-5 and 
received by a nonresident alien individual or a foreign corporation 
engaged in a trade or business in the United States at some time during 
a taxable year beginning after December 31, 1966, shall be treated as 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States only if the income, gain, or loss is 
attributable under paragraphs (b) and (c) of this section to an office 
or other fixed place of business, as defined in Sec.  1.864-7, which the 
taxpayer has in the United States at some time during the taxable year.
    (b) Material factor test--(1) In general. For purposes of paragraph 
(a) of this section, income, gain, or loss is attributable to an office 
or other fixed place of business which a nonresident alien individual or 
a foreign corporation has in the United States only if such office or 
other fixed place of business is a material factor in the realization of 
the income, gain, or loss, and if the income, gain, or loss is realized 
in the ordinary course of the trade or business carried on through that 
office or other fixed place of business. For this purpose, the 
activities of the office or other fixed place of business shall not be 
considered to be a material factor in the realization of the income, 
gain, or loss unless they provide a significant contribution to, by 
being an essential economic element in, the realization of the income, 
gain, or loss. Thus, for example, meetings in the United States of the 
board of directors of a foreign corporation do not of themselves 
constitute a material factor in the realization of income, gain, or 
loss. It is not necessary that the activities of the office or other 
fixed place of business in the United States be a major factor in the 
realization of the income, gain, or loss. An office or other fixed place 
of business located in the United States at some time during a taxable 
year may be a material factor in the realization of an item of income, 
gain, or loss for that year even though the office or other fixed place 
of business is not present in the United States when the income, gain, 
or loss is realized.
    (2) Application of material factor test to specific classes of 
income. For purposes of paragraph (a) of this section, an office or 
other fixed place of business which a nonresident alien individual or a 
foreign corporation, engaged in a trade or business in the United States 
at some time during the taxable year, had in the United States, shall be 
considered a material factor in the realization of income, gain, or loss 
consisting of--
    (i) Rents, royalties, or gains on sales of intangible property. 
Rents, royalties, or gains or losses, from intangible personal property 
specified in paragraph (b)(1) of Sec.  1.864-5, if the office or other 
fixed place of business either actively participates in soliciting, 
negotiating, or performing other activities required to arrange, the 
lease, license, sale, or exchange from which such income, gain, or loss 
is derived or performs significant services incident to such lease, 
license, sale, or exchange. An office or other fixed place of business 
in the United States shall not be considered to be a material factor in 
the realization of income, gain, or loss for purposes of this 
subdivision merely because the office or other fixed place of business 
conducts one or more of the following activities: (a) Develops, creates, 
produces, or acquires and adds substantial value to, the property which 
is leased, licensed, or sold, or exchanged, (b) collects or accounts for 
the rents, royalties, gains, or losses, (c) exercises general 
supervision over the activities of the persons directly responsible for 
carrying on the activities or services described in the immediately 
preceding sentence, (d) performs merely clerical functions incident to 
the lease, license, sale, or exchange or (e) exercises final approval 
over the execution of the lease, license, sale, or exchange. The 
application of this subdivision may be illustrated by the following 
examples:

    Example 1. F, a foreign corporation, is engaged in the active 
conduct of the business of licensing patents which it has either 
purchased or developed in the United States. F has a business office in 
the United States. Licenses for the use of such patents outside

[[Page 345]]

the United States are negotiated by offices of F located outside the 
United States, subject to approval by an officer of such corporation 
located in the U.S. office. All services which are rendered to F's 
foreign licensees are performed by employees of F's offices located 
outside the United States. None of the income, gain, or loss resulting 
from the foreign licenses so negotiated by F is attributable to its 
business office in the United States.
    Example 2. N, a foreign corporation, is engaged in the active 
conduct of the business of distributing motion picture films and 
television programs. N does not distribute such films or programs in the 
United States. The foreign distribution rights to these films and 
programs are acquired by N's U.S. business office from the U.S. owners 
of these films and programs. Employees of N's offices located in various 
foreign countries carry on in such countries all the solicitations and 
negotiations for the licensing of these films and programs to licensees 
located in such countries and provide the necessary incidental services 
to the licensees. N's U.S. office collects the rentals from the foreign 
licensees and maintains the necessary records of income and expense. 
Officers of N located in the United States also maintain general 
supervision over the employees of the foreign offices, but the foreign 
employees conduct the day to day business of N outside the United States 
of soliciting, negotiating, or performing other activities required to 
arrange the foreign licenses. None of the income, gain, or loss 
resulting from the foreign licenses so negotiated by N is attributable 
to N's U.S. office.

    (ii) Dividends or interest, or gains or losses from sales of stock 
or securities--(a) In general. Dividends or interest from any 
transaction, or gains or losses on the sale or exchange of stocks or 
securities, specified in paragraph (b)(2) of Sec.  1.864-5, if the 
office or other fixed place of business either actively participates in 
soliciting, negotiating, or performing other activities required to 
arrange, the issue, acquisition, sale, or exchange, of the asset from 
which such income, gain, or loss is derived or performs significant 
services incident to such issue, acquisition, sale, or exchange. An 
office or other fixed place of business in the United States shall not 
be considered to be a material factor in the realization of income, 
gain, or loss for purposes of this subdivision merely because the office 
or other fixed place of business conducts one or more of the following 
activities: (1) Collects or accounts for the dividends, interest, gains, 
or losses, (2) exercises general supervision over the activities of the 
persons directly responsible for carrying on the activities or services 
described in the immediately preceding sentence, (3) performs merely 
clerical functions incident to the issue, acquisition, sale, or 
exchange, or (4) exercises final approval over the execution of the 
issue, acquisition, sale, or exchange.
    (b) Effective connection of income from stocks or securities with 
active conduct of a banking, financing, or similar business. 
Notwithstanding (a) of this subdivision (ii), the determination as to 
whether any dividends or interest from stocks or securities, or gain or 
loss from the sale or exchange of stocks or securities which are capital 
assets, which is from sources without the United States and derived by a 
nonresident alien individual or a foreign corporation in the active 
conduct during the taxable year of a banking, financing, or similar 
business in the United States, shall be treated as effectively connected 
for such year with the active conduct of that business shall be made by 
applying the principles of paragraph (c)(5)(ii) of Sec.  1.864-4 for 
determining whether income, gain, or loss of such type from sources 
within the United States is effectively connected for such year with the 
active conduct of that business.
    (c) Security defined. For purposes of this subdivision (ii), a 
security is any bill, note, bond, debenture, or other evidence of 
indebtedness, or any evidence of an interest in, or right to subscribe 
or to purchase, any of the foregoing items.
    (d) Limitations on application of rules on banking, financing, or 
similar business--(1) Trading for taxpayer's own account. The provisions 
of (b) of this subdivision (ii) apply for purposes of determining when 
certain income, gain, or loss from stocks or securities is effectively 
connected with the active conduct of a banking, financing, or similar 
business in the United States. Any dividends, interest, gain, or loss 
from sources without the United States which by reason of the 
application of (b) of this subdivision (ii) is not effectively connected 
with the active conduct by a foreign corporation of a banking, 
financing, or similar business in the United States may be effectively

[[Page 346]]

connected for the taxable year, under (a) of this subdivision (ii), with 
the conduct by such taxpayer of a trade or business in the United States 
which consists of trading in stocks or securities for the taxpayer's own 
account.
    (2) Other income. For rules relating to dividends or interest from 
sources without the United States (other than dividends or interest 
from, or gain or loss from the sale or exchange of, stocks or securities 
referred to in (b) of this subdivision (ii)) derived in the active 
conduct of a banking, financing, or similar business in the United 
States, see (a) of this subdivision (ii).
    (iii) Sale of goods or merchandise through U.S. office. Income, 
gain, or loss from sales of goods or merchandise specified in paragraph 
(b)(3) of Sec.  1.864-5, if the office or other fixed place of business 
actively participates in soliciting the order, negotiating the contract 
of sale, or performing other significant services necessary for the 
consummation of the sale which are not the subject of a separate 
agreement between the seller and the buyer. The office or other fixed 
place of business in the United States shall be considered a material 
factor in the realization of income, gain, or loss from a sale made as a 
result of a sales order received in such office or other fixed place of 
business except where the sales order is received unsolicited and that 
office or other fixed place of business is not held out to potential 
customers as the place to which such sales orders should be sent. The 
income, gain, or loss must be realized in the ordinary course of the 
trade or business carried on through the office or other fixed place of 
business in the United States. Thus, if a foreign corporation is engaged 
solely in a manufacturing business in the United States, the income 
derived by its office in the United States as a result of an occasional 
sale outside the United States is not attributable to the U.S. office if 
the sales office of the manufacturing business is located outside the 
United States. On the other hand, if a foreign corporation establishes a 
sales office in the United States to sell for consumption in the Western 
Hemisphere merchandise which the corporation produces in Africa, the 
income derived by the sales office in the United States as a result of 
an occasional sale made by it in Europe shall be attributable to the 
U.S. sales office. An office or other fixed place of business in the 
United States shall not be considered to be a material factor in the 
realization of income, gain, or loss for purposes of this subdivision 
merely because of one or more of the following activities: (a) The sale 
is made subject to the final approval of such office or other fixed 
place of business, (b) the property sold is held in, and distributed 
from, such office or other fixed place of business, (c) samples of the 
property sold are displayed (but not otherwise promoted or sold) in such 
office or other fixed place of business, or (d) such office or other 
fixed place of business performs merely clerical functions incident to 
the sale. Activities carried on by employees of an office or other fixed 
place of business constitute activities of that office or other fixed 
place of business.
    (3) Limitation where foreign office is a material factor in 
realization of income--(i) Goods or merchandise destined for foreign 
use, consumption, or disposition. Notwithstanding subparagraphs (1) and 
(2) of this paragraph, an office or other fixed place of business which 
a nonresident alien individual or a foreign corporation has in the 
United States shall not be considered, for purposes of paragraph (a) of 
this section, to be a material factor in the realization of income, 
gain, or loss from sales of goods or merchandise specified in paragraph 
(b)(3) of Sec.  1.864-5 if the property is sold for use, consumption, or 
disposition outside the United States and an office or other fixed place 
of business, as defined in Sec.  1.864-7, which such nonresident alien 
individual or foreign corporation has outside the United States 
participates materially in the sale. For this purpose an office or other 
fixed place of business which the taxpayer has outside the United States 
shall be considered to have participated materially in a sale made 
through the office or other fixed place of business in the United States 
if the office or other fixed place of business outside the United States 
actively participates in soliciting the order resulting in the sale, 
negotiating the contract of sale,

[[Page 347]]

or performing other significant services necessary for the consummation 
of the sale which are not the subject of a separate agreement between 
the seller and buyer. An office or other fixed place of business which 
the taxpayer has outside the United States shall not be considered to 
have participated materially in a sale merely because of one or more of 
the following activities: (a) The sale is made subject to the final 
approval of such office or other fixed place of business, (b) the 
property sold is held in, and distributed from, such office or other 
fixed place of business, (c) samples of the property sold are displayed 
(but not otherwise promoted or sold) in such office or other fixed place 
of business, (d) such office or other fixed place of business is used 
for purposes of having title to the property pass outside the United 
States, or (e) such office or other fixed place of business performs 
merely clerical functions incident to the sale.
    (ii) Rules for determining country of use, consumption, or 
disposition--(a) In general. As a general rule, personal property which 
is sold to an unrelated person shall 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 
property shall not cause that country to be considered the country of 
destination. However, if at the time of a sale of personal property to 
an unrelated person the taxpayer 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 taxpayer must determine the country of ultimate use, 
consumption, or disposition of the property or the property shall be 
presumed to have been sold for use, consumption, or disposition in the 
United States. A taxpayer who sells personal property to a related 
person shall be presumed to have sold the property for use, consumption, 
or disposition in the United States unless the taxpayer establishes the 
use made of the property by the related person; once he has established 
that the related person has disposed of the property, the rules in the 
two immediately preceding sentences relating to sales to an unrelated 
person shall 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), a 
taxpayer who sells personal property to any person whose principal 
business consists of selling from inventory to retail customers at 
retail outlets outside the United States may assume at the time of the 
sale to that person that the property will be used, consumed, or 
disposed of outside the United States. For purposes of this (a), a 
person is related to another person if either person owns or controls 
directly or indirectly the other, or if any third person or persons own 
or control directly or indirectly both. For this purpose, the term 
``control'' includes any kind of control, whether or not legally 
enforceable, and however, exercised or exercisable. For illustrations of 
the principles of this subdivision, see paragraph (a)(3)(iv) of Sec.  
1.954-3.
    (b) Fungible goods. For purposes of this subparagraph, a taxpayer 
who sells to a purchaser personal property which because of its fungible 
nature cannot reasonably be specifically traced to other purchasers and 
to the countries of ultimate use, consumption, or disposition shall, 
unless the taxpayer establishes a different disposition as being proper, 
treat that 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 ordinary course of business by such first 
purchaser. No apportionment is required to be made, however, on the 
basis of sporadic sales by the first purchaser. This (b) shall apply 
only in a case where the taxpayer knew, or should have known from the 
facts and circumstances surrounding the transaction, the manner in which 
the first purchaser disposes of property from the fungible mass.
    (iii) Illustration. The application of this subparagraph may be 
illustrated by the following example:


[[Page 348]]


    Example. Foreign corporation M has a sales office in the United 
States during the taxable year through which it sells outside the United 
States for use in foreign countries industrial electrical generators 
which such corporation manufactures in a foreign country. M is not a 
controlled foreign corporation within the meaning of section 957 and the 
regulations thereunder, and, by reason of its activities in the United 
States, is engaged in business in the United States during the taxable 
year. The generators require specialized installation and continuous 
adjustment and maintenance services. M has an office in foreign country 
X which is the only organization qualified to perform these 
installation, adjustment, and maintenance services. During the taxable 
year M sells several generators through its U.S. office for use in 
foreign country Y under sales contracts which also provide for 
installation, adjustment, and maintenance by its office in country X. 
The generators are installed in country Y by employees of M's office in 
country X, who also are responsible for the servicing of the equipment. 
Since the office of M in country X performs significant services 
incident to these sales which are necessary for their consummation and 
are not the subject of a separate agreement between M and the purchaser, 
the U.S. office of M is not considered to be a material factor in the 
realization of the income from the sales and, for purposes of paragraph 
(a) of this section, such income is not attributable to the U.S. office 
of that corporation.

    (c) Amount of income, gain, or loss allocable to U.S. office--(1) In 
general. If, in accordance with paragraph (b) of this section, an office 
or other fixed place of business which a nonresident alien individual or 
a foreign corporation has in the United States at some time during the 
taxable year is a material factor in the realization for that year of an 
item of income, gain, or loss specified in paragraph (b) of Sec.  1.864-
5, such item of income, gain, or loss shall be considered to be 
allocable in its entirety to that office or other fixed place of 
business. In no case may any income, gain, or loss for the taxable year 
from sources without the United States, or part thereof, be allocable 
under this paragraph to an office or other fixed place of business which 
a nonresident alien individual or a foreign corporation has in the 
United States if the taxpayer is at no time during the taxable year 
engaged in a trade or business in the United States.
    (2) Special limitation in case of sales of goods or merchandise 
through U.S. office. Notwithstanding subparagraph (1) of this paragraph, 
in the case of a sale of goods or merchandise specified in paragraph 
(b)(3) of Sec.  1.864-5, which is not a sale to which paragraph 
(b)(3)(i) of this section applies, the amount of income which shall be 
considered to be allocable to the office or other fixed place of 
business which the nonresident alien individual or foreign corporation 
has in the United States shall not exceed the amount which would be 
treated as income from sources within the United States if the taxpayer 
had sold the goods or merchandise in the United States. See, for 
example, section 863(b)(2) and paragraph (b) of Sec.  1.863-3, which 
prescribes, as available methods for determining the income from sources 
within the United States, the independent factory or production price 
method, the gross sales and property apportionment method, and any other 
method regularly employed by the taxpayer which more clearly reflects 
taxable income from such sources than those specifically authorized.
    (3) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. Foreign corporation M, which is not a controlled foreign 
corporation within the meaning of section 957 and the regulations 
thereunder, manufactures machinery in a foreign country and sells the 
machinery outside the United States through its sales office in the 
United States for use in foreign countries. Title to the property which 
is sold is transferred to the foreign purchaser outside the United 
States, but no office or other fixed place of business of M in a foreign 
country participates materially in the sale made through its U.S. 
office. During the taxable year M derives a total taxable income 
(determined as though M were a domestic corporation) of $250,000 from 
these sales. If the sales made through the U.S. office for the taxable 
year had been made in the United States and the property had been sold 
for use in the United States, the taxable income from sources within the 
United States from such sales would have been $100,000, determined as 
provided in section 863 and 882(c) and the regulations thereunder. The 
taxable income which is allocable to M's U.S. sales office pursuant to 
this paragraph and which is effectively connected for the taxable year 
with the conduct of a trade or business within the United States by that 
corporation is $100,000.

[[Page 349]]

    Example 2. Foreign corporation N, which is not a controlled foreign 
corporation within the meaning of section 957 and the regulations 
thereunder, has an office in a foreign country which purchases 
merchandise and sells it through its sales office in the United States 
for use in various foreign countries, such sales being made outside the 
United States and title to the property passing outside the United 
States. No other office of N participates materially in these sales made 
through its U.S. office. By reason of its sales activities in the United 
States, N is engaged in business in the United States during the taxable 
year. During the taxable year N derives taxable income (determined as 
though N were a domestic corporation) of $300,000 from these sales made 
through its U.S. sales office. If the sales made through the U.S. office 
for the taxable year had been made in the United States and the property 
had been sold for use in the United States, the taxable income from 
sources within the United States from such sales would also have been 
$300,000, determined as provided in sections 861 and 882(c) and the 
regulations thereunder. The taxable income which is allocable to N's 
U.S. sales office pursuant to this paragraph and which is effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by that corporation is $300,000.
    Example 3. The facts are the same as in example 2, except that N has 
an office in a foreign country which participates materially in the 
sales which are made through its U.S. office. The taxable income which 
is allocable to N's U.S. sales office is not effectively connected for 
the taxable year with the conduct of a trade or business in the United 
States by that corporation.

[T.D. 7216, 37 FR 23431, Nov. 3, 1972]



Sec.  1.864-7  Definition of office or other fixed place of business.

    (a) In general. (1) This section applies for purposes of determining 
whether a nonresident alien individual or a foreign corporation that is 
engaged in a trade or business in the United States at some time during 
a taxable year beginning after December 31, 1966, has an office or other 
fixed place of business in the United States for purposes of applying 
section 864(c)(4)(B) and Sec.  1.864-6 to income, gain, or loss 
specified in paragraph (b) of Sec.  1.864-5 from sources without the 
United States or has an office or other fixed place of business outside 
the United States for purposes of applying section 864(c)(4)(B)(iii) and 
paragraph (b)(3)(i) of Sec.  1.864-6 to sales of goods or merchandise 
for use, consumption, or disposition outside the United States.
    (2) In making a determination under this section due regard shall be 
given to the facts and circumstances of each case, particularly to the 
nature of the taxpayer's trade or business and the physical facilities 
actually required by the taxpayer in the ordinary course of the conduct 
of his trade or business.
    (3) The law of a foreign country shall not be controlling in 
determining whether a nonresident alien individual or a foreign 
corporation has an office or other fixed place of business.
    (b) Fixed facilities--(1) In general. As a general rule, an office 
or other fixed place of business is a fixed facility, that is, a place, 
site, structure, or other similar facility, through which a nonresident 
alien individual or a foreign corporation engages in a trade or 
business. For this purpose an office or other fixed place of business 
shall include, but shall not be limited to, a factory; a store or other 
sales outlet; a workshop; or a mine, quarry, or other place of 
extraction of natural resources. A fixed facility may be considered an 
office or other fixed place of business whether or not the facility is 
continuously used by a nonresident alien individual or foreign 
corporation.
    (2) Use of another person's office or other fixed place of business. 
A nonresident alien individual or a foreign corporation shall not be 
considered to have an office or other fixed place of business merely 
because such alien individual or foreign corporation uses another 
person's office or other fixed place of business, whether or not the 
office or place of business of a related person, through which to 
transact a trade or business, if the trade or business activities of the 
alien individual or foreign corporation in that office or other fixed 
place of business are relatively sporadic or infrequent, taking into 
account the overall needs and conduct of that trade or business.
    (c) Management activity. A foreign corporation shall not be 
considered to have an office or other fixed place of business merely 
because a person controlling that corporation has an office or other 
fixed place of business from which general supervision and control

[[Page 350]]

over the policies of the foreign corporation are exercised. The fact 
that top management decisions affecting the foreign corporation are made 
in a country shall not of itself mean that the foreign corporation has 
an office or other fixed place of business in that country. For example, 
a foreign sales corporation which is a wholly owned subsidiary of a 
domestic corporation shall not be considered to have an office or other 
fixed place of business in the United States merely because of the 
presence in the United States of officers of the domestic parent 
corporation who are generally responsible only for the policy decisions 
affecting the foreign sales corporation, provided that the foreign 
corporation has a chief executive officer, whether or not he is also an 
officer of the domestic parent corporation, who conducts the day-to-day 
trade or business of the foreign corporation from a foreign office. The 
result in this example would be the same even if the executive officer 
should (1) regularly confer with the officers of the domestic parent 
corporation, (2) occasionally visit the U.S. office of the domestic 
parent corporation, and (3) during such visits to the United States 
temporarily conduct the business of the foreign subsidiary corporation 
out of the domestic parent corporation's office in the United States.
    (d) Agent activity--(1) Dependent agents--(i) In general. In 
determining whether a nonresident alien individual or a foreign 
corporation has an office or other fixed place of business, the office 
or other fixed place of business of an agent who is not an independent 
agent, as defined in subparagraph (3) of this paragraph, shall be 
disregarded unless such agent (a) has the authority to negotiate and 
conclude contracts in the name of the nonresident alien individual or 
foreign corporation, and regularly exercises that authority, or (b) has 
a stock of merchandise belonging to the nonresident alien individual or 
foreign corporation from which orders are regularly filed on behalf of 
such alien individual or foreign corporation. A person who purchases 
goods from a nonresident alien individual or a foreign corporation shall 
not be considered to be an agent for such alien individual or foreign 
corporation for purposes of this paragraph where such person is carrying 
on such purchasing activities in the ordinary course of its own 
business, even though such person is related in some manner to the 
nonresident alien individual or foreign corporation. For example, a 
wholly owned domestic subsidiary corporation of a foreign corporation 
shall not be treated as an agent of the foreign parent corporation 
merely because the subsidiary corporation purchases goods from the 
foreign parent corporation and resells them in its own name. However, if 
the domestic subsidiary corporation regularly negotiates and concludes 
contracts in the name of its foreign parent corporation or maintains a 
stock of merchandise from which it regularly fills orders on behalf of 
the foreign parent corporation, the office or other fixed place of 
business of the domestic subsidiary corporation shall be treated as the 
office or other fixed place of business of the foreign parent 
corporation unless the domestic subsidiary corporation is an independent 
agent within the meaning of subparagraph (3) of this paragraph.
    (ii) Authority to conclude contracts or fill orders. For purposes of 
subdivision (i) of this subparagraph, an agent shall be considered 
regularly to exercise authority to negotiate and conclude contracts or 
regularly to fill orders on behalf of his foreign principal only if the 
authority is exercised, or the orders are filled, with some frequency 
over a continuous period of time. This determination shall be made on 
the basis of the facts and circumstances in each case, taking into 
account the nature of the business of the principal; but, in all cases, 
the frequency and continuity tests are to be applied conjunctively. 
Regularity shall not be evidenced by occasional or incidental activity. 
An agent shall not be considered regularly to negotiate and conclude 
contracts on behalf of his foreign principal if the agent's authority to 
negotiate and conclude contracts is limited only to unusual cases or 
such authority must be separately secured by the agent from his 
principal with respect to each transaction effected.

[[Page 351]]

    (2) Independent agents. The office or other fixed place of business 
of an independent agent, as defined in subparagraph (3) of this 
paragraph, shall not be treated as the office or other fixed place of 
business of his principal who is a nonresident alien individual or a 
foreign corporation, irrespective of whether such agent has authority to 
negotiate and conclude contracts in the name of his principal, and 
regularly exercises that authority, or maintains a stock of goods from 
which he regularly fills orders on behalf of his principal.
    (3) Definition of independent agent--(i) In general. For purposes of 
this paragraph, the term ``independent agent'' means a general 
commission agent, broker, or other agent of an independent status acting 
in the ordinary course of his business in that capacity. Thus, for 
example, an agent who, in pursuance of his usual trade or business, and 
for compensation, sells goods or merchandise consigned or entrusted to 
his possession, management, and control for that purpose by or for the 
owner of such goods or merchandise is an independent agent.
    (ii) Related persons. The determination of whether an agent is an 
independent agent for purposes of this paragraph shall be made without 
regard to facts indicating that either the agent or the principal owns 
or controls directly or indirectly the other or that a third person or 
persons own or control directly or indirectly both. For example, a 
wholly owned domestic subsidiary corporation of a foreign corporation 
which acts as an agent for the foreign parent corporation may be treated 
as acting in the capacity of independent agent for the foreign parent 
corporation. The facts and circumstances of a specific case shall 
determine whether the agent, while acting for his principal, is acting 
in pursuance of his usual trade or business and in such manner as to 
constitute him an independent agent in his relations with the 
nonresident alien individual or foreign corporation.
    (iii) Exclusive agents. Where an agent who is otherwise an 
independent agent within the meaning of subdivision (i) of this 
subparagraph acts in such capacity exclusively, or almost exclusively, 
for one principal who is a nonresident alien individual or a foreign 
corporation, the facts and circumstances of a particular case shall be 
taken into account in determining whether the agent, while acting in 
that capacity, may be classified as an independent agent.
    (e) Employee activity. Ordinarily, an employee of a nonresident 
alien individual or a foreign corporation shall be treated as a 
dependent agent to whom the rules of paragraph (d)(1) of this section 
apply if such employer does not in and of itself have a fixed facility 
(as defined in paragraph (b) of this section) in the United States or 
outside the United States, as the case may be. However, where the 
employee, in the ordinary course of his duties, carries on the trade or 
business of his employer in or through a fixed facility of such employer 
which is regularly used by the employee in the course of carrying out 
such duties, such fixed facility shall be considered the office or other 
fixed place of business of the employer, irrespective of the rules of 
paragraph (d)(1) of this section. The application of this paragraph may 
be illustrated by the following example:

    Example. M, a foreign corporation, opens a showroom office in the 
United States for the purpose of promoting its sales of merchandise 
which it purchases in foreign country X. The employees of the U.S. 
office, consisting of salesmen and general clerks, are empowered only to 
run the office, to arrange for the appointment of distributing agents 
for the merchandise offered by M, and to solicit orders generally. These 
employees do not have the authority to negotiate and conclude contracts 
in the name of M, nor do they have a stock of merchandise from which to 
fill orders on behalf of M. Any negotiations entered into by these 
employees are under M's instructions and subject to its approval as to 
any decision reached. The only independent authority which the employees 
have is in the appointment of distributors to whom M is to sell 
merchandise, but even this authority is subject to the right of M to 
approve or disapprove these buyers on receipt of information as to their 
business standing. Under the circumstances, this office used by a group 
of salesmen for sales promotion is a fixed place of business which M has 
in the United States.

    (f) Office or other fixed place of business of a related person. The 
fact that a nonresident alien individual or a foreign corporation is 
related in some

[[Page 352]]

manner to another person who has an office or other fixed place of 
business shall not of itself mean that such office or other fixed place 
of business of the other person is the office or other fixed place of 
business of the nonresident alien individual or foreign corporation. 
Thus, for example, the U.S. office of foreign corporation M, a wholly 
owned subsidiary corporation of foreign corporation N, shall not be 
considered the office or other fixed place of business of N unless the 
facts and circumstances show that N is engaged in trade or business in 
the United States through that office or other fixed place of business. 
However, see paragraph (b)(2) of this section.
    (g) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. S, a foreign corporation, is engaged in the business of 
buying and selling tangible personal property. S is a wholly owned 
subsidiary of P, a domestic corporation engaged in the business of 
buying and selling similar property, which has an office in the United 
States. Officers of P are generally responsible for the policies 
followed by S and are directors of S, but S has an independent group of 
officers, none of whom are regularly employed in the United States. In 
addition to this group of officers, S has a chief executive officer, D, 
who is also an officer of P but who is permanently stationed outside the 
United States. The day-to-day conduct of S's business is handled by D 
and the other officers of such corporation, but they regularly confer 
with the officers of P and on occasion temporarily visit P's offices in 
the United States, at which time they continue to conduct the business 
of S. S does not have an office or other fixed place of business in the 
United States for purposes of this section.
    Example 2. The facts are the same as in example 1 except that, on 
rare occasions, an employee of P receives an order which he, after 
consultation with officials of S and because P cannot fill the order, 
accepts on behalf of S rather than on behalf of P. P does not hold 
itself out as a person which those wishing to do business with S should 
contact. Assuming that orders for S are seldom handled in this manner 
and that they do not constitute a significant part of that corporation's 
business, S shall not be considered to have an office or other fixed 
place of business in the United States because of these activities of an 
employee of P.
    Example 3. The facts are the same as in example 1 except that all 
orders received by S are subject to review by an officer of P before 
acceptance. S has a business office in the United States.
    Example 4. S, a foreign corporation organized under the laws of 
Puerto Rico, is engaged in the business of manufacturing dresses in 
Puerto Rico and is entitled to an income tax exemption under the Puerto 
Rico Industrial Incentive Act of 1963. S is a wholly owned subsidiary of 
P, a domestic corporation engaged in the business of buying and selling 
dresses to customers in the United States. S sells most of the dresses 
it produces to P, the assumption being made that the income from these 
sales is derived from sources without the United States. P in turn sells 
these dresses in the United States in its name and through the efforts 
of its own employees and of distributors appointed by it. S does not 
have a fixed facility in the United States, and none of its employees 
are stationed in the United States. On occasion, employees of S visit 
the office of P in the United States, and executives of P visit the 
office of S in Puerto Rico, to discuss with one another matters of 
mutual business interest involving both corporations, including the 
strategy for marketing the dresses produced by S. These matters are also 
regularly discussed by such persons by telephone calls between the 
United States and Puerto Rico. S's employees do not otherwise 
participate in P's marketing activities. Officers of P are generally 
responsible for the policies followed by S and are directors of S, but S 
has a chief executive officer in Puerto Rico who, from its office 
therein, handles the day-to-day conduct of S's business. Based upon the 
facts presented, and assuming there are no other facts which would lead 
to a different determination, S shall not be considered to have an 
office or other fixed place of business in the United States for 
purposes of this section.
    Example 5. The facts are the same as in example 4 except that the 
dresses are manufactured by S in styles and designs furnished by P and 
out of goods and raw materials purchased by P and sold to S. Based upon 
the facts presented, and assuming there are no other facts which would 
lead to a different determination, S shall not be considered to have an 
office or other fixed place of business in the United States for 
purposes of this section.
    Example 6. The facts are the same as in example 5 except that, 
pursuant to the instructions of P, the dresses sold by P are shipped by 
S directly to P's customers in the United States. Based upon the facts 
presented, and assuming there are no other facts which would lead to a 
different determination, S shall not be considered to have an office or 
other fixed place of business in the United States for purposes of this 
section.

[T.D. 7216, 37 FR 23433, Nov. 3, 1972]

[[Page 353]]



Sec.  1.864-8T  Treatment of related person factoring income (temporary).

    (a) Applicability--(1) General rule. This section applies for 
purposes of determining the treatment of income derived by a person from 
a trade or service receivable acquired from a related person. Except as 
provided in paragraph (d) of this section, if a person acquires 
(directly or indirectly) a trade or service receivable from a related 
person, any income (including any stated interest, discount or service 
fee) derived from the trade or service receivable shall be treated as if 
it were interest received on a loan to the obligor under the receivable. 
The characterization of income as interest pursuant to this section 
shall apply only for purposes of sections 551-558 (relating to foreign 
personal holding companies), sections 951-964 (relating to controlled 
foreign corporations), and section 904 (relating to the limitation on 
the foreign tax credit) of the Code and the regulations thereunder. The 
principles of sections 861 through 863 and the regulations thereunder 
shall be applied to determine the source of such interest income for 
purposes of section 904.
    (2) Override. With respect to income characterized as interest under 
this section, the special rules of section 864(d) and this section 
override any conflicting provisions of the Code and regulations relating 
to foreign personal holding companies, controlled foreign corporations, 
and the foreign tax credit limitation. Thus, for example, pursuant to 
section 864(d)(5) and paragraph (e) of this section, stated interest 
derived from a factored trade or service receivable is not eligible for 
the subpart F de minimis rule of section 954(b)(3), the same country 
exception of section 954(c)(3)(A)(i), or the special rules for export 
financing interest of sections 904(d)(2) and 954(c)(2)(B), even if in 
the absence of this section the treatment of such stated interest would 
be governed by those sections.
    (3) Limitation. Section 864(d) and this section apply only with 
respect to the tax treatment of income derived from a trade or service 
receivable acquired from a related person. Therefore, neither section 
864(d) nor this section affects the characterization of an expense or 
loss of either the seller of a receivable or the obligor under a 
receivable. Accordingly, the obligor under a trade or service receivable 
shall not be allowed to treat any part of the purchase price of property 
or services as interest (other than amounts treated as interest under 
provisions other than section 864(d)).
    (b) Definitions. The following definitions apply for purposes of 
this section and Sec.  1.956-3T.
    (1) Trade or service receivable. The term ``trade or service 
receivable'' means any account receivable or evidence of indebtedness, 
whether or not issued at a discount and whether or not bearing stated 
interest, arising out of the disposition by a related person of property 
described in section 1221(l) (hereinafter referred to as ``inventory 
property'') or the performance of services by a related person.
    (2) Related person. A ``related person'' is:
    (i) A person who is a related person within the meaning of section 
267(b) and the regulations thereunder;
    (ii) A United States shareholder (as defined in section 951(b)); or
    (iii) A person who is related (within the meaning of section 267(b) 
and the regulations thereunder) to a United States shareholder.
    (c) Acquisition of a trade or service receivable--(1) General rule. 
A trade or service receivable is considered to be acquired by a person 
at the time when that person is entitled to receive all or a portion of 
the income from the trade or service receivable. A person who acquires a 
trade or service receivable (hereinafter referred to as the ``factor'') 
is considered to have acquired a trade or service receivable regardless 
of whether:
    (i) The acquisition is characterized for federal income tax purposes 
as a sale, a pledge of collateral for a loan, an assignment, a capital 
contribution, or otherwise;
    (ii) The factor takes title to or obtains physical possession of the 
trade or service receivable;
    (iii) The related person assigns the trade or service receivable 
with or without recourse:
    (iv) The factor or some other person is obligated to collect the 
payments

[[Page 354]]

due under the trade or service receivable;
    (v) The factor is liable for all property, excise, sales, or similar 
taxes due upon collection of the receivable;
    (vi) The factor advances the entire face amount of the trade or 
service receivable transferred;
    (vii) All trade or service receivables assigned by the related 
person are assigned to one factor; and
    (viii) The obligor under the trade or service receivable is notified 
of the assignment.
    (2) Example. The following example illustrates the application of 
paragraphs (a), (b), and (c)(1) of this section.

    Example. P, a domestic corporation, owns all of the outstanding 
stock of FS, a controlled foreign corporation. P manufactures and sells 
paper products to customers, including X, an unrelated domestic 
corporation. As part of a sales transaction, P takes back a trade 
receivable from X and sells the receivable to FS. Because FS has 
acquired a trade or service receivable from a related person, the income 
derived by FS from P's receivable is interest income described in 
paragraph (a)(1) of this section.

    (3) 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 factor. The following example illustrates the application 
of this paragraph (c)(3)(i).

    Example. A, a United States citizen, owns all of the outstanding 
stock of FPHC, a foreign personal holding company. A performs 
engineering services within and without the United States for customers, 
including X, an unrelated corporation. A performs engineering services 
for X and takes back a service receivable. A sells the receivable to Y, 
an unrelated corporation engaged in the factoring business. Y resells 
the receivable to FPHC. Because FPHC has indirectly acquired a service 
receivable from a related person, the income derived by FPHC from A's 
receivable is interest income described in paragraph (a)(1) of this 
section.

    (ii) Acquisition by nominee or pass-through entity. A factor will be 
considered to have acquired a trade or service receivable held on its 
behalf by a nominee or by a partnership, simple trust, S corporation or 
other pass-through entity to the extent the factor owns (directly or 
indirectly) a beneficial interest in such partnership or other pass-
through entity. The rule of this paragraph (c)(3)(ii) does not limit the 
application of paragraph (c)(3)(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 
example illustrates the application of this paragraph (c)(3)(ii).

    Example. FS1, a controlled foreign corporation, acquires a 20 
percent limited partnership interest in PS, a partnership. PS purchases 
trade or service receivables resulting from the sale of inventory 
property by FS1's domestic parent, P. PS does not purchase receivables 
of any person who is related to any other partner in PS. FS1 is 
considered to have acquired a 20 percent interest in the receivables 
acquired by PS. Thus, FS1's distributive share of the income derived by 
PS from the receivables of P is considered to be interest income 
described in paragraph (a)(1) of this section.

    (iii) Swap or pooling arrangements. A trade or service receivable of 
a person unrelated to the factor will be considered to be a trade or 
service receivable acquired from a related 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 persons who are 
also parties to the arrangement, in exchange for reciprocal purchases of 
the first group's receivables. The following example illustrates the 
application of this paragraph (c)(3)(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, except that neither A, B, C nor D 
acquires receivables of its own parent corporation. Because the effect 
of this arrangement is that the unrelated groups acquire each other's 
trade or service receivables pursuant to the arrangement, income derived 
by A, B, C, and D from the receivables acquired from M, N, O, and P

[[Page 355]]

is interest income described in paragraph (a)(1) of this section.

    (iv) Financing arrangements. If a controlled foreign corporation (as 
defined in section 957(a)) participates (directly or indirectly) in a 
lending transaction that results in a loan to the purchaser of inventory 
property, services, or trade or service receivables of a related person 
(or a loan to a person who is related to the 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, 
and income derived by the controlled foreign corporation from such a 
loan shall be considered to be income described in paragraph (a)(1) of 
this section. For purposes of this paragraph (c)(3)(iv), it is 
immaterial that the sums lent are not, in fact, the sums used to finance 
the purchase of a related person's inventory property, services, or 
trade or service receivables. The amount of income derived by the 
controlled foreign corporation to be taken into account shall be the 
total amount of income derived from a lending transaction described in 
this paragraph (c)(3)(iv), if the amount lent is less than or equal to 
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 proportion of the interest charge 
(including original issue discount) that the purchase price bears to the 
total amount lent pursuant to the lending transaction. The following 
examples illustrate the application of this paragraph (c)(3)(iv).

    Example 1. P, a domestic corporation, owns all of the outstanding 
stock of FS1, a controlled foreign corporation engaged in the financing 
business in Country X. P manufactures and sells toys, including sales to 
C, an unrelated corporation. Prior to P's sale of toys to C for $2,000, 
D, a wholly-owned Country X subsidiary of C, borrows $3,000 from FS1. 
The loan from FS1 to D would not have been made or maintained on the 
same terms but for C's purchase of toys from P. Two-thirds of the income 
derived by FS1 from the loan to D is interest income described in 
paragraph (a)(1) of this section.
    Example 2. P, a domestic corporation, owns all of the outstanding 
stock of FS1, a controlled foreign corporation organized under the laws 
of Country X. FS1 has accumulated cash reserves. P has uncollected trade 
and service receivables of foreign obligors. FS1 makes a $1,000 loan to 
U, a foreign corporation that is unrelated to P or FS1. U purchases P's 
trade and service receivables for $2,000. The loan would not have been 
made or maintained on the same terms but for U's purchase of P's 
receivables. The income derived by U from the receivables is not 
interest income within the meaning of paragraph (a) of this section. 
However, the interest paid by U to FS1 is interest income described in 
paragraph (a)(1) of this section.
    Example 3. The facts are the same as in Example (2), except that U 
is a wholly-owned Country Y subsidiary of FS1. Because U is related to P 
within the meaning of paragraph (b)(2) of this section, under paragraph 
(c)(1) of this section, income derived by U from P's receivables is 
interest income described in paragraph (a)(1) of this section. In 
addition, the income derived by FS1 from the loan to U is interest 
income described in paragraph (a)(1) of this section.

    (d) Same country exception--(1) Income from trade or service 
receivables. Income derived from a trade or service receivable acquired 
from a related person shall not be treated as interest income described 
in paragraph (a)(1) of this section if:
    (i) The person acquiring the trade or service receivable and the 
related person are created or organized under the laws of the same 
foreign country;
    (ii) The related person has a substantial part of its assets used in 
its trade or business located in such foreign country; and
    (iii) The related person would not have derived foreign base company 
income, as defined in section 954(a) and the regulations thereunder, or 
income effectively connected with a United States trade or business from 
such receivable if the related person had collected the receivable.


For purposes of paragraph (d)(1)(ii) of this section, the standards 
contained in Sec.  1.954-2(e) shall apply in determining the location of 
a substantial part of the assets of a related person. For purposes of 
paragraph (d)(1)(iii) of this section, a determination of whether the 
related person would have derived foreign base company income shall be 
made without regard to the de minimis test described

[[Page 356]]

in section 954(b)(3)(A). The following examples illustrate the 
application of this paragraph (d)(1).

    Example 1. FS1, a controlled foreign corporation incorporated under 
the laws of Country X, owns all of the outstanding stock of FS2, which 
is also incorporated under the laws of Country X. FS1 has a substantial 
part of its assets used in its business in Country X. FS1 manufactures 
and sells toys for use in Country Y. The toys sold are considered to be 
manufactured in Country X under Sec.  1.954-3(a)(2). FS1 is not 
considered to have a branch or similar establishment in Country Y that 
is treated as a separate corporation under section 954(d)(2) and Sec.  
1.954-3(b). Thus, gross income derived by FS1 from the toy sales is not 
foreign base company sales income. FS1 takes back receivables without 
stated interest from its customers. FS1 assigns those receivables to 
FS2. The income derived by FS2 from the receivables of FS1 is not 
interest income described in paragraph (a)(1) of this section, because 
it satisfies the same country exception under paragraph (d)(1) of this 
section.
    Example 2. The facts are the same as in Example 1, except that the 
toys sold by FS1 are purchased from FS1's U.S. parent and are sold for 
use outside of Country X. Thus, any income derived by FS1 from the sale 
of the toys would be foreign base company sales income. Therefore, 
income derived by FS2 from the receivables of FS1 is interest income 
described in paragraph (a)(1) of this section. FS2 is considered to 
derive interest income from the receivable even if, solely by reason of 
the de minimis rule of section 954(b)(3)(A), FS1 would not have derived 
foreign base company income if FS1 had collected the receivable.

    (2) Income from financing arrangements. Income derived by a 
controlled foreign corporation from a loan to a person that purchases 
inventory property or services of a person that is related to the 
controlled foreign corporation, or from other loans described in 
paragraph (c)(3)(iv) of this section, shall not be treated as interest 
income described in paragraph (a)(1) of this section if:
    (i) The person providing the financing and the related person are 
created or organized under the laws of the same foreign country;
    (ii) The related person has a substantial part of its assets used in 
its trade or business located in such foreign country; and
    (iii) The related person would not have derived foreign base company 
income or income effectively connected with a United States trade or 
business:
    (A) From the sale of inventory property or services to the borrower 
or from financing the borrower's purchase of inventory property or 
services, in the case of a loan to the purchaser of inventory property 
or services of a related person; or
    (B) From collecting amounts due under the receivable or from 
financing the purchase of the receivable, in the case of a loan to the 
purchaser of a trade or service receivable of a related person.


For purposes of paragraph (d)(2)(ii) of this section, the standards 
contained in Sec.  1.954-2(e) shall apply in determining the location of 
a substantial part of the assets of a related person. For purposes of 
paragraph (d)(2)(iii) of this section, a determination of whether the 
related person would have derived foreign base company income shall be 
made without regard to the de minimis test described in section 
954(b)(3)(A). The following examples illustrate the application of this 
paragraph (d)(2).

    Example 1. FS1, a controlled foreign corporation incorporated under 
the laws of Country X, owns all of the outstanding stock of FS2, which 
is also incorporated under the laws of Country X. FS1, which has a 
substantial part of its assets used in its business located in Country 
X, manufactures and sells toys for use in Country Y. The toys sold are 
considered to be manufactured in Country X under Sec.  1.954-3(a)(2). 
FS1 is not considered to have a branch or similar establishment in 
Country Y that is treated as a separate corporation under section 
954(d)(2) and Sec.  1.954-3(b). Thus, the gross income derived by FS1 
from the toy sales is not foreign base company sales income. FS2 makes a 
loan to FS3, a wholly-owned subsidiary of FS1 which is also incorporated 
under the laws of Country X, in connection with FS3's purchase of toys 
from FS1. FS3 does not earn any subpart F gross income. Thus, FS1 would 
not have derived foreign personal holding company interest income if FS1 
had made the loan to FS3, because the interest would be covered by the 
same country exception of section 954(c)(3). Therefore, the income 
derived by FS2 from its loan to FS3 is not treated as interest income 
described in paragraph (a)(1) of this section, because it satisfies the 
same country exception under paragraph (d)(2) of this section. Such 
income is also not treated as foreign personal holding company income 
described in section 954(c)(1)(A) because the same country exception of 
section 954(c)(3)

[[Page 357]]

also applies to the interest actually derived by FS2 from its loan to 
FS3.
    Example 2. FS1, a controlled foreign corporation incorporated under 
the laws of Country X, owns all of the outstanding stock of FS2, which 
is also incorporated under the laws of Country X. FS1 purchases toys 
from its U.S. parent and resells them for use outside of Country X. As 
part of a sales transaction, FS1 takes back trade receivables. FS2 makes 
a loan to U, an unrelated corporation, to finance U's purchase of FS1's 
trade receivables. Because FS1 would have derived foreign base company 
income if FS1 had collected the receivables or made the loan itself, the 
same country exception of paragraph (d)(2) of this section does not 
apply. Accordingly, under paragraph (c)(3)(iv) of this section, the 
income derived by FS2 from its loan to U is treated as interest income 
described in paragraph (a)(1) of this section.

    (e) Special rules--(1) Foreign personal holding companies and 
controlled foreign corporations. For purposes of sections 551-558 
(relating to foreign personal holding companies), the exclusion provided 
by section 552(c) for interest described in section 954(c)(3)(A) shall 
not apply to income described in paragraph (a)(1) of this section. For 
purposes of the sections 951-964 (relating to controlled foreign 
corporations), income described in paragraph (a)(1) of this section 
shall be included in a United States shareholder's pro rata share of a 
controlled foreign corporation's subpart F income without regard to the 
de minimis rule under section 954(b)(3)(A). However, income described in 
paragraph (a)(1) of this section shall be included in the computation of 
a controlled foreign corporation's foreign base company income for 
purposes of applying the de minimis rule under section 954(b)(3)(A) and 
the more than 70 percent of gross income test under section 
954(b)(3)(B). In addition, income described in paragraph (a)(1) of this 
section shall be considered to be subpart F income without regard to the 
exclusions from foreign base company income provided by section 
954(c)(2)(B) (relating to export financing interest derived in the 
conduct of a banking business) and section 954(c)(3)(A)(i) (relating to 
certain interest income received from related persons).
    (2) Foreign tax credit. Income described in paragraph (a)(1) of this 
section shall be considered to be interest income for purposes of the 
section 904 foreign tax credit limitation and is not eligible for the 
exceptions for export financing interest provided in section 904(d)(2) 
(A)(iii)(II), (B)(ii), and (C)(iii). In addition, such income will be 
subject to the look-through rule for subpart F income set forth in 
section 904(d)(3) without regard to the de minimis exception provided in 
section 904(d)(3)(E).
    (3) Possessions corporations--(i) Limitation on credit. Income 
described in paragraph (a)(1) of this section shall not be treated as 
income described in section 936(a)(1) (A) or (B) unless the income is 
considered under the principles of Sec.  1.863-6 to be derived from 
sources within the possessions. Thus, the credit provided by section 936 
is not available for income described in paragraph (a)(1) of this 
section unless the obligor under the receivable is a resident of a 
possession. In the case of a loan described in section 864(d)(6), the 
credit provided by section 936 is not available for income described in 
paragraph (a)(1) of this section unless the purchaser of the inventory 
property or services is a resident of a possession.
    (ii) Eligibility determination. Notwithstanding the limitation on 
the availability of the section 936 credit for income described in 
paragraph (a)(1) of this section, if income treated as interest income 
under paragraph (a)(1) of this section is derived from sources within a 
possession (determined without regard to this section), such income 
shall be eligible for inclusion in a corporation's gross income for 
purposes of section 936(a)(2)(A). If such income is derived from the 
active conduct of a trade or business within a possession (determined 
without regard to this section), such income shall be eligible for 
inclusion in a corporation's gross income for purposes of section 
936(a)(2)(B). (These rules apply for purposes of determining whether a 
corporation is eligible to elect the credit provided under section 
936(a).)
    (iii) Example. The following example illustrates the application of 
paragraph (e)(3) of this section.

    Example. Corporation X is operating in a possession as a possessions 
corporation. In

[[Page 358]]

1985, X earned $50,000 from the active conduct of a business in the 
possession, including $5,000 from trade or service receivables acquired 
from a related party. Obligors under the receivables acquired by X are 
not residents of the possession. Corporation X also earned $20,000 from 
activities other than its active conduct of business in the possession. 
The $5,000 derived by X from the receivables is not eligible for the 
section 936 credit. However, the $5,000 may be used by X to meet the 
percentage tests under section 936(a)(2) to the extent that such income 
is considered to be derived from sources within the possession (for 
purposes of section 936(a)(2)(A)) or is considered to be derived from 
the active conduct of a trade or business in the possession (for 
purposes of section 936(a)(2)(B)), in either case determined without 
regard to the characterization of such income under this section.

    (f) Effective date. The provisions of this section shall apply with 
respect to accounts receivable and evidences of indebtedness transferred 
after March 1, 1984 and are effective June 14, 1988.

[T.D. 8209, 53 FR 22166, June 14, 1988]



Sec.  1.865-1  Loss with respect to personal property other than stock.

    (a) General rules for allocation of loss--(1) Allocation against 
gain. Except as otherwise provided in Sec.  1.865-2 and paragraph (c) of 
this section, loss recognized with respect to personal property shall be 
allocated to the class of gross income and, if necessary, apportioned 
between the statutory grouping of gross income (or among the statutory 
groupings) and the residual grouping of gross income, with respect to 
which gain from a sale of such property would give rise in the hands of 
the seller. For purposes of this section, loss includes bad debt 
deductions under section 166 and loss on property that is marked-to-
market (such as under section 475) and subject to the rules of this 
section. Thus, for example, loss recognized by a United States resident 
on the sale or worthlessness of a bond generally is allocated to reduce 
United States source income.
    (2) Loss attributable to foreign office. Except as otherwise 
provided in Sec.  1.865-2 and paragraph (c) of this section, and except 
with respect to loss subject to paragraph (b) of this section, in the 
case of loss recognized by a United States resident with respect to 
property that is attributable to an office or other fixed place of 
business in a foreign country within the meaning of section 865(e)(3), 
the loss shall be allocated to reduce foreign source income if a gain on 
the sale of the property would have been taxable by the foreign country 
and the highest marginal rate of tax imposed on such gains in the 
foreign country is at least 10 percent. However, paragraph (a)(1) of 
this section and not this paragraph (a)(2) will apply if gain on the 
sale of such property would be sourced under section 865(c), (d)(1)(B), 
or (d)(3).
    (3) Loss recognized by United States citizen or resident alien with 
foreign tax home. Except as otherwise provided in Sec.  1.865-2 and 
paragraph (c) of this section, and except with respect to loss subject 
to paragraph (b) of this section, in the case of loss with respect to 
property recognized by a United States citizen or resident alien that 
has a tax home (as defined in section 911(d)(3)) in a foreign country, 
the loss shall be allocated to reduce foreign source income if a gain on 
the sale of such property would have been taxable by a foreign country 
and the highest marginal rate of tax imposed on such gains in the 
foreign country is at least 10 percent.
    (4) Allocation for purposes of section 904. For purposes of section 
904, loss recognized with respect to property that is allocated to 
foreign source income under this paragraph (a) shall be allocated to the 
separate category under section 904(d) to which gain on the sale of the 
property would have been assigned (without regard to section 
904(d)(2)(A)(iii)(III)). For purposes of Sec.  1.904-4(c)(2)(ii)(A), any 
such loss allocated to passive income shall be allocated (prior to the 
application of Sec.  1.904-4(c)(2)(ii)(B)) to the group of passive 
income to which gain on a sale of the property would have been assigned 
had a sale of the property resulted in the recognition of a gain under 
the law of the relevant foreign jurisdiction or jurisdictions.
    (5) Loss recognized by partnership. A partner's distributive share 
of loss recognized by a partnership with respect to personal property 
shall be allocated and apportioned in accordance with this section as if 
the partner had recognized the loss. If loss is attributable to

[[Page 359]]

an office or other fixed place of business of the partnership within the 
meaning of section 865(e)(3), such office or fixed place of business 
shall be considered to be an office of the partner for purposes of this 
section.
    (b) Special rules of application--(1) Depreciable property. In the 
case of a loss recognized with respect to depreciable personal property, 
the gain referred to in paragraph (a)(1) of this section is the gain 
that would be sourced under section 865(c)(1) (depreciation recapture).
    (2) Contingent payment debt instrument. Loss described in the last 
sentence of Sec.  1.1275-4(b)(9)(iv)(A) that is recognized with respect 
to a contingent payment debt instrument to which Sec.  1.1275-4(b) 
applies (instruments issued for money or publicly traded property) shall 
be allocated to the class of gross income and, if necessary, apportioned 
between the statutory grouping of gross income (or among the statutory 
groupings) and the residual grouping of gross income, with respect to 
which interest income from the instrument (in the amount of the loss 
subject to this paragraph (b)(2)) would give rise.
    (c) Exceptions--(1) Foreign currency and certain financial 
instruments. This section does not apply to loss governed by section 988 
and loss recognized with respect to options contracts or derivative 
financial instruments, including futures contracts, forward contracts, 
notional principal contracts, or evidence of an interest in any of the 
foregoing.
    (2) Inventory. This section does not apply to loss recognized with 
respect to property described in section 1221(a)(1).
    (3) Interest equivalents and trade receivables. Loss subject to 
Sec.  1.861-9T(b) (loss equivalent to interest expense and loss on trade 
receivables) shall be allocated and apportioned under the rules of Sec.  
1.861-9T and not under the rules of this section.
    (4) Unamortized bond premium. If a taxpayer recognizing loss with 
respect to a bond (within the meaning of Sec.  1.171-1(b)) did not 
amortize bond premium to the full extent permitted by section 171 and 
the regulations thereunder, then, to the extent of the amount of bond 
premium that could have been, but was not, amortized by the taxpayer, 
loss recognized with respect to the bond shall be allocated to the class 
of gross income and, if necessary, apportioned between the statutory 
grouping of gross income (or among the statutory groupings) and the 
residual grouping of gross income, with respect to which interest income 
from the bond was assigned.
    (5) Accrued interest. Loss attributable to accrued but unpaid 
interest on a debt obligation shall be allocated to the class of gross 
income and, if necessary, apportioned between the statutory grouping of 
gross income (or among the statutory groupings) and the residual 
grouping of gross income, with respect to which interest income from the 
obligation was assigned. For purposes of this section, whether loss is 
attributable to accrued but unpaid interest (rather than to principal) 
shall be determined under the principles of Sec. Sec.  1.61-7(d) and 
1.446-2(e).
    (6) Anti-abuse rules--(i) Transactions involving built-in losses. If 
one of the principal purposes of a transaction is to change the 
allocation of a built-in loss with respect to personal property by 
transferring the property to another person, qualified business unit, 
office or other fixed place of business, or branch that subsequently 
recognizes the loss, the loss shall be allocated by the transferee as if 
it were recognized by the transferor immediately prior to the 
transaction. If one of the principal purposes of a change of residence 
is to change the allocation of a built-in loss with respect to personal 
property, the loss shall be allocated as if the change of residence had 
not occurred. If one of the principal purposes of a transaction is to 
change the allocation of a built-in loss on the disposition of personal 
property by converting the original property into other property and 
subsequently recognizing loss with respect to such other property, the 
loss shall be allocated as if it were recognized with respect to the 
original property immediately prior to the transaction. Transactions 
subject to this paragraph shall include, without limitation, 
reorganizations within the meaning of section 368(a), liquidations under 
section 332, transfers to a corporation under section 351, transfers to 
a partnership under section 721, transfers to a trust,

[[Page 360]]

distributions by a partnership, distributions by a trust, transfers to 
or from a qualified business unit, office or other fixed place of 
business, or branch, or exchanges under section 1031. A person may have 
a principal purpose of affecting loss allocation even though this 
purpose is outweighed by other purposes (taken together or separately).
    (ii) Offsetting positions. If a taxpayer recognizes loss with 
respect to personal property and the taxpayer (or any person described 
in section 267(b) (after application of section 267(c)), 267(e), 318 or 
482 with respect to the taxpayer) holds (or held) offsetting positions 
with respect to such property with a principal purpose of recognizing 
foreign source income and United States source loss, the loss shall be 
allocated and apportioned against such foreign source income. For 
purposes of this paragraph (c)(6)(ii), positions are offsetting if the 
risk of loss of holding one or more positions is substantially 
diminished by holding one or more other positions.
    (iii) Matching rule. If a taxpayer (or a person described in section 
1059(c)(3)(C) with respect to the taxpayer) engages in a transaction or 
series of transactions with a principal purpose of recognizing foreign 
source income that results in the creation of a corresponding loss with 
respect to personal property (as a consequence of the rules regarding 
the timing of recognition of income, for example), the loss shall be 
allocated and apportioned against such income to the extent of the 
recognized foreign source income. For an example illustrating a similar 
rule with respect to stock loss, see Sec.  1.865-2(b)(4)(iv) Example 3.
    (d) Definitions--(1) Contingent payment debt instrument. A 
contingent payment debt instrument is any debt instrument that is 
subject to Sec.  1.1275-4.
    (2) Depreciable personal property. Depreciable personal property is 
any property described in section 865(c)(4)(A).
    (3) Terms defined in Sec.  1.861-8. See Sec.  1.861-8 for the 
meaning of class of gross income, statutory grouping of gross income, 
and residual grouping of gross income.
    (e) Examples. The application of this section may be illustrated by 
the following examples:

    Example 1. On January 1, 2000, A, a domestic corporation, purchases 
for $1,000 a machine that produces widgets, which A sells in the United 
States and throughout the world. Throughout A's holding period, the 
machine is located and used in Country X. During A's holding period, A 
incurs depreciation deductions of $400 with respect to the machine. 
Under Sec.  1.861-8, A allocates and apportions depreciation deductions 
of $250 against foreign source general limitation income and $150 
against U.S. source income. On December 12, 2002, A sells the machine 
for $100 and recognizes a loss of $500. Because the machine was used 
predominantly outside the United States, under sections 865(c)(1)(B) and 
865(c)(3)(B)(ii) gain on the disposition of the machine would be foreign 
source general limitation income to the extent of the depreciation 
adjustments. Therefore, under paragraph (b)(1) of this section, the 
entire $500 loss is allocated against foreign source general limitation 
income.
    Example 2. On January 1, 2002, A, a domestic corporation, loans 
$2,000 to N, its wholly-owned controlled foreign corporation, in 
exchange for a contingent payment debt instrument subject to Sec.  
1.1275-4(b). During 2002 through 2004, A accrues and receives interest 
income of $630, $150 of which is foreign source general limitation 
income and $480 of which is foreign source passive income under section 
904(d)(3). Assume there are no positive or negative adjustments pursuant 
to Sec.  1.1275-4(b)(6) in 2002 through 2004. On January 1, 2005, A 
disposes of the debt instrument and recognizes a $770 loss. Under Sec.  
1.1275-4(b)(8)(ii), $630 of the loss is treated as ordinary loss and 
$140 is treated as capital loss. Assume that $140 of interest income 
earned in 2005 with respect to the debt instrument would be foreign 
source passive income under section 904(d)(3). Under Sec.  1.1275-
4(b)(9)(iv), $150 of the ordinary loss is allocated against foreign 
source general limitation income and $480 of the ordinary loss is 
allocated against foreign source passive income. Under paragraph (b)(2) 
of this section, the $140 capital loss is allocated against foreign 
source passive income.
    Example 3. (i) On January 1, 2003, A, a domestic corporation, 
purchases for $1,200 a taxable bond maturing on December 31, 2008, with 
a stated principal amount of $1,000, payable at maturity. The bond 
provides for unconditional payments of interest of $100, payable 
December 31 of each year. The issuer of the bond is a foreign 
corporation and interest on the bond is thus foreign source. Interest 
payments for 2003 and 2004 are timely made. A does not elect to amortize 
its bond

[[Page 361]]

premium under section 171 and the regulations thereunder, which would 
have permitted A to offset the $100 of interest income by $28.72 of bond 
premium in 2003, and by $30.42 in 2004. On January 1, 2005, A sells the 
bond and recognizes a $100 loss. Under paragraph (c)(4) of this section, 
$59.14 of the loss is allocated against foreign source income. Under 
paragraph (a)(1) of this section, the remaining $40.86 of the loss is 
allocated against U.S. source income.
    (ii) The facts are the same as in paragraph (i) of this Example 3, 
except that A made the election to amortize its bond premium effective 
for taxable year 2004 (see Sec.  1.171-4(c)). Under paragraph (c)(4) of 
this section, $28.72 of the loss is allocated against foreign source 
income. Under paragraph (a)(1) of this section, the remaining $71.28 of 
the loss is allocated against U.S. source income.
    Example 4. On January 1, 2002, A, a domestic corporation, purchases 
for $1,000 a bond maturing December 31, 2014, with a stated principal 
amount of $1,000, payable at maturity. The bond provides for 
unconditional payments of interest of $100, payable December 31 of each 
year. The issuer of the bond is a foreign corporation and interest on 
the bond is thus foreign source. Between 2002 and 2006, A accrues and 
receives foreign source interest income of $500 with respect to the 
bond. On January 1, 2007, A sells the bond and recognizes a $500 loss. 
Under paragraph (a)(1) of this section, the $500 loss is allocated 
against U.S. source income.
    Example 5. On January 1, 2002, A, a domestic corporation on the 
accrual method of accounting, purchases for $1,000 a bond maturing 
December 31, 2012, with a stated principal amount of $1,000, payable at 
maturity. The bond provides for unconditional payments of interest of 
$100, payable December 31 of each year. The issuer of the bond is a 
foreign corporation and interest on the bond is thus foreign source. On 
June 10, 2002, after A has accrued $44 of interest income, but before 
any interest has been paid, the issuer suddenly becomes insolvent and 
declares bankruptcy. A sells the bond (including the accrued interest) 
for $20. Assuming that A properly accrued $44 of interest income, A 
treats the $20 proceeds from the sale of the bond as payment of interest 
previously accrued and recognizes a $1,000 loss with respect to the bond 
principal and a $24 loss with respect to the accrued interest. See Sec.  
1.61-7(d). Under paragraph (a)(1) of this section, the $1,000 loss with 
respect to the principal is allocated against U.S. source income. Under 
paragraph (c)(5) of this section, the $24 loss with respect to accrued 
but unpaid interest is allocated against foreign source interest income.

    (f) Effective date--(1) In general. Except as provided in paragraph 
(f)(2) of this section, this section is applicable to loss recognized on 
or after January 8, 2002. For purposes of this paragraph (f), loss that 
is recognized but deferred (for example, under section 267 or 1092) 
shall be treated as recognized at the time the loss is taken into 
account.
    (2) Application to prior periods. A taxpayer may apply the rules of 
this section to losses recognized in any taxable year beginning on or 
after January 1, 1987, and all subsequent years, provided that--
    (i) The taxpayer's tax liability as shown on an original or amended 
tax return is consistent with the rules of this section for each such 
year for which the statute of limitations does not preclude the filing 
of an amended return on June 30, 2002; and
    (ii) The taxpayer makes appropriate adjustments to eliminate any 
double benefit arising from the application of this section to years 
that are not open for assessment.
    (3) Examples. See Sec.  1.865-2(e)(3) for examples illustrating an 
applicability date provision similar to the applicability date provided 
in this paragraph (f).

[T.D. 8973, 66 FR 67083, Dec. 28, 2001]



Sec.  1.865-2  Loss with respect to stock.

    (a) General rules for allocation of loss with respect to stock--(1) 
Allocation against gain. Except as otherwise provided in paragraph (b) 
of this section, loss recognized with respect to stock shall be 
allocated to the class of gross income and, if necessary, apportioned 
between the statutory grouping of gross income (or among the statutory 
groupings) and the residual grouping of gross income, with respect to 
which gain (other than gain treated as a dividend under section 
964(e)(1) or 1248) from a sale of such stock would give rise in the 
hands of the seller (without regard to section 865(f)). For purposes of 
this section, loss includes loss on property that is marked-to-market 
(such as under section 475) and subject to the rules of this section. 
Thus, for example, loss recognized by a United States resident on the 
sale of stock generally is allocated to reduce United States source 
income.
    (2) Stock attributable to foreign office. Except as otherwise 
provided in paragraph (b) of this section, in the case of

[[Page 362]]

loss recognized by a United States resident with respect to stock that 
is attributable to an office or other fixed place of business in a 
foreign country within the meaning of section 865(e)(3), the loss shall 
be allocated to reduce foreign source income if a gain on the sale of 
the stock would have been taxable by the foreign country and the highest 
marginal rate of tax imposed on such gains in the foreign country is at 
least 10 percent.
    (3) Loss recognized by United States citizen or resident alien with 
foreign tax home--(i) In general. Except as otherwise provided in 
paragraph (b) of this section, in the case of loss with respect to stock 
that is recognized by a United States citizen or resident alien that has 
a tax home (as defined in section 911(d)(3)) in a foreign country, the 
loss shall be allocated to reduce foreign source income if a gain on the 
sale of the stock would have been taxable by a foreign country and the 
highest marginal rate of tax imposed on such gains in the foreign 
country is at least 10 percent.
    (ii) Bona fide residents of Puerto Rico. Except as otherwise 
provided in paragraph (b) of this section, in the case of loss with 
respect to stock in a corporation described in section 865(g)(3) 
recognized by a United States citizen or resident alien that is a bona 
fide resident of Puerto Rico during the entire taxable year, the loss 
shall be allocated to reduce foreign source income. If gain from a sale 
of such stock would give rise to income exempt from tax under section 
933, the loss with respect to such stock shall be allocated to amounts 
that are excluded from gross income under section 933(1) and therefore 
shall not be allowed as a deduction from gross income. See section 
933(1) and Sec.  1.933-1(c).
    (4) Stock constituting a United States real property interest. Loss 
recognized by a nonresident alien individual or a foreign corporation 
with respect to stock that constitutes a United States real property 
interest shall be allocated to reduce United States source income. For 
additional rules governing the treatment of such loss, see section 897 
and the regulations thereunder.
    (5) Allocation for purposes of section 904. For purposes of section 
904, loss recognized with respect to stock that is allocated to foreign 
source income under this paragraph (a) shall be allocated to the 
separate category under section 904(d) to which gain on a sale of the 
stock would have been assigned (without regard to section 
904(d)(2)(A)(iii)(III)). For purposes of Sec.  1.904-4(c)(2)(ii)(A), any 
such loss allocated to passive income shall be allocated (prior to the 
application of Sec.  1.904-4(c)(2)(ii)(B)) to the group of passive 
income to which gain on a sale of the stock would have been assigned had 
a sale of the stock resulted in the recognition of a gain under the law 
of the relevant foreign jurisdiction or jurisdictions.
    (b) Exceptions--(1) Dividend recapture exception--(i) In general. If 
a taxpayer recognizes a loss with respect to shares of stock, and the 
taxpayer (or a person described in section 1059(c)(3)(C) with respect to 
such shares) included in income a dividend recapture amount (or amounts) 
with respect to such shares at any time during the recapture period, 
then, to the extent of the dividend recapture amount (or amounts), the 
loss shall be allocated and apportioned on a proportionate basis to the 
class or classes of gross income or the statutory or residual grouping 
or groupings of gross income to which the dividend recapture amount was 
assigned.
    (ii) Exception for de minimis amounts. Paragraph (b)(1)(i) of this 
section shall not apply to a loss recognized by a taxpayer on the 
disposition of stock if the sum of all dividend recapture amounts (other 
than dividend recapture amounts eligible for the exception described in 
paragraph (b)(1)(iii) of this section (passive limitation dividends)) 
included in income by the taxpayer (or a person described in section 
1059(c)(3)(C)) with respect to such stock during the recapture period is 
less than 10 percent of the recognized loss.
    (iii) Exception for passive limitation dividends. Paragraph 
(b)(1)(i) of this section shall not apply to the extent of a dividend 
recapture amount that is treated as income in the separate category for 
passive income described in section 904(d)(2)(A) (without regard to 
section 904(d)(2)(A)(iii)(III)). The exception provided for in this 
paragraph

[[Page 363]]

(b)(1)(iii) shall not apply to any dividend recapture amount that is 
treated as income in the separate category for financial services income 
described in section 904(d)(2)(C).
    (iv) Examples. The application of this paragraph (b)(1) may be 
illustrated by the following examples:

    Example 1. (i) P, a domestic corporation, is a United States 
shareholder of N, a controlled foreign corporation. N has never had any 
subpart F income and all of its earnings and profits are described in 
section 959(c)(3). On May 5, 1998, N distributes a dividend to P in the 
amount of $100. The dividend gives rise to a $5 foreign withholding tax, 
and P is deemed to have paid an additional $45 of foreign income tax 
with respect to the dividend under section 902. Under the look-through 
rules of section 904(d)(3) the dividend is general limitation income 
described in section 904(d)(1)(I).
    (ii) On February 6, 2000, P sells its shares of N and recognizes a 
$110 loss. In 2000, P has the following taxable income, excluding the 
loss on the sale of N:
    (A) $1,000 of foreign source income that is general limitation 
income described in section 904(d)(1)(I);
    (B) $1,000 of foreign source capital gain from the sale of stock in 
a foreign affiliate that is sourced under section 865(f) and is passive 
income described in section 904(d)(1)(A); and
    (C) $1,000 of U.S. source income.
    (iii) The $100 dividend paid in 1998 is a dividend recapture amount 
that was included in P's income within the recapture period preceding 
the disposition of the N stock. The de minimis exception of paragraph 
(b)(1)(ii) of this section does not apply because the $100 dividend 
recapture amount exceeds 10 percent of the $110 loss. Therefore, to the 
extent of the $100 dividend recapture amount, the loss must be allocated 
under paragraph (b)(1)(i) of this section to the separate limitation 
category to which the dividend was assigned (general limitation income).
    (iv) P's remaining $10 loss on the disposition of the N stock is 
allocated to U.S. source income under paragraph (a)(1) of this section.
    (v) After allocation of the stock loss, P's foreign source taxable 
income in 2000 consists of $900 of foreign source general limitation 
income and $1,000 of foreign source passive income.
    Example 2. (i) P, a domestic corporation, owns all of the stock of 
N1, which owns all of the stock of N2, which owns all of the stock of 
N3. N1, N2, and N3 are controlled foreign corporations. All of the 
corporations use the calendar year as their taxable year. On February 5, 
1997, N3 distributes a dividend to N2. The dividend is foreign personal 
holding company income of N2 under section 954(c)(1)(A) that results in 
an inclusion of $100 in P's income under section 951(a)(1)(A)(i) as of 
December 31, 1997. Under section 904(d)(3)(B) the inclusion is general 
limitation income described in section 904(d)(1)(I). The income 
inclusion to P results in a corresponding increase in P's basis in the 
stock of N1 under section 961(a).
    (ii) On March 5, 1999, P sells its shares of N1 and recognizes a 
$110 loss. The $100 1997 subpart F inclusion is a dividend recapture 
amount that was included in P's income within the recapture period 
preceding the disposition of the N1 stock. The de minimis exception of 
paragraph (b)(1)(ii) of this section does not apply because the $100 
dividend recapture amount exceeds 10 percent of the $110 loss. 
Therefore, to the extent of the $100 dividend recapture amount, the loss 
must be allocated under paragraph (b)(1)(i) of this section to the 
separate limitation category to which the dividend recapture amount was 
assigned (general limitation income). The remaining $10 loss is 
allocated to U.S. source income under paragraph (a)(1) of this section.
    Example 3. (i) P, a domestic corporation, owns all of the stock of 
N1, which owns all of the stock of N2. N1 and N2 are controlled foreign 
corporations. All the corporations use the calendar year as their 
taxable year and the U.S. dollar as their functional currency. On May 5, 
1998, N2 pays a dividend of $100 to N1 out of general limitation 
earnings and profits.
    (ii) On February 5, 2000, N1 sells its N2 stock to an unrelated 
purchaser. The sale results in a loss to N1 of $110 for U.S. tax 
purposes. In 2000, N1 has the following current earnings and profits, 
excluding the loss on the sale of N2:
    (A) $1,000 of non-subpart F foreign source general limitation 
earnings and profits described in section 904(d)(1)(I);
    (B) $1,000 of foreign source gain from the sale of stock that is 
taken into account in determining foreign personal holding company 
income under section 954(c)(1)(B)(i) and which is passive limitation 
earnings and profits described in section 904(d)(1)(A);
    (C) $1,000 of foreign source interest income received from an 
unrelated person that is foreign personal holding company income under 
section 954(c)(1)(A) and which is passive limitation earnings and 
profits described in section 904(d)(1)(A).
    (iii) The $100 dividend paid in 1998 is a dividend recapture amount 
that was included in N1's income within the recapture period preceding 
the disposition of the N2 stock. The de minimis exception of paragraph 
(b)(1)(ii) of this section does not apply because the $100 dividend 
recapture amount exceeds 10 percent of the $110 loss. Therefore, to the 
extent of the $100 dividend recapture amount, the loss must be allocated 
under paragraph

[[Page 364]]

(b)(1)(i) of this section to the separate limitation category to which 
the dividend was assigned (general limitation earnings and profits).
    (iv) N1's remaining $10 loss on the disposition of the N2 stock is 
allocated to foreign source passive limitation earnings and profits 
under paragraph (a)(1) of this section.
    (v) After allocation of the stock loss, N1's current earnings and 
profits for 1998 consist of $900 of foreign source general limitation 
earnings and profits and $1,990 of foreign source passive limitation 
earnings and profits.
    (vi) After allocation of the stock loss, N1's subpart F income for 
2000 consists of $1,000 of foreign source interest income that is 
foreign personal holding company income under section 954(c)(1)(A) and 
$890 of foreign source net gain that is foreign personal holding company 
income under section 954(c)(1)(B)(i). P includes $1,890 in income under 
section 951(a)(1)(A)(i) as passive income under sections 904(d)(1)(A) 
and 904(d)(3)(B).
    Example 4. P, a foreign corporation, has two wholly-owned 
subsidiaries, S, a domestic corporation, and B, a foreign corporation. 
On January 1, 2000, S purchases a one-percent interest in N, a foreign 
corporation, for $100. On January 2, 2000, N distributes a $20 dividend 
to S. The $20 dividend is foreign source financial services income. On 
January 3, 2000, S sells its N stock to B for $80 and recognizes a $20 
loss that is deferred under section 267(f). On June 10, 2008, B sells 
its N stock to an unrelated person for $55. Under section 267(f) and 
Sec.  1.267(f)-1(c)(1), S's $20 loss is deferred until 2008. Under this 
paragraph (b)(1), the $20 loss is allocated to reduce foreign source 
financial services income in 2008 because the loss was recognized 
(albeit deferred) within the 24-month recapture period following the 
receipt of the dividend. See Sec. Sec.  1.267(f)-1(a)(2)(i)(B) and 
1.267(f)-1(c)(2).
    Example 5. The facts are the same as in Example 4, except P, S, and 
B are domestic corporations and members of the P consolidated group. 
Under the matching rule of Sec.  1.1502-13(c)(1), the separate entity 
attributes of S's intercompany items and B's corresponding items are 
redetermined to the extent necessary to produce the same effect on 
consolidated taxable income as if S and B were divisions of a single 
corporation and the intercompany transaction was a transaction between 
divisions. If S and B were divisions of a single corporation, the 
transfer of N stock on January 3, 2000 would be ignored for tax 
purposes, and the corporation would be treated as selling that stock 
only in 2008. Thus, the corporation's entire $45 loss would have been 
allocated against U.S. source income under paragraph (a)(1) of this 
section because a dividend recapture amount was not received during the 
corporation's recapture period. Accordingly, S's $20 loss and B's $25 
loss are allocated to reduce U.S. source income.
    Example 6. (i) On January 1, 1998, P, a domestic corporation, 
purchases N, a foreign corporation, for $1,000. On March 1, 1998, P 
causes N to sell its operating assets, distribute a $400 general 
limitation dividend to P, and invest its remaining $600 in short-term 
government securities. P converted the N assets into low-risk 
investments with a principal purpose of holding the N stock without 
significant risk of loss until the recapture period expired. N earns 
interest income from the securities. The income constitutes subpart F 
income that is included in P's income under section 951, increasing P's 
basis in the N stock under section 961(a). On March 1, 2002, P sells N 
and recognizes a $400 loss.
    (ii) Pursuant to paragraph (d)(3) of this section, the recapture 
period is increased by the period in which N's assets were held as low-
risk investments because P caused N's assets to be converted into and 
held as low-risk investments with a principal purpose of enabling P to 
hold the N stock without significant risk of loss. Accordingly, under 
paragraph (b)(1)(i) of this section the $400 loss is allocated against 
foreign source general limitation income.

    (2) Exception for inventory. This section does not apply to loss 
recognized with respect to stock described in section 1221(1).
    (3) Exception for stock in an S corporation. This section does not 
apply to loss recognized with respect to stock in an S corporation (as 
defined in section 1361).
    (4) Anti-abuse rules--(i) Transactions involving built-in losses. If 
one of the principal purposes of a transaction is to change the 
allocation of a built-in loss with respect to stock by transferring the 
stock to another person, qualified business unit (within the meaning of 
section 989(a)), office or other fixed place of business, or branch that 
subsequently recognizes the loss, the loss shall be allocated by the 
transferee as if it were recognized with respect to the stock by the 
transferor immediately prior to the transaction. If one of the principal 
purposes of a change of residence is to change the allocation of a 
built-in loss with respect to stock, the loss shall be allocated as if 
the change of residence had not occurred. If one of the principal 
purposes of a transaction is to change the allocation of a built-in loss 
with respect to stock

[[Page 365]]

(or other personal property) by converting the original property into 
other property and subsequently recognizing loss with respect to such 
other property, the loss shall be allocated as if it were recognized 
with respect to the original property immediately prior to the 
transaction. Transactions subject to this paragraph shall include, 
without limitation, reorganizations within the meaning of section 
368(a), liquidations under section 332, transfers to a corporation under 
section 351, transfers to a partnership under section 721, transfers to 
a trust, distributions by a partnership, distributions by a trust, or 
transfers to or from a qualified business unit, office or other fixed 
place of business. A person may have a principal purpose of affecting 
loss allocation even though this purpose is outweighed by other purposes 
(taken together or separately).
    (ii) Offsetting positions. If a taxpayer recognizes loss with 
respect to stock and the taxpayer (or any person described in section 
267(b) (after application of section 267(c)), 267(e), 318 or 482 with 
respect to the taxpayer) holds (or held) offsetting positions with 
respect to such stock with a principal purpose of recognizing foreign 
source income and United States source loss, the loss will be allocated 
and apportioned against such foreign source income. For purposes of this 
paragraph (b)(4)(ii), positions are offsetting if the risk of loss of 
holding one or more positions is substantially diminished by holding one 
or more other positions.
    (iii) Matching rule. If a taxpayer (or a person described in section 
1059(c)(3)(C) with respect to the taxpayer) engages in a transaction or 
series of transactions with a principal purpose of recognizing foreign 
source income that results in the creation of a corresponding loss with 
respect to stock (as a consequence of the rules regarding the timing of 
recognition of income, for example), the loss shall be allocated and 
apportioned against such income to the extent of the recognized foreign 
source income. This paragraph (b)(4)(iii) applies to any portion of a 
loss that is not allocated under paragraph (b)(1)(i) of this section 
(dividend recapture rule), including a loss in excess of the dividend 
recapture amount and a loss that is related to a dividend recapture 
amount described in paragraph (b)(1)(ii) (de minimis exception) or 
(b)(1)(iii) (passive dividend exception) of this section.
    (iv) Examples. The application of this paragraph (b)(4) may be 
illustrated by the following examples. No inference is intended 
regarding the application of any other Internal Revenue Code section or 
judicial doctrine that may apply to disallow or defer the recognition of 
loss. The examples are as follows:

    Example 1. (i) Facts. On January 1, 2000, P, a domestic corporation, 
owns all of the stock of N1, a controlled foreign corporation, which 
owns all of the stock of N2, a controlled foreign corporation. N1's 
basis in the stock of N2 exceeds its fair market value, and any loss 
recognized by N1 on the sale of N2 would be allocated under paragraph 
(a)(1) of this section to reduce foreign source passive limitation 
earnings and profits of N1. In contemplation of the sale of N2 to an 
unrelated purchaser, P causes N1 to liquidate with principal purposes of 
recognizing the loss on the N2 stock and allocating the loss against 
U.S. source income. P sells the N2 stock and P recognizes a loss.
    (ii) Loss allocation. Because one of the principal purposes of the 
liquidation was to transfer the stock to P in order to change the 
allocation of the built-in loss on the N2 stock, under paragraph 
(b)(4)(i) of this section the loss is allocated against P's foreign 
source passive limitation income.
    Example 2. (i) Facts. On January 1, 2000, P, a domestic corporation, 
forms N and F, foreign corporations, and contributes $1,000 to the 
capital of each. N and F enter into offsetting positions in financial 
instruments that produce financial services income. Holding the N stock 
substantially diminishes P's risk of loss with respect to the F stock 
(and vice versa). P holds N and F with a principal purpose of 
recognizing foreign source income and U.S. source loss. On March 31, 
2000, when the financial instrument held by N is worth $1,200 and the 
financial instrument held by F is worth $800, P sells its F stock and 
recognizes a $200 loss.
    (ii) Loss allocation. Because P held an offsetting position with 
respect to the F stock with a principal purpose of recognizing foreign 
source income and U.S. source loss, the $200 loss is allocated against 
foreign source financial services income under paragraph (b)(4)(ii) of 
this section.
    Example 3. (i) Facts. On January 1, 2002, P and Q, domestic 
corporations, form R, a domestic partnership. The corporations and 
partnership use the calendar year as their

[[Page 366]]

taxable year. P contributes $900 to R in exchange for a 90-percent 
partnership interest and Q contributes $100 to R in exchange for a 10-
percent partnership interest. R purchases a dance studio in Country X 
for $1,000. On January 2, 2002, R enters into contracts to provide dance 
lessons in Country X for a 5-year period beginning January 1, 2003. 
These contracts are prepaid by the dance studio customers on December 
31, 2002, and R recognizes foreign source taxable income of $500 from 
the prepayments (R's only income in 2002). P takes into income its $450 
distributive share of partnership taxable income. On January 1, 2003, 
P's basis in its partnership interest is $1,350 ($900 from its 
contribution under section 722, increased by its $450 distributive share 
of partnership income under section 705). On September 22, 2003, P 
contributes its R partnership interest to S, a newly-formed domestic 
corporation, in exchange for all the stock of S. Under section 358, P's 
basis in S is $1,350. On December 1, 2003, P sells S to an unrelated 
party for $1050 and recognizes a $300 loss.
    (ii) Loss allocation. P recognized foreign source income for tax 
purposes before the income had economically accrued, and the accelerated 
recognition of income increased P's basis in R without increasing its 
value by a corresponding amount, which resulted in the creation of a 
built-in loss with respect to the S stock. Under paragraph (b)(4)(iii) 
of this section the $300 loss is allocated against foreign source income 
if P had a principal purpose of recognizing foreign source income and 
corresponding loss.

    (c) Loss recognized by partnership. A partner's distributive share 
of loss recognized by a partnership shall be allocated and apportioned 
in accordance with this section as if the partner had recognized the 
loss. If loss is attributable to an office or other fixed place of 
business of the partnership within the meaning of section 865(e)(3), 
such office or fixed place of business shall be considered to be an 
office of the partner for purposes of this section.
    (d) Definitions--(1) Terms defined in Sec.  1.861-8. See Sec.  
1.861-8 for the meaning of class of gross income, statutory grouping of 
gross income, and residual grouping of gross income.
    (2) Dividend recapture amount. A dividend recapture amount is a 
dividend (except for an amount treated as a dividend under section 78), 
an inclusion described in section 951(a)(1)(A)(i) (but only to the 
extent attributable to a dividend (including a dividend under section 
964(e)(1)) included in the earnings of a controlled foreign corporation 
(held directly or indirectly by the person recognizing the loss) that is 
included in foreign personal holding company income under section 
954(c)(1)(A)) and an inclusion described in section 951(a)(1)(B).
    (3) Recapture period. A recapture period is the 24-month period 
ending on the date on which a taxpayer recognized a loss with respect to 
stock. For example, if a taxpayer recognizes a loss on March 15, 2002, 
the recapture period begins on and includes March 16, 2000, and ends on 
and includes March 15, 2002. A recapture period is increased by any 
period of time in which the taxpayer has diminished its risk of loss in 
a manner described in section 246(c)(4) and the regulations thereunder 
and by any period in which the assets of the corporation are hedged 
against risk of loss (or are converted into and held as low-risk 
investments) with a principal purpose of enabling the taxpayer to hold 
the stock without significant risk of loss until the recapture period 
has expired. In the case of a loss recognized after a dividend is 
declared but before such dividend is paid, the recapture period is 
extended through the date on which the dividend is paid.
    (4) United States resident. See section 865(g) and the regulations 
thereunder for the definition of United States resident.
    (e) Effective date--(1) In general. This section is applicable to 
loss recognized on or after January 11, 1999, except that paragraphs 
(a)(3)(ii), (b)(1)(iv) Example 6, (b)(4)(iii), (b)(4)(iv) Example 3, and 
(d)(3) of this section are applicable to loss recognized on or after 
January 8, 2002. For purposes of this paragraph (e), loss that is 
recognized but deferred (for example, under section 267 or 1092) shall 
be treated as recognized at the time the loss is taken into account.
    (2) Application to prior periods. A taxpayer may apply the rules of 
this section to losses recognized in any taxable year beginning on or 
after January 1, 1987, and all subsequent years, provided that--
    (i) The taxpayer's tax liability as shown on an original or amended 
tax return is consistent with the rules of this section for each such 
year for which the statute of limitations does

[[Page 367]]

not preclude the filing of an amended return on June 30, 2002; and
    (ii) The taxpayer makes appropriate adjustments to eliminate any 
double benefit arising from the application of this section to years 
that are not open for assessment.
    (3) Examples. The rules of this paragraph (e) may be illustrated by 
the following examples:

    Example 1. (i) P, a domestic corporation, has a calendar taxable 
year. On March 10, 1985, P recognizes a $100 capital loss on the sale of 
N, a foreign corporation. Pursuant to sections 1211(a) and 1212(a), the 
loss is not allowed in 1985 and is carried over to the 1990 taxable 
year. The loss is allocated against foreign source income under Sec.  
1.861-8(e)(7). In 1999, P chooses to apply this section to all losses 
recognized in its 1987 taxable year and in all subsequent years.
    (ii) Allocation of the loss on the sale of N is not affected by the 
rules of this section because the loss was recognized in a taxable year 
that did not begin after December 31, 1986.
    Example 2. (i) P, a domestic corporation, has a calendar taxable 
year. On March 10, 1988, P recognizes a $100 capital loss on the sale of 
N, a foreign corporation. Pursuant to sections 1211(a) and 1212(a), the 
loss is not allowed in 1988 and is carried back to the 1985 taxable 
year. The loss is allocated against foreign source income under Sec.  
1.861-8(e)(7) on P's federal income tax return for 1985 and increases an 
overall foreign loss account under Sec.  1.904(f)-1.
    (ii) In 1999, P chooses to apply this section to all losses 
recognized in its 1987 taxable year and in all subsequent years. 
Consequently, the loss on the sale of N is allocated against U.S. source 
income under paragraph (a)(1) of this section. Allocation of the loss 
against U.S. source income reduces P's overall foreign loss account and 
increases P's tax liability in 2 years: 1990, a year that will not be 
open for assessment on June 30, 1999, and 1997, a year that will be open 
for assessment on June 30, 1999. Pursuant to paragraph (e)(2)(i) of this 
section, P must file an amended federal income tax return that reflects 
the rules of this section for 1997, but not for 1990.
    Example 3. (i) P, a domestic corporation, has a calendar taxable 
year. On March 10, 1989, P recognizes a $100 capital loss on the sale of 
N, a foreign corporation. The loss is allocated against foreign source 
income under Sec.  1.861-8(e)(7) on P's federal income tax return for 
1989 and results in excess foreign tax credits for that year. The excess 
credit is carried back to 1988, pursuant to section 904(c). In 1999, P 
chooses to apply this section to all losses recognized in its 1989 
taxable year and in all subsequent years. On June 30, 1999, P's 1988 
taxable year is closed for assessment, but P's 1989 taxable year is open 
with respect to claims for refund.
    (ii) Because P chooses to apply this section to its 1989 taxable 
year, the loss on the sale of N is allocated against U.S. source income 
under paragraph (a)(1) of this section. Allocation of the loss against 
U.S. source income would have permitted the foreign tax credit to be 
used in 1989, reducing P's tax liability in 1989. Nevertheless, under 
paragraph (e)(2)(ii) of this section, because the credit was carried 
back to 1988, P may not claim the foreign tax credit in 1989.

[T.D. 8805, 64 FR 1511, Jan. 11, 1999, as amended by T.D. 8973, 66 FR 
67085, Dec. 28, 2001; 67 FR 3812, Jan. 28, 2002]

               Nonresident Aliens and Foreign Corporations

                      nonresident alien individuals



Sec.  1.871-1  Classification and manner of taxing alien individuals.

    (a) Classes of aliens. For purposes of the income tax, alien 
individuals are divided generally into two classes, namely, resident 
aliens and nonresident aliens. Resident alien individuals are, in 
general, taxable the same as citizens of the United States; that is, a 
resident alien is taxable on income derived from all sources, including 
sources without the United States. See Sec.  1.1-1(b). Nonresident alien 
individuals are taxable only on certain income from sources within the 
United States and on the income described in section 864(c)(4) from 
sources without the United States which is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States. However, nonresident alien individuals may elect, under section 
6013 (g) or (h), to be treated as U.S. residents for purposes of 
determining their income tax liability under Chapters 1 and 24 of the 
code. Accordingly, any reference in Sec. Sec.  1.1-1 through 1.1388-1 to 
non-resident alien individuals does not include those with respect to 
whom an election under section 6013 (g) or (h) is in effect, unless 
otherwise specifically provided. Similarly, any reference to resident 
aliens or U.S. residents includes those with respect to whom an election 
is in effect, unless otherwise specifically provided.
    (b) Classes of nonresident aliens--(1) In general. For purposes of 
the income

[[Page 368]]

tax, nonresident alien individuals are divided into the following three 
classes:
    (i) Nonresident alien individuals who at no time during the taxable 
year are engaged in a trade or business in the United States,
    (ii) Nonresident alien individuals who at any time during the 
taxable year are, or are deemed under Sec.  1.871-9 to be, engaged in a 
trade or business in the United States, and
    (iii) Nonresident alien individuals who are bona fide residents of a 
section 931 possession (as defined in Sec.  1.931-1(c)(1) of this 
chapter) or Puerto Rico during the entire taxable year. An individual 
described in paragraph (b)(1)(i) or (ii) of this section is subject to 
tax pursuant to the provisions of subpart A (section 871 and following), 
part II, subchapter N, chapter 1 of the Code, and the regulations under 
those provisions. The provisions of subpart A do not apply to 
individuals described in this paragraph (b)(1)(iii), but such 
individuals, except as provided in section 931 or 933, are subject to 
the tax imposed by section 1 or 55. See Sec.  1.876-1.
    (2) Treaty income. If the gross income of a nonresident alien 
individual described in subparagraph (1) (i) or (ii) of this paragraph 
includes income on which the tax is limited by tax convention, see Sec.  
1.871-12.
    (3) Exclusions from gross income. For rules relating to the 
exclusion of certain items from the gross income of a nonresident alien 
individual, including annuities excluded under section 871(f), see 
Sec. Sec.  1.872-2 and 1.894-1.
    (4) Expatriation to avoid tax. For special rules applicable in 
determining the tax of a nonresident alien individual who has lost U.S. 
citizenship with a principal purpose of avoiding certain taxes, see 
section 877.
    (5) Adjustment of tax of certain nonresident aliens. For the 
application of pre-1967 income tax provisions to residents of a foreign 
country which imposes a more burdensome income tax than the United 
States, and for the adjustment of the income tax of a national or 
resident of a foreign country which imposes a discriminatory income tax 
on the income of citizens of the United States or domestic corporations, 
see section 896.
    (6) Conduit financing arrangements. For rules regarding conduit 
financing arrangements, see Sec. Sec.  1.881-3 and 1.881-4.
    (c) Effective/applicability date. This section shall apply for 
taxable years beginning after December 31, 1966. For corresponding rules 
applicable to taxable years beginning before January 1, 1967, see 26 CFR 
1.871-1 and 1.871-7(a) (Revised as of January 1, 1971). Paragraph 
(b)(1)(iii) of this section applies to taxable years ending after April 
9, 2008.

[T.D. 7332, 39 FR 44218, Dec. 23, 1974, as amended by T.D. 7670, 45 FR 
6928, Jan. 31, 1980; T.D. 8611, 60 FR 41004, Aug. 11, 1995; T.D. 9194, 
70 FR 18928, Apr. 11, 2005; T.D. 9391, 73 FR 19358, Apr. 9, 2008; T.D. 
9849, 84 FR 9236, Mar. 14, 2019]



Sec.  1.871-2  Determining residence of alien individuals.

    (a) General. The term nonresident alien individual means an 
individual whose residence is not within the United States, and who is 
not a citizen of the United States. The term includes a nonresident 
alien fiduciary. For such purpose the term fiduciary shall have the 
meaning assigned to it by section 7701(a)(6) and the regulations in part 
301 of this chapter (Regulations on Procedure and Administration). For 
presumption as to an alien's nonresidence, see paragraph (b) of Sec.  
1.871-4.
    (b) Residence defined. An alien actually present in the United 
States who is not a mere transient or sojourner is a resident of the 
United States for purposes of the income tax. Whether he is a transient 
is determined by his intentions with regard to the length and nature of 
his stay. A mere floating intention, indefinite as to time, to return to 
another country is not sufficient to constitute him a transient. If he 
lives in the United States and has no definite intention as to his stay, 
he is a resident. One who comes to the United States for a definite 
purpose which in its nature may be promptly accomplished is a transient; 
but, if his purpose is of such a nature that an extended stay may be 
necessary for its accomplishment, and to that end the alien makes his 
home temporarily in the United States, he becomes a resident, though it 
may be his intention at all times to return to his domicile

[[Page 369]]

abroad when the purpose for which he came has been consummated or 
abandoned. An alien whose stay in the United States is limited to a 
definite period by the immigration laws is not a resident of the United 
States within the meaning of this section, in the absence of exceptional 
circumstances.
    (c) Application and effective dates. Unless the context indicates 
otherwise, Sec. Sec.  1.871-2 through 1.871-5 apply to determine the 
residence of aliens for taxable years beginning before January 1, 1985. 
To determine the residence of aliens for taxable years beginning after 
December 31, 1984, see section 7701(b) and Sec. Sec.  301.7701(b)-1 
through 301.7701(b)-9 of this chapter. However, for purposes of 
determining whether an individual is a qualified individual under 
section 911(d)(1)(A), the rules of Sec. Sec.  1.871-2 and 1.871-5 shall 
continue to apply for taxable years beginning after December 31, 1984. 
For purposes of determining whether an individual is a resident of the 
United States for estate and gift tax purposes, see Sec.  20.0-1(b) (1) 
and (2) and Sec.  25.2501-1(b) of this chapter, respectively.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960; 25 FR 14021, Dec. 31, 1960, as 
amended by T.D. 8411, 57 FR 15241, Apr. 27, 1992]



Sec.  1.871-3  Residence of alien seamen.

    In order to determine whether an alien seaman is a resident of the 
United States for purposes of the income tax, it is necessary to decide 
whether the presumption of nonresidence (as prescribed by paragraph (b) 
of Sec.  1.871-4) is overcome by facts showing that he has established a 
residence in the United States. Residence may be established on a vessel 
regularly engaged in coastwise trade, but the mere fact that a sailor 
makes his home on a vessel which is flying the United States flag and is 
engaged in foreign trade is not sufficient to establish residence in the 
United States, even though the vessel, while carrying on foreign trade, 
touches at American ports. An alien seaman may acquire an actual 
residence in the United States within the rules laid down in Sec.  
1.871-4, although the nature of his calling requires him to be absent 
for a long period from the place where his residence is established. An 
alien seaman may acquire such a residence at a sailors' boarding house 
or hotel, but such a claim should be carefully scrutinized in order to 
make sure that such residence is bona fide. The filing of Form 1078 or 
taking out first citizenship papers is proof of residence in the United 
States from the time the form is filed or the papers taken out, unless 
rebutted by other evidence showing an intention to be a transient.



Sec.  1.871-4  Proof of residence of aliens.

    (a) Rules of evidence. The following rules of evidence shall govern 
in determining whether or not an alien within the United States has 
acquired residence therein for purposes of the income tax.
    (b) Nonresidence presumed. An alien by reason of his alienage, is 
presumed to be a nonresident alien.
    (c) Presumption rebutted--(1) Departing alien. In the case of an 
alien who presents himself for determination of tax liability before 
departure from the United States, the presumption as to the alien's 
nonresidence may be overcome by proof--
    (i) That the alien, at least six months before the date he so 
presents himself, has filed a declaration of his intention to become a 
citizen of the United States under the naturalization laws; or
    (ii) That the alien, at least six months before the date he so 
presents himself, has filed Form 1078 or its equivalent; or
    (iii) Of acts and statements of the alien showing a definite 
intention to acquire residence in the United States or showing that his 
stay in the United States has been of such an extended nature as to 
constitute him a resident.
    (2) Other aliens. In the case of other aliens, the presumption as to 
the alien's nonresidence may be overcome by proof--
    (i) That the alien has filed a declaration of his intention to 
become a citizen of the United States under the naturalization laws; or
    (ii) That the alien has filed Form 1078 or its equivalent; or
    (iii) Of acts and statements of the alien showing a definite 
intention to acquire residence in the United States or showing that his 
stay in the United

[[Page 370]]

States has been of such an extended nature as to constitute him a 
resident.
    (d) Certificate. If, in the application of paragraph (c)(1)(iii) or 
(2)(iii) of this section, the internal revenue officer or employee who 
examines the alien is in doubt as to the facts, such officer or employee 
may, to assist him in determining the facts, require a certificate or 
certificates setting forth the facts relied upon by the alien seeking to 
overcome the presumption. Each such certificate, which shall contain, or 
be verified by, a written declaration that it is made under the 
penalties of perjury, shall be executed by some credible person or 
persons, other than the alien and members of his family, who have known 
the alien at least six months before the date of execution of the 
certificate or certificates.



Sec.  1.871-5  Loss of residence by an alien.

    An alien who has acquired residence in the United States retains his 
status as a resident until he abandons the same and actually departs 
from the United States. An intention to change his residence does not 
change his status as a resident alien to that of a nonresident alien. 
Thus, an alien who has acquired a residence in the United States is 
taxable as a resident for the remainder of his stay in the United 
States.



Sec.  1.871-6  Duty of witholding agent to determine status of alien payees.

    For the obligation of a witholding agent to withold the tax imposed 
by this section, see chapter 3 of the Internal Revenue Code and the 
regulations thereunder.

[T.D. 8734, 62 FR 53416, Oct. 14, 1997]



Sec.  1.871-7  Taxation of nonresident alien individuals 
not engaged in U.S. business.

    (a) Imposition of tax. (1) This section applies for purposes of 
determining the tax of a nonresident alien individual who at no time 
during the taxable year is engaged in trade or business in the United 
States. However, see also Sec.  1.871-8 where such individual is a 
student or trainee deemed to be engaged in trade or business in the 
United States or where he has an election in effect for the taxable year 
in respect to real property income. Except as otherwise provided in 
Sec.  1.871-12, a nonresident alien individual to whom this section 
applies is not subject to the tax imposed by section 1 or section 
1201(b) but, pursuant to the provision of section 871(a), is liable to a 
flat tax of 30 percent upon the aggregate of the amounts determined 
under paragraphs (b), (c), and (d) of this section which are received 
during the taxable year from sources within the United States. Except as 
specifically provided in such paragraphs, such amounts do not include 
gains from the sale or exchange of property. To determine the source of 
such amounts, see sections 861 through 863, and the regulations 
thereunder.
    (2) The tax of 30 percent is imposed by section 871(a) upon an 
amount only to the extent the amount constitutes gross income. Thus, for 
example, the amount of an annuity which is subject to such tax shall be 
determined in accordance with section 72.
    (3) Deductions shall not be allowed in determining the amount 
subject to tax under this section except that losses from sales or 
exchanges of capital assets shall be allowed to the extent provided in 
section 871(a)(2) and paragraph (d) of this section.
    (4) Except as provided in Sec. Sec.  1.871-9 and 1.871-10, a 
nonresident alien individual not engaged in trade or business in the 
United States during the taxable year has no income, gain, or loss for 
the taxable year which is effectively connected for the taxable year 
with the conduct of a trade or business in the United States. See 
section 864(c)(1)(B) and Sec.  1.864-3.
    (5) Gains and losses which, by reason of section 871(d) and Sec.  
1.871-10, are treated as gains or losses which are effectively connected 
for the taxable year with the conduct of a trade or business in the 
United States by the nonresident alien individual shall not be taken 
into account in determining the tax under this section. See, for 
example, paragraph (c)(2) of Sec.  1.871-10.
    (6) For special rules applicable in determining the tax of certain 
nonresident alien individuals, see paragraph (b) of Sec.  1.871-1.
    (b) Fixed or determinable annual or periodical income--(1) General 
rule. The tax of 30 percent imposed by section

[[Page 371]]

871(a)(1) applies to the gross amount received from sources within the 
United States as fixed or determinable annual or periodical gains, 
profits, or income. Specific items of fixed or determinable annual or 
periodical income are enumerated in section 871(a)(1)(A) as interest, 
dividends, rents, salaries, wages, premiums, annuities, compensations, 
remunerations, and emoluments, but other items of fixed or determinable 
annual or periodical gains, profits, or income are also subject to the 
tax, as, for instance, royalties, including royalties for the use of 
patents, copyrights, secret processes and formulas, and other like 
property. As to the determination of fixed or determinable annual or 
periodical income see Sec.  1.1441-2(b). For special rules treating gain 
on the disposition of section 306 stock as fixed or determinable annual 
or periodical income for purposes of section 871(a), see section 306(f) 
and paragraph (h) of Sec.  1.306-3.
    (2) Substitute payments. For purposes of this section, a substitute 
interest payment (as defined in Sec.  1.861-2(a)(7)) received by a 
foreign person pursuant to a securities lending transaction or a sale-
repurchase transaction (as defined in Sec.  1.861-2(a)(7)) shall have 
the same character as interest income paid or accrued with respect to 
the terms of the transferred security. Similarly, for purposes of this 
section, a substitute dividend payment (as defined in Sec.  1.861-
3(a)(6)) received by a foreign person pursuant to a securities lending 
transaction or a sale-repurchase transaction (as defined in Sec.  1.861-
3(a)(6)) shall have the same character as a distribution received with 
respect to the transferred security. Where, pursuant to a securities 
lending transaction or a sale-repurchase transaction, a foreign person 
transfers to another person a security the interest on which would 
qualify as portfolio interest under section 871(h) in the hands of the 
lender, substitute interest payments made with respect to the 
transferred security will be treated as portfolio interest, provided 
that in the case of interest on an obligation in registered form (as 
defined in Sec.  1.871-14(c)(1)(i)), the transferor complies with the 
documentation requirement described in Sec.  1.871-14(c)(1)(ii)(C) with 
respect to the payment of the substitute interest and none of the 
exceptions to the portfolio interest exemption in sections 871(h) (3) 
and (4) apply. See also Sec. Sec.  1.861-2(b)(2) and 1.894-1(c).
    (c) Other income and gains--(1) Items subject to tax. The tax of 30 
percent imposed by section 871(a)(1) also applies to the following gains 
received during the taxable year from sources within the United States:
    (i) Gains described in section 402(a)(2), relating to the treatment 
of total distributions from certain employees' trusts; section 
403(a)(2), relating to treatment of certain payments under certain 
employee annuity plans; and section 631 (b) or (c), relating to 
treatment of gain on the disposal of timber, coal, or iron ore with a 
retained economic interest;
    (ii) [Reserved]
    (iii) Gains on transfers described in section 1235, relating to 
certain transfers of patent rights, made on or before October 4, 1966; 
and
    (iv) Gains from the sale or exchange after October 4, 1966, of 
patents, copyrights, secret processes and formulas, good will, 
trademarks, trade brands, franchises, or other like property, or of any 
interest in any such property, to the extent the gains are from payments 
(whether in a lump sum or in installments) which are contingent on the 
productivity, use or disposition of the property or interest sold or 
exchanged, or from payments which are treated under section 871(e) and 
Sec.  1.871-11 as being so contingent.
    (2) Nonapplication of 183-day rule. The provisions of section 
871(a)(2), relating to gains from the sale or exchange of capital 
assets, and paragraph (d)(2) of this section do not apply to the gains 
described in this paragraph; as a consequence, the taxpayer receiving 
gains described in subparagraph (1) of this paragraph during a taxable 
year is subject to the tax of 30 percent thereon without regard to the 
183-day rule contained in such provisions.
    (3) Determination of amount of gain. The tax of 30 percent imposed 
upon the gains described in subparagraph (1) of this paragraph applies 
to the full amount of the gains and is determined (i) without regard to 
the alternative tax imposed by section 1201(b) upon the excess of the 
net long-term capital

[[Page 372]]

gain over the net short-term capital loss; (ii) without regard to the 
deduction allowed by section 1202 in respect of capital gains; (iii) 
without regard to section 1231, relating to property used in the trade 
or business and involuntary conversions; and (iv), except in the case of 
gains described in subparagraph (1)(ii) of this paragraph, whether or 
not the gains are considered to be gains from the sale or exchange of 
property which is a capital asset.
    (d) Gains from sale or exchange of capital assets--(1) Gains subject 
to tax. The tax of 30 percent imposed by section 871(a)(2) applies to 
the excess of gains derived from sources within the United States over 
losses allocable to sources within the United States, which are derived 
from the sale or exchange of capital assets, determined in accordance 
with the provisions of subparagraphs (2) through (4) of this paragraph.
    (2) Presence in the United States 183 days or more. (i) If the 
nonresident alien individual has been present in the United States for a 
period or periods aggregating 183 days or more during the taxable year, 
he is liable to a tax of 30 percent upon the amount by which his gains, 
derived from sources within the United States, from sales or exchanges 
of capital assets effected at any time during the year exceed his 
losses, allocable to sources within the United States, from sales or 
exchanges of capital assets effected at any time during that year. Gains 
and losses from sales or exchanges effected at any time during such 
taxable year are to be taken into account for this purpose even though 
the nonresident alien individual is not present in the United States at 
the time the sales or exchanges are effected. In addition, if the 
nonresident alien individual has been present in the United States for a 
period or periods aggregating 183 days or more during the taxable year, 
gains and losses for such taxable year from sales or exchanges of 
capital assets effected during a previous taxable year beginning after 
December 31, 1966, are to be taken into account, but only if he was also 
present in the United States during such previous taxable year for a 
period or periods aggregating 183 days or more.
    (ii) If the nonresident alien individual has not been present in the 
United States during the taxable year, or if he has been present in the 
United States for a period or periods aggregating less than 183 days 
during the taxable year, gains and losses from sales or exchanges of 
capital assets effected during the year are not to be taken into 
account, except as required by paragraph (c) of this section, in 
determining the tax of such individual even though the sales or 
exchanges are effected during his presence in the United States. 
Moreover, gains and losses for such taxable year from sales or exchanges 
of capital assets effected during a previous taxable year beginning 
after December 31, 1966, are not to be taken into account, even though 
the nonresident alien individual was present in the United States during 
such previous year for a period or periods aggregating 183 days or more.
    (iii) For purposes of this subparagraph, a nonresident alien 
individual is not considered to be present in the United States by 
reason of the presence in the United States of a person who is an agent 
or partner of such individual or who is a fiduciary of an estate or 
trust of which such individual is a beneficiary or a grantor-owner to 
whom section 671 applies.
    (iv) The application of this subparagraph may be illustrated by the 
following examples:

    Example 1. B, a nonresident alien individual not engaged in trade or 
business in the United States and using the calendar year as the taxable 
year, is present in the United States from May 1, 1971, to November 15, 
1971, a period of more than 182 days. While present in the United 
States, B effects for his own account on various dates a number of 
transactions in stocks and securities on the stock exchange, as a result 
of which he has recognized capital gains of $10,000. During the period 
from January 1, 1971, to April 30, 1971, he carries out similar 
transactions through an agent in the United States, as a result of which 
B has recognized capital gains of $5,000. On December 15, 1971, through 
an agent in the United States B sells a capital asset on the installment 
plan, no payments being made by the purchaser in 1971. During 1972, B 
receives installment payments of $50,000 on the installment sale made in 
1971, and the capital gain from sources

[[Page 373]]

within the United States for 1972 attributable to such payments is 
$12,500. In addition, during the period from January 1, 1972, to May 31, 
1972, B effects for his own account, through an agent in the United 
States, a number of transactions in stocks and securities on the stock 
exchange, as a result of which B has recognized capital gains of 
$20,000. At no time during 1972 is B present in the United States or 
engaged in trade or business in the United States. Accordingly, for 
1971, B is subject to tax under section 871(a)(2) on his capital gains 
of $15,000 from the transactions in that year on the stock exchange. For 
1972, B is not subject to tax on the capital gain of $12,500 from the 
installment sale in 1971 or on the capital gains of $20,000 from the 
transactions in 1972 on the stock exchange.
    Example 2. The facts are the same as in example 1 except that B is 
present in the United States from June 15, 1972, to December 31, 1972, a 
period of more than 182 days. Accordingly, B is subject to tax under 
section 871(a)(2) for 1971 on his capital gains of $15,000 from the 
transactions in that year on the stock exchange. He is also subject to 
tax under section 871(a)(2) for 1972 on his capital gains of $32,500 
($12,500 from the installment sale in 1971 plus $20,000 from the 
transactions in 1972 on the stock exchange).
    Example 3. D, a nonresident alien individual not engaged in trade or 
business in the United States and using the calendar year as the taxable 
year, is present in the United States from April 1, 1971, to August 31, 
1971, a period of less than 183 days. While present in the United 
States, D effects for his own account on various dates a number of 
transactions in stocks and securities on the stock exchange, as a result 
of which he has recognized capital gains of $15,000. During the period 
from January 1, 1971, to March 31, 1971, he carries out similar 
transactions through an agent in the United States, as a result of which 
D has recognized capital gains of $8,000. On December 20, 1971, through 
an agent in the United States D sells a capital asset on the installment 
plan, no payments being made by the purchaser in 1971. During 1972, D 
receives installment payments of $200,000 on the installment sale made 
in 1971, and the capital gain from sources within the United States for 
1972 attributable to such payments is $50,000. In addition, during the 
period from February 1, 1972, to August 15, 1972, a period of more than 
182 days. D effects for his own account, through an agent in the United 
States, a number of transactions in stocks and securities on the stock 
exchange, as a result of which D has recognized capital gains of 
$25,000. At no time during 1972 is D present in the United States or 
engaged in trade or business in the United States. Accordingly, D is not 
subject to tax for 1971 or 1972 on any of his recognized capital gains.
    Example 4. The facts are the same as in example 3 except that D is 
present in the United States from February 1, 1972, to August 15, 1972, 
a period of more than 182 days. Accordingly, D is not subject to tax for 
1971 on his capital gains of $23,000 from the transactions in that year 
on the stock exchange. For 1972 he is subject to tax under section 
871(a)(2) on his capital gains of $25,000 from the transactions in that 
year on the stock exchange, but he is not subject to the tax on the 
capital gain of $50,000 from the installment sale in 1971.

    (3) Determination of 183-day period--(i) In general. In determining 
the total period of presence in the United States for a taxable year for 
purposes of subparagraph (2) of this paragraph, all separate periods of 
presence in the United States during the taxable year are to be 
aggregated. If the nonresident alien individual has not previously 
established a taxable year, as defined in section 441(b), he shall be 
treated as having a taxable year which is the calendar year, as defined 
in section 441(d). Subsequent adoption by such individual of a fiscal 
year as the taxable year will be treated as a change in the taxpayer's 
annual accounting period to which section 442 applies, and the change 
must be authorized under this part (Income Tax Regulations) or prior 
approval must be obtained by filing an application on Form 1128 in 
accordance with paragraph (b) of Sec.  1.442-1. If in the course of his 
taxable year the nonresident alien individual changes his status from 
that of a citizen or resident of the United States to that of a 
nonresident alien individual, or vice versa, the determination of 
whether the individual has been present in the United States for 183 
days or more during the taxable year shall be made by taking into 
account the entire taxable year, and not just that part of the taxable 
year during which he has the status of a nonresident alien individual.
    (ii) Definition of ``day''. The term ``day'', as used in 
subparagraph (2) of this paragraph, means a calendar day during any 
portion of which the nonresident alien individual is physically present 
in the United States (within the meaning of sections 7701(a)(9) and 638) 
except that, in the case of an individual who is a resident of Canada or 
Mexico and, in the normal course of his employment in transportation 
service

[[Page 374]]

touching points within both Canada or Mexico and the United States, 
performs personal services in both the foreign country and the United 
States, the following rules shall apply:
    (a) The performance of labor or personal services during 8 hours or 
more in any 1 day within the United States shall be considered as 1 day 
in the United States, except that if a period of more or less than 8 
hours is considered a full workday in the transportation job involved, 
such period shall be considered as 1 day within the United States.
    (b) The performance of labor or personal services during less than 8 
hours in any day in the United States shall, except as provided in (a) 
of this subdivision, be considered as a fractional part of a day in the 
United States. The total number of hours during which such services are 
performed in the United States during the taxable year, when divided by 
eight, shall be the number of days during which such individual shall be 
considered present in the United States during the taxable year.
    (c) The aggregate number of days determined under (a) and (b) of 
this subdivision shall be considered the total number of days during 
which such individual is present in the United States during the taxable 
year.
    (4) Determination of amount of excess gains--(i) In general. For the 
purpose of determining the excess of gains over losses subject to tax 
under this paragraph, gains and losses shall be taken into account only 
if, and to the extent that, they would be recognized and taken into 
account if the nonresident alien individual were engaged in trade or 
business in the United States during the taxable year and such gains and 
losses were effectively connected for such year with the conduct of a 
trade or business in the United States by such individual. However, in 
determining such excess of gains over losses no deduction may be taken 
under section 1202, relating to the deduction for capital gains, or 
section 1212, relating to the capital loss carryover. Thus, for example, 
in determining such excess gains all amounts considered under chapter 1 
of the Code as gains or losses from the sale or exchange of capital 
assets shall be taken into account, except those gains which are 
described in section 871(a)(1) (B) or (D) and taken into account under 
paragraph (c) of this section and are considered to be gains from the 
sale or exchange of capital assets. Also, for example, a loss described 
in section 631 (b) or (c) which is considered to be a loss from the sale 
of a capital asset shall be taken into account in determining the excess 
gains which are subject to tax under this paragraph. In further 
illustration, in determining such excess gains no deduction shall be 
allowed, pursuant to the provisions of section 267, for losses from 
sales or exchanges of property between related taxpayers. Any gains 
which are taken into account under section 871(a)(1) and paragraph (c) 
of this section shall not be taken into account in applying section 1231 
for purposes of this paragraph. Gains and losses are to be taken into 
account under this paragraph whether they are short-term or long-term 
capital gains or losses within the meaning of section 1222.
    (ii) Gains not included. The provisions of this paragraph do not 
apply to any gains described in section 871(a)(1) (B) or (D), and in 
subdivision (i), (iii), or (iv) of paragraph (c)(1) of this section, 
which are considered to be gains from the sale or exchange of capital 
assets.
    (iii) Allowance of losses. In determining the excess of gains over 
losses subject to tax under this paragraph losses shall be allowed only 
to the extent provided by section 165(c). Losses from sales or exchanges 
of capital assets in excess of gains from sales or exchanges of capital 
assets shall not be taken into account.
    (e) Credits against tax. The credits allowed by section 31 (relating 
to tax withheld on wages), by section 32 (relating to tax withheld at 
source on nonresident aliens), by section 39 (relating to certain uses 
of gasoline and lubricating oil), and by section 6402 (relating to 
overpayments of tax) shall be allowed against the tax of a nonresident 
alien individual determined in accordance with this section.
    (f) Effective date. Except as otherwise provided in this paragraph, 
this section shall apply for taxable years beginning after December 31, 
1966. Paragraph (b)(2) of this section is applicable to

[[Page 375]]

payments made after November 13, 1997. For corresponding rules 
applicable to taxable years beginning before January 1, 1967, see 26 CFR 
1.871-7 (b) and (c) (Revised as of January 1, 1971).

[T.D. 7332, 39 FR 44219, Dec. 23, 1974, as amended by T.D. 8734, 62 FR 
53416, Oct. 14, 1997; T.D. 8735, 62 FR 53501, Oct. 14, 1997]



Sec.  1.871-8  Taxation of nonresident alien individuals engaged 
in U.S. business or treated as having effectively connected income.

    (a) Segregation of income. This section applies for purposes of 
determining the tax of a nonresident alien individual who at any time 
during the taxable year is engaged in trade or business in the United 
States. It also applies for purposes of determining the tax of a 
nonresident alien student or trainee who is deemed under section 871(c) 
and Sec.  1.871-9 to be engaged in trade or business in the United 
States or of a nonresident alien individual who at no time during the 
taxable year is engaged in trade or business in the United States but 
has an election in effect for the taxable year under section 871(d) and 
Sec.  1.871-10 in respect to real property income. A nonresident alien 
individual to whom this section applies must segregate his gross income 
for the taxable year into two categories, namely (1) the income which is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that individual, and (2) the income 
which is not effectively connected for the taxable year with the conduct 
of a trade or business in the United States by that individual. A 
separate tax shall then be determined upon each such category of income, 
as provided in paragraph (b) of this section. The determination of 
whether income or gain is or is not effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by the nonresident alien individual shall be made in accordance 
with section 864(c) and Sec. Sec.  1.864-3 through 1.864-7. For purposes 
of this section income which is effectively connected for the taxable 
year with the conduct of a trade or business in the United States 
includes all income which is treated under section 871 (c) or (d) and 
Sec.  1.871-9 or Sec.  1.871-10 as income which is effectively connected 
for such year with the conduct of a trade or business in the United 
States by the nonresident alien individual.
    (b) Imposition of tax--(1) Income not effectively connected with the 
conduct of a trade or business in the United States. If a nonresident 
alien individual who is engaged in trade or business in the United 
States at any time during the taxable year derives during such year from 
sources within the United States income or gains described in section 
871(a)(1), and paragraph (b) or (c) of Sec.  1.871-7 or gains from the 
sale or exchange of capital assets determined as provided in section 
871(a)(2) and paragraph (d) of Sec.  1.871-7, which are not effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by that individual, such income or gains shall be 
subject to a flat tax of 30 percent of the aggregate amount of such 
items. This tax shall be determined in the manner, and subject to the 
same conditions, set forth in Sec.  1.871-7 as though the income or 
gains were derived by a nonresident alien individual not engaged in 
trade or business in the United States during the taxable year, except 
that (i) the rule in paragraph (d)(3) of such section for treating the 
calendar year as the taxable year shall not apply and (ii) in applying 
paragraph (c) and (d)(4) of such section, there shall not be taken into 
account any gains or losses which are taken into account in determining 
the tax under section 871(b) and subparagraph (2) of this paragraph. A 
nonresident alien individual who has an election in effect for the 
taxable year under section 871(d) and Sec.  1.871-10 and who at no time 
during the taxable year is engaged in trade or business in the United 
States must determine his tax under Sec.  1.871-7 on his income which is 
not treated as effectively connected with the conduct of a trade or 
business in the United States, subject to the exception contained in 
subdivision (ii) of this subparagraph.
    (2) Income effectively connected with the conduct of a trade or 
business in the United States--(i) In general. If a nonresident alien to 
whom this section applies derives income or gains which are

[[Page 376]]

effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that individual, the taxable income 
or gains shall, except as provided in Sec.  1.871-12, be taxed in 
accordance with section 1 or, in the alternative, section 1201(b). See 
section 871(b)(1). Any income of the nonresident alien individual which 
is not effectively connected for the taxable year with the conduct of a 
trade or business in the United States by that individual shall not be 
taken into account in determining either the rate or amount of such tax. 
See paragraph (b) of Sec.  1.872-1.
    (ii) Determination of taxable income. The taxable income for any 
taxable year for purposes of this subparagraph consists only of the 
nonresident alien individual's taxable income which is effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by that individual; and, for this purpose, it is 
immaterial that the trade or business with which that income is 
effectively connected is not the same as the trade or business carried 
on in the United States by that individual during the taxable year. See 
example 2 in Sec.  1.864-4(b). In determining such taxable income all 
amounts constituting, or considered to be, gains or losses for the 
taxable year from the sale or exchange of capital assets shall be taken 
into account if such gains or losses are effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by that individual, and, for such purpose, the 183-day rule set 
forth in section 871(a)(2) and paragraph (d)(2) of Sec.  1.871-7 shall 
not apply. Losses which are not effectively connected for the taxable 
year with the conduct of a trade or business in the United States by 
that individual shall not be taken into account in determining taxable 
income under this subdivision, except as provided in section 873(b)(1).
    (iii) Cross references. For rules for determining the gross income 
and deductions for the taxable year, see sections 872 and 873, and the 
regulations thereunder.
    (c) Change in trade or business status--(1) In general. The 
determination as to whether a nonresident alien individual is engaged in 
trade or business within the United States during the taxable year is to 
be made for each taxable year. If at any time during the taxable year he 
is engaged in a trade or business in the United States, he is considered 
to be engaged in trade or business within the United States during the 
taxable year for purposes of sections 864(c)(1) and 871(b), and the 
regulations thereunder. Income, gain, or loss of a nonresident alien 
individual is not treated as being effectively connected for the taxable 
year with the conduct of a trade or business in the United States if he 
is not engaged in trade or business within the United States during such 
year, even though such income, gain, or loss may have been effectively 
connected for a previous taxable year with the conduct of a trade or 
business in the United States. See Sec.  1.864-3. However, income, gain, 
or loss which is treated as effectively connected for the taxable year 
with the conduct of a trade or business in the United States by a 
nonresident alien individual will generally be treated as effectively 
connected for a subsequent taxable year if he is engaged in a trade or 
business in the United States during such subsequent year, even though 
such income, gain, or loss is not effectively connected with the conduct 
of the trade or business carried on in the United States during such 
subsequent year. This subparagraph does not apply to income described in 
section 871 (c) or (d). It may not apply to a nonresident alien 
individual who for the taxable year uses an accrual method of accounting 
or to income which is constructively received in the taxable year within 
the meaning of Sec.  1.451-2.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. B, a nonresident alien individual using the calendar year 
as the taxable year and the cash receipts and disbursements method of 
accounting, is engaged in business (business R) in the United States 
from January 1, 1971, to August 31, 1971. During the period of September 
1, 1971, to December 31, 1971, B receives installment payments of 
$30,000 on sales made in the United States by business R during that 
year, and the income from sources within the United States for that year 
attributable to such payments is

[[Page 377]]

$7,509. On September 15, 1971, another business (business S), which is 
carried on by B only in a foreign country sells to U.S. customers on the 
installment plan several pieces of equipment from inventory. During the 
period of September 16, 1971, to December 31, 1971, B receives 
installment payments of $50,000 on these sales by business S, and the 
income from sources within the United States for that year attributable 
to such payments is $10,000. Under section 864(c)(3) and paragraph (b) 
of Sec.  1.864-4 the entire income of $17,500 is effectively connected 
for 1971 with the conduct of a business in the United States by B. 
Accordingly, such income is taxable to B under paragraph (b)(2) of this 
section.
    Example 2. Assume the same facts as in example 1, except that during 
1972 B receives installment payments of $20,000 from the sales made 
during 1971 in the United States by business R, and of $80,000 from the 
sales made in 1971 to U.S. customers by business S, the total income 
from sources within the United States for 1972 attributable to such 
payments being $13,000. At no time during 1972 is B engaged in a trade 
or business in the United States. Under section 864(c)(1)(B) the income 
of $13,000 for 1972 is not effectively connected with the conduct of a 
trade or business in the United States by B. Moreover, such income is 
not fixed or determinable annual or periodical income. Accordingly, no 
amount of such income is taxable to B under section 871.
    Example 3. Assume the same facts as in example 2, except that during 
1972 B is engaged in a new business (business T) in the United States 
from July 1, 1972, to December 31, 1972. Under section 864(c)(3) and 
paragraph (b) of Sec.  1.864-4, the income of $13,000 is effectively 
connected for 1972 with the conduct of a business in the United States 
by B. Accordingly, such income is taxable to B under paragraph (b)(2) of 
this section.
    Example 4. Assume the same facts as in example 2, except that the 
installment payments of $20,000 from the sales made during 1971 in the 
United States by business R and not received by B until 1972 could have 
been received by B in 1971 if he had so desired. Under Sec.  1.451-2, B 
is deemed to have constructively received the payments of $20,000 in 
1971. Accordingly, the income attributable to such payments is 
effectively connected for 1971 with the conduct of a business in the 
United States by B and is taxable to B in 1971 under paragraph (b)(2) of 
this section.

    (d) Credits against tax. The credits allowed by section 31 (relating 
to tax withheld on wages), section 32 (relating to tax withheld at 
source on nonresident aliens), section 33 (relating to the foreign tax 
credit), section 35 (relating to partially tax-exempt interest), section 
38 (relating to investment in certain depreciable property), section 39 
(relating to certain uses of gasoline and lubricating oil), section 40 
(relating to expenses of work incentive programs), and section 6402 
(relating to overpayments of tax) shall be allowed against the tax 
determined in accordance with this section. However, the credits allowed 
by sections 33, 38, and 40 shall not be allowed against the flat tax of 
30 percent imposed by section 871(a) and paragraph (b)(1) of this 
section. Moreover, no credit shall be allowed under section 35 to a non- 
resident alien individual with respect to whom a tax is imposed for the 
taxable year under section 871(a) and paragraph (b)(1) of this section, 
even though such individual has income for such year upon which tax is 
imposed under section 871(b) and paragraph (b)(2) of this section. For 
special rules applicable in determining the foreign tax credit, see 
section 906(b) and the regulations thereunder. For the disallowance of 
certain credits where a return is not filed for the taxable year, see 
section 874 and Sec.  1.874-1.
    (e) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. For corresponding rules applicable to 
taxable years beginning before January 1, 1967, see 26 CFR 1.871-7(d) 
(Revised as of January 1, 1971).

[T.D. 7332, 39 FR 44221, Dec. 23, 1974]



Sec.  1.871-9  Nonresident alien students or trainees deemed to be engaged 
in U.S. business.

    (a) Participants in certain exchange or training programs. For 
purposes of Sec. Sec.  1.871-7 and 1.871-8 a nonresident alien 
individual who is temporarily present in the United States during the 
taxable year as a nonimmigrant under subparagraph (F) (relating to the 
admission of students into the United States) or subparagraph (J) 
(relating to the admission of teachers, trainees, specialists, etc., 
into the United States) of section 101(a)(15) of the Immigration and 
Nationality Act (8 U.S.C. 1101(a)(15) (F) or (J)), and who without 
regard to this paragraph is not engaged in trade or business in the 
United States during such year, shall be

[[Page 378]]

deemed to be engaged in trade or business in the United States during 
the taxable year. For purposes of determining whether an alien who is 
present in the United States on an F visa or a J visa is a resident of 
the United States, see Sec. Sec.  301.7701(b)-1 through 301.7701(b)-9 of 
this chapter.
    (b) Income treated as effectively connected with U.S. business. Any 
income described in paragraph (1) (relating to the nonexcluded portion 
of certain scholarship or fellowship grants) or paragraph (2) (relating 
to certain nonexcluded expenses incident to such grants) of section 
1441(b) which is received during the taxable year from sources within 
the United States by a nonresident alien individual described in 
paragraph (a) of this section is to be treated for purposes of 
Sec. Sec.  1.871-7, 1.871-8, 1.872-1, and 1.873-1 as income which is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that individual. However, such 
income is not to be treated as effectively connected for the taxable 
year with the conduct of a trade or business in the United States for 
purposes of section 1441(c)(1) and paragraph (a) of Sec.  1.1441-4. For 
exclusion relating to compensation paid to such individual by a foreign 
employer, see paragraph (b) of Sec.  1.872-2.
    (c) Exchange visitors. For purposes of paragraph (a) of this section 
a nonresident alien individual who is temporarily present in the United 
States during the taxable year as a nonimmigrant under subparagraph (J) 
of section 101(a)(15) of the Immigration and Nationality Act includes a 
nonresident alien individual admitted to the United States as an 
``exchange visitor'' under section 201 of the U.S. Information and 
Educational Exchange Act of 1948 (22 U.S.C. 1446), which section was 
repealed by section 111 of the Mutual Educational and Cultural Exchange 
Act of 1961 (75 Stat. 538).
    (d) Mandatory application of rule. The application of this section 
is mandatory and not subject to an election by the taxpayer.
    (e) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. For corresponding rules applicable to 
taxable years beginning before January 1, 1967, see 26 CFR 1.871-7(a)(3) 
(Revised as of January 1, 1971).

[T.D. 7332, 39 FR 44222, Dec. 23, 1974, as amended by T.D. 8411, 57 FR 
15241, Apr. 27, 1992]



Sec.  1.871-10  Election to treat real property income as effectively 
connected with U.S. business.

    (a) When election may be made. A nonresident alien individual or 
foreign corporation which during the taxable year derives any income 
from real property which is located in the United States and, in the 
case of a nonresident alien individual, held for the production of 
income, or derives income from any interest in any such property, may 
elect, pursuant to section 871(d) or 882(d) and this section, to treat 
all such income as income which is effectively connected for the taxable 
year with the conduct of a trade or business in the United States by 
that taxpayer. The election may be made whether or not the taxpayer is 
engaged in trade or business in the United States during the taxable 
year for which the election is made or whether or not the taxpayer has 
income from real property which for the taxable year is effectively 
connected with the conduct of a trade or business in the United States, 
but it may be made only with respect to that income from sources within 
the United States which, without regard to this section, is not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by the taxpayer. If for the taxable 
year the taxpayer has no income from real property located in the United 
States, or from any interest in such property, which is subject to the 
tax imposed by section 871(a) or 881(a), the election may not be made. 
But if an election has been properly made under this section for a 
taxable year, the election remains in effect, unless properly revoked, 
for subsequent taxable years even though during any such subsequent 
taxable year there is no income from the real property, or interest 
therein, in respect of which the election applies.
    (b) Income to which the election applies--(1) Included income. An 
election

[[Page 379]]

under this section shall apply to all income from real property which is 
located in the United States and, in the case of a nonresident alien 
individual, held for the production of income, and to all income derived 
from any interest in such property, including (i) gains from the sale or 
exchange of such property or an interest therein, (ii) rents or 
royalties from mines, oil or gas wells, or other natural resources, and 
(iii) gains described in section 631 (b) or (c), relating to treatment 
of gain on the disposal of timber, coal, or iron ore with a retained 
economic interest. The election may not be made with respect to only one 
class of such income. For purposes of the election, income from real 
property, or from any interest in real property, includes any amount 
included under section 652 or 662 in the gross income of a nonresident 
alien individual or foreign corporation that is the beneficiary of an 
estate or trust if, by reason of the application of section 652(b) or 
662(b), and the regulations thereunder, such amount has the character in 
the hands of that beneficiary of income from real property, or from any 
interest in real property. It is immaterial that no tax would be imposed 
on the income by section 871(a) and paragraph (a) of Sec.  1.871-7, or 
by section 881(a) and paragraph (a) of Sec.  1.881-2, if the election 
were not in effect. Thus, for example, if an election under this section 
has been made by a nonresident alien individual not engaged in trade or 
business in the United States during the taxable year, the tax imposed 
by section 871(b)(1) and paragraph (b)(2) of Sec.  1.871-8 applies to 
his gains derived from the sale of real property located in the United 
States and held for the production of income, even though such income 
would not be subject to tax under section 871(a) if the election had not 
been made. In further illustration, assume that a nonresident alien 
individual not engaged in trade or business, or present, in the United 
States during the taxable year has income from sources within the United 
States consisting of oil royalties, rentals from a former personal 
residence, and capital gain from the sale of another residence held for 
the production of income. If he makes an election under this section, it 
will apply with respect to his royalties, rentals, and capital gain, 
even though such capital gain would not be subject to tax under section 
871(a) if the election had not been made.
    (2) Income not included. For purposes of subparagraph (1) of this 
paragraph, income from real property, or from any interest in real 
property, does not include (i) interest on a debt obligation secured by 
a mortgage of real property, (ii) any portion of a dividend, within the 
meaning of section 316, which is paid by a corporation or a trust, such 
as a real estate investment trust described in section 857, which 
derives income from real property, (iii) in the case of a nonresident 
alien individual, income from real property, such as a personal 
residence, which is not held for the production of income or from any 
transaction in such property which was not entered into for profit, (iv) 
rentals from personal property, or royalties from intangible personal 
property, within the meaning of subparagraph (3) of this paragraph, or 
(v) income which, without regard to section 871(d) or 882(d) and this 
section, is treated as income which is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States.
    (3) Rules applicable to personal property. For purposes of 
subparagraph (2) of this paragraph, in the case of a sales agreement, or 
rental or royalty agreement, affecting both real and personal property, 
the income from the transaction is to be allocated between the real 
property and the personal property in proportion to their respective 
fair market values unless the agreement specifically provides otherwise. 
In the case of such a rental or royalty agreement, the respective fair 
market values are to be determined as of the time the agreement is 
signed. In making determinations of this subparagraph, the principles of 
paragraph (c) of Sec.  1.48-1, relating to the definition of ``section 
38 property,'' apply for purposes of determining whether property is 
tangible or intangible personal property and of paragraph (a)(5) of 
Sec.  1.1245-1 apply for purposes of making the allocation of income 
between real and personal property.

[[Page 380]]

    (c) Effect of the election--(1) Determination of tax. The income to 
which, in accordance with paragraph (b) of this section, an election 
under this section applies shall be subject to tax in the manner, and 
subject to the same conditions, provided by section 871(b)(1) and 
paragraph (b)(2) of Sec.  1.871-8, or by section 882(a)(1) and paragraph 
(b)(2) of Sec.  1.882-1. For purposes of determining such tax for the 
taxable year, income to which the election applies shall be aggregated 
with all other income of the nonresident alien individual or foreign 
corporation which is effectively connected for the taxable year with the 
conduct of a trade or business in the United States by that taxpayer. To 
the extent that deductions are connected with income from real property 
to which the election applies, they shall be treated for purposes of 
section 873(a) or section 882(c)(1) as connected with income which is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by the nonresident alien individual or 
foreign corporation. An election under this section does not cause a 
nonresident alien individual or foreign corporation, which is not 
engaged in trade or business in the United States during the taxable 
year, to be treated as though such taxpayer were engaged in trade or 
business in the United States during the taxable year. Thus, for 
example, the compensation received during the taxable year for services 
performed in the United States in a previous taxable year by a 
nonresident alien individual, who has an election in effect for the 
taxable year under this section but is engaged in trade or business in 
the United States at no time during the taxable year, is not effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States. In further illustration, gain for the taxable year 
from the casual sale of personal property described in section 1221(I) 
derived by a nonresident alien individual who is not engaged in trade or 
business in the United States during the taxable year but has an 
election in effect for such year under this section is not effectively 
connected with the conduct of a trade or business in the United States. 
See Sec.  1.864-3. If an election under this section is in effect for 
the taxable year, the income to which the election applies shall be 
treated, for purposes of section 871(b)(1) or section 882(a)(1), section 
1441(c)(1), and paragraph (a) of Sec.  1.1441-4, as income which is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by the taxpayer.
    (2) Treatment of property to which election applies. Any real 
property, or interest in real property, with respect to which an 
election under this section applies shall be treated as a capital asset 
which, if depreciable, is subject to the allowance for depreciation 
provided in section 167 and the regulations thereunder. Such property, 
or interest in property, shall be treated as property not used in a 
trade or business for purposes of applying any provisions of the Code, 
such as section 172(d)(4)(A), relating to gain or loss attributable to a 
trade or business for purposes of determining a net operating loss; 
section 1221(2), relating to property not constituting a capital asset; 
or section 1231(b), relating to special rules for treatment of gains and 
losses. For example, if a nonresident alien individual makes the 
election under this section and, while the election is in effect, sells 
unimproved land which is located in the United States and held for 
investment purposes, any gain or loss from the sale shall be considered 
gain or loss from the sale of a capital asset and shall be treated, for 
purposes of determining the tax under section 871(b)(1) and paragraph 
(b)(2) of Sec.  1.871-8, as a gain or loss which is effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States.
    (d) Manner of making or revoking an election--(1) Election, or 
revocation, without consent of Commissioner--(i) In general. A 
nonresident alien individual or foreign corporation may, for the first 
taxable year for which the election under this section is to apply, make 
the initial election at any time before the expiration of the period 
prescribed by section 6511(a), or by section 6511(c) if the period for 
assessment is extended by agreement, for filing a claim for credit or 
refund of the tax imposed by chapter 1 of the Code for such taxable

[[Page 381]]

year. This election may be made without the consent of the Commissioner. 
Having made the initial election, the taxpayer may, within the time 
prescribed for making the election for such taxable year, revoke the 
election without the consent of the Commissioner. If the revocation is 
timely and properly made, the taxpayer may make his initial election 
under this section for a later taxable year without the consent of the 
Commissioner. If the taxpayer revokes the initial election without the 
consent of the Commissioner he must file amended income tax returns, or 
claims for credit or refund, where applicable, for the taxable years to 
which the revocation applies.
    (ii) Statement to be filed with return. An election made under this 
section without the consent of the Commissioner shall be made for a 
taxable year by filing with the income tax return required under section 
6012 and the regulations thereunder for such taxable year a statement to 
the effect that the election is being made. This statement shall include 
(a) a complete schedule of all real property, or any interest in real 
property, of which the taxpayer is titular or beneficial owner, which is 
located in the United States, (b) an indication of the extent to which 
the taxpayer has direct or beneficial ownership in each such item of 
real property, or interest in real property, (c) the location of the 
real property or interest therein, (d) a description of any substantial 
improvements on any such property, and (e) an identification of any 
taxable year or years in respect of which a revocation or new election 
under this section has previously occurred. This statement may not be 
filed with any return under section 6851 and the regulations thereunder.
    (iii) Exemption from withholding of tax. For statement to be filed 
with a withholding agent at the beginning of a taxable year in respect 
of which an election under this section is to be made, see paragraph (a) 
of Sec.  1.1441-4.
    (2) Revocation, or election, with consent of Commissioner--(i) In 
general. If the nonresident alien individual or foreign corporation 
makes the initial election under this section for any taxable year and 
the period prescribed by subparagraph (1)(i) of this paragraph for 
making the election for such taxable year has expired, the election 
shall remain in effect for all subsequent taxable years, including 
taxable years for which the taxpayer realizes no income from real 
property, or from any interest therein, or for which he is not required 
under section 6012 and the regulations thereunder to file an income tax 
return. However, the election may be revoked in accordance with 
subdivision (iii) of this subparagraph for any subsequent taxable year 
with the consent of the Commissioner. If the election for any such 
taxable year is revoked with the consent of the Commissioner, the 
taxpayer may not make a new election before his fifth taxable year which 
begins after the first taxable year for which the revocation is 
effective unless consent is given to such new election by the 
Commissioner in accordance with subdivision (iii) of this subparagraph.
    (ii) Effect of new election. A new election made for the fifth 
taxable year, or taxable year thereafter, without the consent of the 
Commissioner, and a new election made with the consent of the 
Commissioner, shall be treated as an initial election to which 
subparagraph (1) of this paragraph applies.
    (iii) Written request required. A request to revoke an election made 
under this section when such revocation requires the consent of the 
Commissioner, or to make a new election when such election requires the 
consent of the Commissioner, shall be made in writing and shall be 
addressed to the Director of International Operations, Internal Revenue 
Service, Washington, DC 20225. The request shall include the name and 
address of the taxpayer and shall be signed by the taxpayer or his duly 
authorized representative. It must specify the taxable year for which 
the revocation or new election is to be effective and shall be filed 
within 75 days after the close of the first taxable year for which it is 
desired to make the change. The request must specify the grounds which 
are considered to justify the revocation or new election. The Director 
of International Operations may require such other information as may be 
necessary in order to determine whether the proposed change will be 
permitted. A copy of the consent by

[[Page 382]]

the Director of International Operations shall be attached to the 
taxpayer's return required under section 6012 and the regulations 
thereunder for the taxable year for which the revocation or new election 
is effective. A copy of such consent may not be filed with any return 
under section 6851 and the regulations thereunder.
    (3) Election by partnership. If a non-resident alien individual or 
foreign corporation is a member of a partnership which has income 
described in paragraph (b)(1) of this section from real property, any 
election to be made under this section in respect of such income shall 
be made by the partners and not by the partnership. A nonresident alien 
or foreign corporation that makes an election generally must provide the 
partnership a Form W-8ECI, ``Certificate of Foreign Person's Claim for 
Exemption from Withholding on Income Effectively Connected with the 
Conduct of a Trade or Business in the United States,'' and attach to 
such form a copy of the election (or a statement that indicates that the 
nonresident alien or foreign corporation will make the election). 
However, if the nonresident alien or foreign corporation has already 
submitted a valid form to the partnership that establishes such 
partner's foreign status, the partner shall furnish the partnership a 
copy of the election (or a statement that indicates that the nonresident 
alien or foreign corporation will make the election). To the extent the 
partnership has income to which the election pertains, the partnership 
shall treat such income as effectively connected income subject to 
withholding under section 1446. See also Sec.  1.1446-2.
    (e) Effective dates. This section shall apply for taxable years 
beginning after December 31, 1966, except the last four sentences of 
paragraph (d)(3) of this section shall apply to partnership taxable 
years beginning after May 18, 2005, or such earlier time as the 
regulations under Sec. Sec.  1.1446-1 through 1.1446-5 apply by reason 
of an election under Sec.  1.1446-7. There are no corresponding rules in 
this part for taxable years beginning before January 1, 1967.

[T.D. 7332, 39 FR 44222, Dec. 23, 1974, as amended by T.D. 9200, 70 FR 
28717, May 18, 2005]



Sec.  1.871-11  Gains from sale or exchange of patents, copyrights, 
or similar property.

    (a) Contingent payment defined. For purposes of section 
871(a)(1)(D), section 881(a)(4), Sec.  1.871-7(c)(1)(iv), Sec.  1.881-
2(c)(1)(iii), and this section, payments which are contingent on the 
productivity, use, or disposition of property or of an interest therein 
include continuing payments measured by a percentage of the selling 
price of the products marketed, or based on the number of units 
manufactured or sold, or based in a similar manner upon production, sale 
or use, or disposition of the property or interest transferred. A 
payment which is certain as to the amount to be received, but contingent 
as to the time of payment, or an installment payment of a principal sum 
agreed upon in a transfer agreement, shall not be treated as a 
contingent payment for purposes of this paragraph. For the inapplication 
of section 1253 to certain amounts described in this paragraph, see 
paragraph (a) of Sec.  1.1253-1.
    (b) Payments treated as contingent on use. Pursuant to section 
871(e), if more than 50 percent of the gain of a nonresident alien 
individual or foreign corporation for any taxable year from the sale or 
exchange after October 4, 1966, of any patent, copyright, secret process 
or formula, goodwill, trademark, trade brand, franchise, or other like 
property, or of any interest in any such property, is from payments 
which are contingent on the productivity, use, or disposition of such 
property or interest, all of the gain of such individual or corporation 
for the taxable year from the sale or exchange of such property or 
interest are, for purposes of section 871(a)(1)(D), section 881(a)(4), 
section 1441(b), or section 1442(a), and the regulations thereunder, to 
be treated as being from payments which are contingent on the 
productivity, use, or disposition of such property or interest. This 
paragraph does not apply for purposes of determining under section 
871(b)(1) or 882(a)(1) the tax of a nonresident alien individual or 
foreign corporation on income which is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States.

[[Page 383]]

    (c) Sale or exchange. A sale or exchange for purposes of this 
section includes, but is not limited to, a transfer by an individual 
which by reason of section 1235, relating to the sale or exchange of 
patents, is considered the sale or exchange of a capital asset. The 
provisions of section 1253, relating to transfers of franchises, 
trademarks, and trade names, do not apply in determining whether a 
transfer is a sale or exchange for purposes of this section.
    (d) Recovery of adjusted basis. For purposes of determining for any 
taxable year the amount of gains which are subject to tax under section 
871(a)(1)(D) or 881(a)(4), payments received by the nonresident alien 
individual or foreign corporation during such year must be reduced by 
amounts representing recovery of the taxpayer's adjusted basis of the 
property or interest which is sold or exchanged. Where the taxpayer 
receives in the same taxable year payments which, without reference to 
section 871(e) and this section, are not contingent on the productivity, 
use, or disposition of the property or interest which is sold or 
exchanged and payments which are contingent on the productivity, use, or 
disposition of the property or interest which is sold or exchanged, the 
taxpayer's unrecovered adjusted basis in the property or interest which 
is sold or exchanged must be allocated for the taxable year between such 
payments on the basis of the gross amount of each such type of payments. 
Where the taxpayer receives in the taxable year only payments which are 
not so contingent or only payments which are so contingent, the 
taxpayer's unrecovered basis must be allocated in its entirety to such 
payments for the taxable year.
    (e) Source rule. In determining whether gains described in section 
871(a)(1)(D) or 881(a)(4) and paragraph (b) of this section are received 
from sources within the United States, such gains shall be treated, for 
purposes of section 871(a)(1)(D), section 881(a)(4), section 1441(b), 
and section 1442(a), as rentals or royalties for the use of, or 
privilege of using, property or an interest in property. See section 
861(a)(4), Sec.  1.861-5, and paragraph (a) of Sec.  1.862-1.
    (f) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. (a) A, a nonresident alien individual who uses the cash 
receipts and disbursements method of accounting and the calendar year as 
the taxable year, holds a U.S. patent which he developed through his own 
effort. On December 15, 1967, A enters into an agreement of sale with M 
Corporation, a domestic corporation, whereby A assigns to M Corporation 
all of his U.S. rights in the patent. In consideration of the sale, M 
Corporation is obligated to pay a fixed sum of $60,000, $20,000 being 
payable on execution of the contract and the balance payable in four 
annual installments of $10,000 each. As additional consideration, M 
Corporation agrees to pay to A a royalty in the amount of 2 percent of 
the gross sales of the products manufactured by M Corporation under the 
patent. A is not engaged in trade or business in the United States at 
any time during 1967 and 1968. His adjusted basis in the patent at the 
time of sale is $28,800.
    (b) In 1967, A receives only the $20,000 paid by M Corporation on 
the execution of the contract of sale. No gain is realized by A upon 
receipt of this amount, and his unrecovered adjusted basis in the patent 
is reduced to $8,800 ($28,800 less $20,000).
    (c) In 1968, M Corporation has gross sales of $600,000 from products 
manufactured under the patent. Consequently, for 1968, M Corporation 
pays $22,000 to A, $10,000 being the annual installment on the fixed 
payment and $12,000 being payments under the terms of the royalty 
provision. A's recognized gain for 1968 is $13,200 ($22,000 reduced by 
the unrecovered adjusted basis of $8,800). Of the total gain of $13,200, 
gain in the amount of $6,000 ($10,000- [$8,800 x $10,000/$22,000]) is 
considered to be from the fixed installment payment and of $7,200 
($12,000-[$8,800 x $12,000/$22,000]) is considered to be from the 
royalty payment. Since 54.5 percent ($7,200/$13,200) of the gain 
recognized in 1968 from the sale of the patent is from payments which 
are contingent on the productivity, use, or disposition of the patent, 
all of the $13,200 gain recognized in 1968 is treated, for purposes of 
section 871(a)(1)(D) and section 1441(b), as being from payments which 
are contingent on the productivity, use, or disposition of the patent.
    Example 2. (a) F, a foreign corporation using the calendar year as 
the taxable year and not engaged in trade or business in the United 
States, holds a U.S. patent on certain property which it developed 
through its own efforts. Corporation F uses the cash receipts and 
disbursements method of accounting. On December 1, 1966, F Corporation 
enters into an agreement of sale with D Corporation, a

[[Page 384]]

domestic corporation, whereby D Corporation purchases the exclusive 
right and license, and the right to sublicense to others, to 
manufacture, use, and/or sell certain devices under the patent in the 
United States during the term of the patent. The agreement grants D 
Corporation the right to dispose, anywhere in the world, of machinery 
manufactured in the United States and equipped with such devices. 
Corporation D is granted the right, at its own expense, to prosecute 
infringers in its own name or in the name of F Corporation, or both, and 
to retain any damages recovered.
    (b) Corporation D agrees to pay to F Corporation annually $5 for 
each device manufactured under the patent during the year but in no case 
less than $5,000 per year. In 1967, D Corporation manufactures 2,500 
devices under the patent; and, in 1968, 1,500 devices. Under the terms 
of the contract D Corporation pays to F Corporation in 1967 $12,500 with 
respect to production in that year and $7,500 in 1968 with respect to 
production in that year. F Corporation's basis in the patent at the time 
of the sale is $17,000.
    (c) With respect to the payments received by F Corporation in 1967, 
no gain is realized by that corporation and its unrecovered adjusted 
basis in the patent is reduced to $4,500 ($17,000 less $12,500).
    (d) With respect to the payments received by F Corporation in 1968, 
such corporation has recognized gain of $3,000 ($7,500 reduced by 
unrecovered adjusted basis of $4,500). Of the total gain of $3,000, gain 
in the amount of $2,000 ($5,000- [$4,500 x $5,000/$7,500]) is considered 
to be from the fixed installment payment and of $1,000 ($2,500-[$4,500 x 
$2,500/$7,500]) is considered to be from payments which are contingent 
on the productivity, use, or disposition of the patent. Since 33.3 
percent ($1,000/$3,000) of the gain recognized in 1968 from the sale of 
the patent is from payments which are contingent on the productivity, 
use, or disposition of the patent, only $1,000 of the $3,000 gain for 
that year constitutes gains which, for purposes of section 881(a)(4) and 
section 1442(a), are from payments which are contingent on the 
productivity, use, or disposition of the patent. The balance of $2,000 
is gain from the sale of property and is not subject to tax under 
section 881(a).

    (g) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966, but only in respect of gains from 
sales or exchanges occurring after October 4, 1966. There are no 
corresponding rules in this part for taxable years beginning before 
January 1, 1967.

[T.D. 7332, 39 FR 44224, Dec. 23, 1974]



Sec.  1.871-12  Determination of tax on treaty income.

    (a) In general. This section applies for purposes of determining 
under Sec.  1.871-7 or Sec.  1.871-8 the tax of a nonresident alien 
individual, or under Sec.  1.881-2 or Sec.  1.882-1 the tax of a foreign 
corporation, which for the taxable year has income described in section 
872(a) or 882(b) upon which the tax is limited by an income tax 
convention to which the United States is a party. Income for such 
purposes does not include income of any kind which is exempt from tax 
under the provisions of an income tax convention to which the United 
States is a party. See Sec. Sec.  1.872-2(c) and 1.883-1(b). This 
section shall not apply to a nonresident alien individual who is a bona 
fide resident of Puerto Rico during the entire taxable year.
    (b) Definition of treaty and nontreaty income--(1) In general. (i) 
For purposes of this section the term ``treaty income'' shall be 
construed to mean the gross income of a nonresident alien individual or 
foreign corporation, as the case may be, the tax on which is limited by 
a tax convention. The term ``non-treaty income'' shall be construed, for 
such purposes, to mean the gross income of the nonresident alien 
individual or foreign corporation other than the treaty income. Neither 
term includes income of any kind which is exempt from the tax imposed by 
chapter 1 of the Code.
    (ii) In determining either the treaty or nontreaty income the gross 
income shall be determined in accordance with Sec. Sec.  1.872-1 and 
1.872-2, or with Sec. Sec.  1.882-3 and 1.883-1, except that in 
determining the treaty income the exclusion granted by section 116(a) 
for dividends shall not be taken into account. Thus, for example, treaty 
income includes the total amount of dividends paid by a domestic 
corporation not disqualified by section 116(b) and received from sources 
within the United States if, in accordance with a tax convention, the 
dividends are subject to the income tax at a rate not to exceed 15 
percent but does not include interest which, in accordance with a tax 
convention, is exempt from the income tax. In further illustration, 
neither the treaty nor the nontreaty income includes interest on certain 
governmental obligations

[[Page 385]]

which by reason of section 103 is excluded from gross income, or 
interest which by reason of a tax convention is exempt from the tax 
imposed by chapter 1 of the Code.
    (iii) For purposes of applying any income tax convention to which 
the United States is a party, original issue discount which is subject 
to tax under section 871(a)(1)(C) or 881(a)(3) is to be treated as 
interest, and gains which are subject to tax under section 871(a)(1)(D) 
or 881(a)(4) are to be treated as royalty income. This subdivision shall 
not apply, however, where its application would be contrary to any 
treaty obligation of the United States.
    (2) Application of permanent establishment rule of treaties. In 
applying this section with respect to income which is not effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by a nonresident alien individual or foreign 
corporation, see section 894(b), which provides that with respect to 
such income the nonresident alien individual or foreign corporation 
shall be deemed not to have a permanent establishment in the United 
States at any time during the taxable year for purposes of applying any 
exemption from, or reduction in rate of, tax provided by any tax 
convention.
    (c) Determination of tax--(1) In general. If the gross income of a 
nonresident alien individual or foreign corporation, as the case may be, 
consists of both treaty and nontreaty income, the tax liability for the 
taxable year shall be the sum of the amounts determined in accordance 
with subparagraphs (2) and (3) of this paragraph. In no case, however, 
may the tax liability so determined exceed the tax liability (tax 
reduced by allowable credits) with respect to the taxpayer's entire 
income, determined in accordance with Sec.  1.871-7 or Sec.  1.871-8, or 
with Sec.  1.881-2 or Sec.  1.882-1, as though the tax convention had 
not come into effect and without reference to the provisions of this 
section. Determinations under this paragraph shall be made without 
taking into account any credits allowed by sections 31, 32, 39, and 
6402, but such credits shall be allowed against the tax liability 
determined in accordance with this subparagraph.
    (2) Tax on nontreaty income. For purposes of subparagraph (1) of 
this paragraph, compute a partial tax (determined without the allowance 
of any credit) upon only the nontreaty income in accordance with Sec.  
1.871-7 or Sec.  1.871-8, or with Sec.  1.881-2 or Sec.  1.882-1, 
whichever applies, as though the tax convention had not come into 
effect. To the extent allowed by paragraph (d) of Sec.  1.871-8, or 
paragraph (c) of Sec.  1.882-1, the credits allowed by sections 33, 35, 
38, and 40 shall then be allowed, without taking into account any item 
included in the treaty income, against the tax determined under this 
subparagraph.
    (3) Tax on treaty income. For purposes of subparagraph (1) of this 
paragraph, compute a tax upon the gross amount, determined without the 
allowance of any deduction, of each separate item of treaty income at 
the reduced rate applicable to that item under the tax convention. No 
credits shall be allowed against the tax determined under this 
subparagraph.
    (d) Illustration. The application of this section may be illustrated 
by the following example:

    Example. (a) A nonresident alien individual who is a resident of a 
foreign country with which the United States has entered into a tax 
convention receives during the taxable year 1967 from sources within the 
United States total gross income of $22,000, consisting of the following 
items:

Compensation for personal services the tax on which is not       $20,000
 limited by the tax convention (effectively connected income
 under Sec.   1.864-4(c)(6)(ii))..............................
Oil royalties the tax on which is limited by the tax               2,000
 convention to 15 percent of the gross amount thereof
 (effectively connected income by reason of election under
 Sec.   1.871-10).............................................
                                                               ---------
   Total gross income.........................................    22,000
 

    (b) The taxpayer is engaged in business in the United States during 
the taxable year but does not have a permanent establishment therein. 
There are no allowable deductions, other than the deductions allowed by 
sections 613 and 873(b)(3).
    (c) The tax liability for the taxable year is $6,100, determined as 
follows:

Nontreaty gross income........................................   $20,000
Less: Deduction for personal exemption........................       600
                                                               ---------
   Nontreaty taxable income...................................    19,400
                                                               =========
Tax under section 1 of the Code on nontreaty taxable income        5,800
 ($5,170 plus 45 percent of $1,400)...........................
Plus: Tax on treaty income (Gross oil royalties) ($2,000 x 15        300
 percent).....................................................
                                                               ---------

[[Page 386]]

 
    Total tax (determined as provided in paragraph (c) (2) and     6,100
     (3) of this section).....................................
                                                               =========
 

    (d) If the tax had been determined under paragraph (b)(2) of Sec.  
1.871-8 as though the tax liability would have been $6,478, determined 
as follows and by taking into account the election under Sec.  1.871-10:

Total gross income...................................  .......   $22,000
  Less: Deduction under section 613 for percentage        $550
   depletion ($2000 x 27\1/2\ percent)...............
  Deduction for personal exemption...................      600     1,150
                                                      ------------------
   Taxable income....................................   20,850
                                                               =========
Tax under section 1 of the Code on taxable income ($6,070 plus     6,478
 48 percent of $850)..........................................
 

    (e) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. For corresponding rules applicable to 
taxable years beginning before January 1, 1967, see 26 CFR 1.871-7(e) 
(Revised as of January 1, 1971).

[T.D. 7332, 39 FR 44225, Dec. 23, 1974, as amended at T.D. 8657, 61 FR 
9338, Mar. 8, 1996]



Sec.  1.871-13  Taxation of individuals for taxable year of change 
of U.S. citizenship or residence.

    (a) In general. (1) An individual who is a citizen or resident of 
the United States at the beginning of the taxable year but a nonresident 
alien at the end of the taxable year, or a nonresident alien at the 
beginning of the taxable year but a citizen or resident of the United 
States at the end of the taxable year, is taxable for such year as 
though his taxable year were comprised of two separate periods, one 
consisting of the time during which he is a citizen or resident of the 
United States and the other consisting of the time during which he is 
not a citizen or resident of the United States. Thus, for example, the 
income tax liability of an alien individual under chapter 1 of the Code 
for the taxable year in which he changes his residence will be computed 
under two different sets of rules, one relating to resident aliens for 
the period of residence and the other relating to nonresident aliens for 
the period of nonresidence. However, in determining the taxable income 
for such year which is subject to the graduated rate of tax imposed by 
section 1 or 1201 of the Code, all income for the period of U.S. 
citizenship or residence must be aggregated with the income for the 
period of nonresidence which is effectively connected for such year with 
the conduct of a trade or business in the United States. This section 
does not apply to alien individuals treated as residents for the entire 
taxable year under section 6013 (g) or (h). These individuals are taxed 
under the rules in Sec.  1.1-1(b).
    (2) For purposes of this section, an individual is deemed to be a 
citizen or resident of the United States for the day on which he becomes 
a citizen or resident of the United States, a nonresident of the United 
States for the day on which he abandons his U.S. residence, and an alien 
for the day on which he gives up his U.S. citizenship.
    (b) Acquisition of U.S. citizenship or residence. Income from 
sources without the United States which is not effectively connected 
with the conduct by the taxpayer of a trade or business in the United 
States is not taxable if received by an alien individual while he is not 
a resident of the United States even though he becomes a citizen or 
resident of the United States after its receipt and before the close of 
the taxable year. However, income from sources without the United States 
which is not effectively connected with the conduct by the taxpayer of a 
trade or business in the United States is taxable if received by an 
individual while he is a citizen or resident of the United States, even 
though he earns the income earlier in the taxable year while he is 
neither a citizen nor resident of the United States.
    (c) Abandonment of U.S. citizenship or residence. Income from 
sources without the United States which is not effectively connected 
with the conduct by the taxpayer of a trade or business in the United 
States is not taxable if received by an alien individual while he is not 
a resident of the United States, even though he earns the income earlier 
in the taxable year while he is a citizen or resident of the United 
States. However, income from sources without the United States which is 
not effectively connected with the conduct by the taxpayer of a trade or 
business in the United States is taxable if received by an individual 
while he is a citizen or resident of the United States, even though he 
abandons his

[[Page 387]]

U.S. citizenship or residence after its receipt and before the close of 
the taxable year.
    (d) Special rules--(1) Method of accounting. Paragraphs (b) and (c) 
of this section may not apply to an individual who for the taxable year 
uses an accrual method of accounting.
    (2) Deductions for personal exemptions. An alien individual to whom 
this section applies is entitled to deduct one personal exemption for 
the taxable year under section 151. In addition, he is entitled to such 
additional exemptions as are allowed as a deduction under section 151 
but only to the extent the amount of such additional exemptions do not 
exceed his taxable income (determined without regard to any deduction 
for personal exemptions) for the period in the taxable year during which 
he is a citizen or resident of the United States. This subparagraph does 
not apply to the extent it is inconsistent with section 873, and the 
regulations thereunder, or with the provisions of an income tax 
convention to which the United States is a party.
    (3) Exclusion of dividends received. In determining the $100 
exclusion for the taxable year provided by section 116 in respect of 
certain dividends, only those dividends for the period during which the 
individual is neither a citizen nor resident of the United States may be 
taken into account as are effectively connected for the taxable year 
with the conduct of a trade or business in the United States. See Sec.  
1.116-1(e)(1).
    (e) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. A, a married alien individual who uses the calendar year 
as the taxable year and the cash receipts and disbursements method of 
accounting, becomes a resident of the United States on June 1, 1971. 
During the period of nonresidence from January 1, 1971, to May 31, 1971, 
inclusive, A receives $15,000 income from sources without the United 
States which is not effectively connected with the conduct of a trade or 
business in the United States. During the period of residence from June 
1, 1971, to December 31, 1971, A receives wages of $10,000, dividends of 
$200 from a foreign corporation, and dividends of $75 from a domestic 
corporation qualifying under section 116(a). Of the amount of wages so 
received, $2,000 is for services performed by A outside the United 
States during the period of nonresidence. Total allowable deductions 
(other than for personal exemptions) amount to $700, none of which are 
deductible under section 62 in computing adjusted gross income. For 1971 
A's spouse has no gross income and is not the dependent of another 
taxpayer. For 1971, A's taxable income is $8,200, all of which is 
subject to tax under section 1, as follows:

Wages.........................................................   $10,000
Dividends from foreign corporation............................       200
Dividends from domestic corporation ($75 less $75 exclusion)..         0
                                                      ----------
Adjusted gross income.........................................    10,200
Less deductions:
  Personal exemptions (2 x $650).....................   $1,300
  Other allowable deductions.........................      700     2,000
                                                      ------------------
Taxable income.......................................  .......     8,200
                                                               =========
 

    Example 2. The facts are the same as in example 1 except that during 
the period of nonresidence from January 1, 1971, to May 31, 1971, A 
receives from sources within the United States income of $1,850 which is 
effectively connected with the conduct by A of a business in the United 
States and $350 in dividends from domestic corporations qualifying under 
section 116(a). Only $50 of these dividends are effectively connected 
with the conduct by A of a business in the United States. The assumption 
is made that there are no allowable deductions connected with such 
effectively connected income. For 1971, A has taxable income of $10,075 
subject to tax under section 1 and $300 income subject to tax under 
section 871(a)(1)(A), as follows:

Wages.........................................................   $10,000
Business income...............................................     1,850
Dividends from foreign corporation............................       200
Dividends from domestic corporation ($125 less $100 exclusion)        25
                                                      ----------
Adjusted gross income.........................................    12,075
Less deductions:
  Personal exemptions (2 x $650).....................   $1,300
  Other allowable deductions.........................      700     2,000
                                                      ------------------
Taxable income subject to tax under section 1.................    10,075
                                                      ==========
Income subject to tax under section 871(a)(1)(A)..............       300
                                                      ==========
 

    Example 3. A, a married alien individual with three children, uses 
the calendar year as the taxable year and the cash receipts and 
disbursements method of accounting. On October 1, 1971, A and his family 
become residents of the United States. During the period of nonresidence 
from January 1, 1971, to September 30, 1971, A receives income of 
$18,000 from sources without the United States which is not effectively 
connected with the conduct of a trade or business in the United States 
and of $2,500 from sources within the United States which is effectively 
connected with the conduct of a business in the United States. It is 
assumed there are no allowable deductions connected with such 
effectively

[[Page 388]]

connected income. During the period of residence from October 1, 1971, 
to December 31, 1971, A receives wages of $2,000, of which $400 is for 
services performed outside the United States during the period of 
nonresidence. Total allowable deductions (other than for personal 
exemptions) amount to $250, none of which are deductible under section 
62 in computing adjusted gross income. Neither the spouse nor any of the 
children has any gross income for 1971, and the spouse is not the 
dependent of another taxpayer for such year. For 1971, A's taxable 
income is $1,850, all of which is subject to tax under section 1, as 
follows:

Wages (residence period).............................   $2,000
Less: Allowable deductions...........................      250
                                                      ---------
Taxable income (without deduction for personal exemptions)        $1,750
 (residence period)...........................................
Business income (nonresidence period).........................     2,500
                                                      ----------
Total taxable income (without deduction for personal               4,250
 exemptions)..................................................
Less deduction for personal exemptions:
  Taxpayer...........................................      650
  Wife and 3 children (4 x $650, but not to exceed       1,750     2,400
   $1,750)...........................................
                                                      ------------------
Taxable income.......................................  .......     1,850
                                                               =========
 

    (f) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. There are no corresponding rules in 
this part for taxable years beginning before January 1, 1967.

[T.D. 7332, 39 FR 44226, Dec. 23, 1974, as amended by T.D. 7670, 45 FR 
6928, Jan. 31, 1980]



Sec.  1.871-14  Rules relating to repeal of tax on interest 
of nonresident alien individuals and foreign corporations received 
from certain portfolio debt investments.

    (a) General rule. No tax shall be imposed under section 
871(a)(1)(A), 871(a)(1)(C), 881(a)(1) or 881(a)(3) on any portfolio 
interest as defined in sections 871(h)(2) and 881(c)(2) received by a 
foreign person. But see section 871(b) or 882(a) if such interest is 
effectively connected with the conduct of a trade or business within the 
United States.
    (b) Rules concerning obligations in bearer form before March 19, 
2012--(1) In general. Interest (including original issue discount) with 
respect to an obligation in bearer form is portfolio interest within the 
meaning of section 871(h)(2)(A) or 881(c)(2)(A) only if it is paid with 
respect to an obligation issued after July 18, 1984, and issued before 
March 19, 2012, that is described in section 163(f)(2)(B), as in effect 
before the amendment by section 502 of the Hiring Incentives to Restore 
Employment Act of 2010 (HIRE Act), Public Law 111-147, and the 
regulations under that section and an exception under section 871(h) or 
881(c) does not apply. Any obligation that is not in registered form as 
defined in paragraph (c)(1)(i) of this section is an obligation in 
bearer form.
    (2) Coordination with withholding and reporting rules. For an 
exemption from withholding under section 1441 with respect to 
obligations described in this paragraph (b), see Sec.  1.1441-
1(b)(4)(i). See Sec.  1.1471-2 for rules relating to withholding under 
chapter 4 of the Code that may apply to withholdable payments (as 
defined in Sec.  1.1471-4(b)(145)) made on or after July 1, 2014, with 
respect to an agreement or instrument that is not treated as an 
obligation outstanding before March 19, 2012. For purposes of the 
preceding sentence, the terms obligation and outstanding are described 
in Sec.  1.1471-2(b)). See also Sec.  1.1471-4(d)(6) for the reporting 
requirements of participating foreign financial institutions (as defined 
in Sec.  1.1471-1(b)(91)) with respect to accounts held by recalcitrant 
account holders (as defined in Sec.  1.1471-5(g)). For rules relating to 
an exemption from Form 1099 reporting and backup withholding under 
section 3406, see section 6049 and Sec.  1.6049-5(b)(8) for the payment 
of interest and Sec.  1.6045-1(g)(1)(ii) for the redemption, retirement, 
or sale of an obligation in bearer form.
    (c) Rules concerning obligations in registered form--(1) In 
general--(i) Obligation in registered form. For purposes of this 
section, an obligation is in registered form only as provided in this 
paragraph (c)(1)(i). The conditions for an obligation to be considered 
in registered form are identical to the conditions described in Sec.  
5f.103-1 of this chapter. Therefore, an obligation that would be an 
obligation in registered form except for the fact that it can be 
converted at any time in the future into an obligation that is not in 
registered form shall not be an obligation in registered form. An 
obligation that is not in registered form by reason of

[[Page 389]]

the preceding sentence may nevertheless be in registered form, but only 
after the possibility of conversion is terminated. An obligation that is 
not in registered form and can be converted into an obligation that 
would meet the requirements of this paragraph (c)(1)(i) for being in 
registered form shall be considered in registered form only after the 
conversion is effected. For purposes of this section, an obligation is 
convertible if the obligation can be transferred by any means not 
described in Sec.  5f.103-1(c) of this chapter. An obligation is treated 
as an obligation in registered form if--
    (A) The obligation is registered as to both principal and any stated 
interest with the issuer (or its agent) and transfer of the obligation 
may be effected only by surrender of the old instrument, and either the 
reissuance by the issuer of the old instrument to the new holder or the 
issuance by the issuer of a new instrument to the new holder;
    (B) The right to the principal of, and stated interest on, the 
obligation may be transferred only through a book entry system 
maintained by the issuer (or its agent) described in this paragraph 
(c)(1)(i)(B). An obligation shall be considered transferable through a 
book entry system if the ownership of an interest in the obligation, is 
required to be reflected in a book entry, whether or not physical 
securities are issued. A book entry is a record of ownership that 
identifies the owner of an interest in the obligation; or
    (C) It is registered as to both principal and any stated interest 
with the issuer (or its agent) and may be transferred by way of either 
of the methods described in paragraph (c)(1)(i) (A) or (B) of this 
section.
    (ii) Requirements for portfolio interest qualification in the case 
of an obligation in registered form. Interest (including original issue 
discount) received on an obligation that is in registered form qualifies 
as portfolio interest only if--
    (A) The interest is paid on an obligation issued after July 18, 
1984;
    (B) The interest would be subject to tax under section 871(a)(1)(A), 
871(a)(1)(C), 881(a)(1) or 881(a)(3) but for section 871(h) or 881(c);
    (C) A United States (U.S.) person otherwise required to deduct and 
withhold tax under chapter 3 of the Internal Revenue Code (Code) 
receives a statement that meets the requirements of section 871(h)(5) 
that the beneficial owner of the obligation is not a U.S. person; and
    (D) An exception under section 871(h) or 881(c) does not apply.
    (2) Required statement. For purposes of paragraph (c)(1)(ii)(C) of 
this section, a U.S. person will be considered to have received a 
statement that meets the requirements of section 871(h)(5) if either it 
complies with one of the procedures described in this paragraph (c)(2) 
and does not have actual knowledge or reason to know that the beneficial 
owner is a U.S. person or it complies with the procedures described in 
paragraph (d) or (e) of this section (to the extent applicable).
    (i) The U.S. person (or its authorized agent described in Sec.  
1.1441-7(c)(2)) can reliably associate the payment with documentation 
upon which it can rely to treat the payment as made to a foreign 
beneficial owner in accordance with Sec.  1.1441-1(e)(1)(ii). See Sec.  
1.1441-1(b)(2)(vii) for rules regarding reliable association with 
documentation.
    (ii) The U.S. person (or its authorized agent described in Sec.  
1.1441-7(c)(2)) can reliably associate the payment with a withholding 
certificate described in Sec.  1.1441-5(c)(2)(iv) from a person claiming 
to be a withholding foreign partnership or Sec.  1.1441-5(e)(v) for a 
person claiming to be a withholding foreign trust.
    (iii) The U.S. person (or its authorized agent described in Sec.  
1.1441-7(c)(2)) can reliably associate the payment with a withholding 
certificate described in Sec.  1.1441-1(e)(3)(ii) from a person 
representing to be a qualified intermediary that has assumed primary 
withholding responsibility for the payment in accordance with Sec.  
1.1441-1(e)(5)(iv) or a qualified intermediary that has provided a 
withholding statement that meets the requirements of Sec.  1.1441-
1(e)(5)(v)(C) or that includes the payment in a withholding rate pool 
for payments excepted from withholding.
    (iv) The U.S. person (or its authorized agent described in Sec.  
1.1441-7(c)(2)) can reliably associate the payment

[[Page 390]]

with a withholding certificate described in Sec.  1.1441-1(e)(3)(v) from 
a person claiming to be a U.S. branch of a foreign bank or of a foreign 
insurance company that is described in Sec.  1.1441-1(b)(2)(iv)(A) or a 
U.S. branch designated in accordance with Sec.  1.1441-1(b)(2)(iv)(E).
    (v) The U.S. person receives a statement from a securities clearing 
organization, a bank, or another financial institution that holds 
customers' securities in the ordinary course of its trade or business. 
In such case the statement must be signed under penalties of perjury by 
an authorized representative of the financial institution and must state 
that the institution has received from the beneficial owner a 
withholding certificate described in Sec.  1.1441-1(e)(2)(i) (a Form W-8 
or an acceptable substitute form as defined Sec.  1.1441-1(e)(4)(vi)) or 
that it has received from another financial institution a similar 
statement that it, or another financial institution acting on behalf of 
the beneficial owner, has received the Form W-8 from the beneficial 
owner. In the case of multiple financial institutions between the 
beneficial owner and the U.S. person, this statement must be given by 
each financial institution to the one above it in the chain. No 
particular form is required for the statement provided by the financial 
institutions. However, the statement must provide the name and address 
of the beneficial owner, and a copy of the Form W-8 provided by the 
beneficial owner must be attached. The statement is subject to the same 
rules described in Sec.  1.1441-1(e)(4) that apply to intermediary Forms 
W-8 described in Sec.  1.1441-1(e)(3)(iii). If the information on the 
Form W-8 changes, the beneficial owner must so notify the financial 
institution acting on its behalf within 30 days of such changes, and the 
financial institution must promptly so inform the U.S. person. This 
notice also must be given if the financial institution has actual 
knowledge that the information has changed but has not been so informed 
by the beneficial owner. In the case of multiple financial institutions 
between the beneficial owner and the U.S. person, this notice must be 
given by each financial institution to the institution above it in the 
chain.
    (vi) The U.S. person complies with procedures that the U.S. 
competent authority may agree to with the competent authority of a 
country with which the United States has an income tax treaty in effect.
    (3) Time for providing certificate or documentary evidence--(i) 
General rule. Interest on a registered obligation shall qualify as 
portfolio interest if the withholding certificate or documentary 
evidence that must be provided is furnished before expiration of the 
beneficial owner's period of limitation for claiming a refund of tax 
with respect to such interest. See, however, Sec.  1.1441-1(b)(7) for 
consequences to a withholding agent that makes a payment without 
withholding even though it cannot reliably associate the payment with 
the documentation prior to the payment. If a withholding agent withholds 
an amount under chapter 3 of the Code because it cannot reliably 
associate the payment with the documentation for the beneficial owner on 
the date of payment, the beneficial owner may nevertheless claim the 
benefit of an exemption from tax under this section by claiming a refund 
or credit for the amount withheld based upon the procedures described in 
Sec. Sec.  1.1464-1 and 301.6402-3(e) of this chapter. See Sec. Sec.  
1.1474-5 and 301.6402-3(e) of this chapter for the allowance and 
requirements for a refund with respect to an amount (including a payment 
of interest) that was withheld upon under chapter 4 of the Code. In the 
alternative, adjustments to any amount of overwithheld tax may be made 
under the procedures described in Sec.  1.1461-2(a) for a payment 
withheld upon under chapter 3 of the Code or in Sec.  1.1474-2 for a 
payment withheld upon under chapter 4 of the Code.
    (ii) Example. The following example illustrates the rules of this 
paragraph (c)(3) and their coordination with Sec.  1.1441-1(b)(7):

    Example. A is a withholding agent who, on October 12, 2001, pays 
interest on a registered obligation to B, a foreign corporation. B is a 
calendar year taxpayer, engaged in the conduct of a trade or business in 
the United States, and is, therefore, required to file an annual income 
tax return on Form 1120F. The interest, however, is not effectively 
connected with B's U.S. trade or business. On the date of payment, B has 
not furnished,

[[Page 391]]

and A cannot associate the payment with documentation for B. However, A 
does not withhold under section 1442, even though, under Sec.  1.1441-
1(b)(3)(iii)(A), A should presume that B is a foreign person, because 
A's communications with B are mailed to an address in a foreign country. 
Assuming that B files a return for its taxable year ending December 31, 
2001, and that its statute of limitations period with regard to that 
year expires on June 15, 2005, the interest paid on October 12, 2001, 
may qualify as portfolio interest only if B provides appropriate 
documentation to A on or before June 15, 2005. If B does not provide the 
documentation on or before June 15, 2005, and does not pay the tax, A is 
liable for the tax under section 1463, even if B provides the 
documentation to A after June 15, 2005. Therefore, the provisions in 
Sec.  1.1441-1(b)(7), regarding late-received documentation would not 
help A avoid liability for tax under section 1463 even if the 
documentation is furnished within the statute of limitations period of 
A. This is because, in a case involving interest, the documentation 
received within the limitations period of the beneficial owner serves as 
a condition for the interest to qualify as portfolio interest. When 
documentation is received after the expiration of the beneficial owner's 
limitations period, the interest can no longer qualify as portfolio 
interest. On the other hand, A could rely on documentation that it 
receives after the expiration of B's limitations period to establish B's 
right to a reduced rate of withholding under an applicable income tax 
treaty (since, in such a case, a claim of treaty benefits is not 
conditioned upon providing documentation prior to the expiration of the 
beneficial owner's limitations period).

    (4) Coordination with withholding and reporting rules. For an 
exemption from withholding under section 1441 with respect to 
obligations described in this paragraph (c)(4), see Sec.  1.1441-
1(b)(4)(i). For rules applicable to withholding certificates, see Sec.  
1.1441-1(e)(4). For rules regarding documentary evidence, see Sec.  
1.6049-5(c)(1). For application of presumptions when the U.S. person 
cannot reliably associate the payment with documentation, see Sec.  
1.1441-1(b)(3). For standards of knowledge applicable to withholding 
agents, see Sec.  1.1441-7(b). For rules relating to reporting on Forms 
1042 and 1042-S, see Sec.  1.1461-1(b) and (c). For rules relating to an 
exemption from Form 1099 reporting and backup withholding under section 
3406, see section 6049 and Sec.  1.6049-5(b)(8) for the payment of 
interest and Sec.  1.6045-1(g)(1)(i) for the redemption, retirement, or 
sale of an obligation in registered form. For rules relating to 
withholding under sections 1471 and 1472 that may apply notwithstanding 
the exemption for payments of portfolio interest under section 1441, see 
Sec. Sec.  1.1471-2(a), 1.1471-4(b), and 1.1472-1(b).
    (d) Application of repeal of 30-percent withholding to pass-through 
certificates--(1) In general. Interest received on a pass-through 
certificate qualifies as portfolio interest under section 871(h)(2) or 
881(c)(2) if the interest satisfies the conditions described in 
paragraph (b)(1), (c)(1), or (e) of this section without regard to 
whether any obligation held by the fund or trust to which the pass-
through certificate relates is described in paragraph (b)(1), 
(c)(1)(ii), or (e) of this section. This paragraph (d)(1) applies only 
to payments made to the holder of the pass-through certificate from the 
trustee of the pass-through trust and does not apply to payments made to 
the trustee of the pass-through trust. For example, a mortgage pass-
through certificate in bearer form must meet the requirements set forth 
in paragraph (b)(1) of this section, but the obligations held by the 
fund or trust to which the mortgage pass-through certificate relates 
need not meet the requirements set forth in paragraph (b)(1), 
(c)(1)(ii), or (e) of this section. However, for purposes of paragraphs 
(b)(1), (c)(1)(ii), and (e) of this section and section 127 of the Tax 
Reform Act of 1984, a pass-through certificate will be considered as 
issued after July 18, 1984, only to the extent that the obligations held 
by the fund or trust to which the pass-through certificate relates are 
issued after July 18, 1984.
    (2) Interest in REMICs. Interest received on a regular or residual 
interest in a REMIC qualifies as portfolio interest under section 
871(h)(2) or 881(c)(2) if the interest satisfies the conditions 
described in paragraph (b)(1), (c)(1)(ii), or (e) of this section. For 
purposes of paragraph (b)(1), (c)(1)(ii), or (e) of this section, 
interest on a regular interest in a REMIC is not considered interest on 
any mortgage obligations held by the REMIC. The foregoing rule, however, 
applies only to payments made to the holder of the regular interest from

[[Page 392]]

the REMIC and does not apply to payments made to the REMIC. For purposes 
of paragraph (b)(1), (c)(1)(ii), or (e) of this section, interest on a 
residual interest in a REMIC is considered to be interest on or with 
respect to the obligations held by the REMIC, and not on or with respect 
to the residual interest. For purposes of paragraphs (b)(1), (c)(1)(ii), 
and (e) of this section and section 127 of the Tax Reform Act of 1984, a 
residual interest in a REMIC will be considered as issued after July 18, 
1984, only to the extent that the obligations held by the REMIC are 
issued after July 18, 1984, but a regular interest in a REMIC will be 
considered as issued after July 18, 1984, if the regular interest was 
issued after July 18, 1984, without regard to the date on which the 
mortgage obligations held by the REMIC were issued.
    (3) Date of issuance. In general, a mortgage pass-through 
certificate will be considered to have been issued after July 18, 1984, 
if all of the mortgages held by the fund or trust were issued after July 
18, 1984. If some of the mortgages held by the fund or trust were issued 
before July 19, 1984, then the portion of any interest payment which 
represents interest on those mortgages shall not be considered to be 
portfolio interest. The preceding sentence shall not apply, however, if 
all of the following conditions are satisfied:
    (i) The mortgage pass-through certificate is issued after December 
31, 1986;
    (ii) Payment of the mortgage pass-through certificate is guaranteed 
by, and a guarantee commitment has been issued by, an entity that is 
independent from the issuer of the underlying obligation;
    (iii) The guarantee commitment with respect to the mortgage pass-
through certificate cannot have been issued more than 14 months prior to 
the date on which the mortgage pass-through certificate is issued; and
    (iv) The fund or trust to which the mortgage pass-through 
certificate relates cannot contain mortgage obligations on which the 
first scheduled monthly payment of principal and interest was made more 
than twelve months before the date on which the guarantee commitment was 
made.
    (e) Foreign-targeted registered obligations--(1) General rule. The 
statement described in paragraph (c)(1)(ii) of this section is not 
required with respect to interest paid on an obligation issued before 
January 1, 2016, that is a registered obligation targeting foreign 
markets in accordance with the provisions of paragraph (e)(2) of this 
section if the interest is paid by a U.S. person, a withholding foreign 
partnership, or a U.S. branch described in Sec.  1.1441-1(b)(2)(iv)(A) 
or (E) to a registered owner at an address outside the United States, 
provided that the registered owner is a financial institution described 
in section 871(h)(5)(B). In that case, the U.S. person otherwise 
required to deduct and withhold tax may treat the interest as portfolio 
interest if it does not have actual knowledge that the beneficial owner 
is a United States person and if it receives the certificate described 
in paragraph (e)(3)(i) of this section from a financial institution or 
member of a clearing organization, which member is the beneficial owner 
of the obligation, or the documentary evidence or statement described in 
paragraph (e)(3)(ii) of this section from the beneficial owner, in 
accordance with the procedures described in paragraph (e)(4) of this 
section.
    (2) Definition of a foreign-targeted registered obligation. An 
obligation is considered to be targeted to foreign markets for purposes 
of paragraph (e)(1) of this section if it is sold (or resold in 
connection with its original issuance) only to foreign persons (or to 
foreign branches of United States financial institutions described in 
section 871(h)(5)(B)) in accordance with procedures similar to those 
prescribed in Sec.  1.163-5(c)(2)(i) (A), (B), or (D). However, the 
provisions of that section that require an obligation to be offered for 
sale or resale in connection with its original issuance only outside the 
United States do not apply with respect to registered obligations 
offered for sale through a public auction. Similarly, the provisions of 
that section that require delivery to be made outside the United States 
do not apply to registered obligations offered for sale through a public 
auction if the obligations are considered to be in registered

[[Page 393]]

form by virtue of the fact that they may be transferred only through a 
book entry system. The obligation, if evidenced by a physical document 
other than a confirmation receipt, must contain on its face a legend 
indicating that it has been sold (or resold in connection with its 
original issuance) in accordance with those procedures.
    (3) Documentation. A certificate described in paragraph (e)(3)(i) of 
this section is required if the United States person otherwise required 
to deduct and withhold tax (the withholding agent) pays interest to a 
financial institution described in section 871(h)(5)(B) or to a member 
of a clearing organization, which member is the beneficial owner of the 
obligation. The documentation described in paragraph (e)(3)(ii) of this 
section is required if a withholding agent pays interest to a beneficial 
owner that is neither a financial institution described in section 
871(h)(5)(B) nor a member of a clearing organization.
    (i) Interest paid to a financial institution or a member of a 
clearing organization--(A) Requirement of a certificate--(1) If the 
withholding agent pays interest to a financial institution described in 
section 871(h)(5)(B) or to a member of a clearing organization, which 
member is the beneficial owner of the obligation, the withholding agent 
must receive a certificate which states that, beginning at the time the 
last preceding certificate under this paragraph (e)(3)(i) was provided 
and while the financial institution or clearing organization member has 
held the obligation, with respect to each foreign-targeted registered 
obligation which has been held by the person providing the certificate 
at any time since the provision of such last preceding certificate, 
either--
    (i) The beneficial owner of the obligation has not been a United 
States person on each interest payment date; or
    (ii) If the person providing the certificate is a financial 
institution which is holding or has held an obligation on behalf of the 
beneficial owner, the beneficial owner of the obligation has been a 
United States person on one or more interest payment dates (identifying 
such date or dates), and the person making the certification has 
forwarded or will forward the appropriate United States beneficial 
ownership notification to the withholding agent in accordance with the 
provisions of paragraph (e)(4) of this section.
    (2) The person providing the certificate need not state the 
foregoing where no previous certificate has been required to be provided 
by the payee to the withholding agent under this paragraph (e)(3)(i).
    (B) Additional representations. Whether or not a previous 
certificate has been required to be provided with respect to the 
obligation, each certificate furnished pursuant to the provisions in 
this paragraph (e)(3)(i) must further state that, for each foreign-
targeted registered obligation held and every other such obligation to 
be acquired and held by the person providing the certificate during the 
period beginning on the date of the certificate and ending on the date 
the next certificate is required to be provided, the beneficial owner of 
the obligation will not be a United States person on each interest 
payment date while the financial institution or clearing organization 
member holds the obligation and that, if the person providing the 
certificate is a financial institution which is holding or will be 
holding the obligation on behalf of a beneficial owner, such person will 
provide a United States beneficial ownership notification to the 
withholding agent (and a clearing organization that is not a withholding 
agent where a member organization is required by this paragraph (e)(3) 
to furnish the clearing organization with a statement) in accordance 
with paragraph (e)(4) of this section in the event such certificate (or 
statement in the case of a statement provided by a member organization 
to a clearing organization that is not a withholding agent) is or 
becomes untrue with respect to any obligation. A clearing organization 
is an entity which is in the business of holding obligations for member 
organizations and transferring obligations among such members by credit 
or debit to the account of a member without the necessity of physical 
delivery of the obligation.
    (C) Obligation must be identified. The certificate described in 
paragraph

[[Page 394]]

(e)(3)(ii)(A) of this section must identify the obligation or 
obligations with respect to which it is given, except where the 
certification is given with respect to an obligation that has not been 
acquired at the time the certification is made. An obligation is 
identified if it or the larger issuance of which it is a part is 
described on a list (e.g., $5 million principal amount of 12% debentures 
of ABC Savings and Loan Association due February 25, 1995, $3 million 
principal amount of 10% U.S. Treasury notes due May 28, 1990) of all 
registered obligations targeted to foreign markets held by or on behalf 
of the person providing the certificate and the list is attached to, and 
incorporated by reference into, the certificate. The certificate must 
identify and provide the address of the person furnishing the 
certificate.
    (D) Payment to a depository of a clearing organization. If the 
withholding agent pays interest to a depository of a clearing 
organization, then the clearing organization must provide the 
certificate described in this paragraph (e)(3)(i) to the withholding 
agent. Any certificate that is provided by a clearing organization must 
state that the clearing organization has received a statement from each 
member which complies with the provisions of this paragraph (e)(3)(i) 
and of paragraph (e)(4) of this section (as if the clearing organization 
were the withholding agent and regardless of whether the member is a 
financial institution described in section 871(h)(5)(B)).
    (E) Statement in lieu of Form W-8. Subject to the requirements set 
out in paragraph (e)(4) of this section, a certificate or statement in 
the form described in this paragraph (e)(3)(i), in conjunction with the 
next annual certificate or statement, will serve as the certificate that 
may be provided in lieu of a Form W-8 with respect to interest on all 
foreign-targeted registered obligations held by the person making the 
certification or statement and which is paid to such person within the 
period beginning on the date of the certificate and ending on the date 
the next certificate is required to be provided.
    (F) Electronic transmission. The certificate described in this 
paragraph (e)(3)(i) may be provided electronically under the terms and 
conditions of Sec.  1.163-5(c)(2)(i)(D)(3)(ii).
    (ii) Payment to a person other than a financial institution or 
member of a clearing organization. If the withholding agent pays 
interest to the beneficial owner of an obligation that is neither a 
financial institution described in section 871(h)(5)(B) nor a member of 
a clearing organization, then such owner must provide the withholding 
agent a statement described in paragraph (c)(1)(ii)(C) of this section.
    (4) Applicable procedures regarding documentation--(i) Procedures 
applicable to certificates required under paragraph (e)(3)(i) of this 
section--(A) Time for providing certificate. Where no previous 
certificate for foreign-targeted registered obligations has been 
provided to the withholding agent by the person providing the 
certificate under paragraph (e)(3)(i) of this section, such certificate 
must be provided within the period beginning 90 days prior to the first 
interest payment date on which the person holds a foreign-targeted 
registered obligation. The withholding agent may, in its discretion, 
withhold under section 1441(a), 1442(a), or 1443 if the certificate is 
not received by the date 30 days prior to the interest payment. 
Thereafter the certificate must be filed within the period beginning on 
January 15 and ending January 31 of each year. If a certificate provided 
pursuant to the first sentence of this paragraph (e)(4)(i)(A) is 
provided during the period beginning on January 15 and ending on January 
31 of any year, then no other certificate need be provided during such 
period in such year.
    (B) Change of status notification on Form W-9. If, on any interest 
payment date after the obligation was acquired by the person making the 
certification, the beneficial owner of the obligation is a U.S. person, 
then the person to whom the withholding agent pays interest must furnish 
the withholding agent with a U.S. beneficial ownership notification 
within 30 days after such interest payment date. A U.S. beneficial 
ownership notification must include a statement that the beneficial 
owner of the obligation has been a U.S. person on an interest payment 
date (identifying such date), that such

[[Page 395]]

owner has provided to the person providing the notification a Form W-9 
(or a substitute form that is substantially similar to Form W-9 and 
completed under penalties of perjury), and that the person providing the 
notification has been and will be complying with the information 
reporting requirements of section 6049, if applicable.
    (C) Alternative notification statement. Where the person providing 
the notification described in paragraph (e)(4)(i)(B) of this section is 
neither a controlled foreign corporation within the meaning of section 
957(a), nor a foreign corporation 50-percent or more of the gross income 
of which from all sources for the three-year period ending with the 
close of the taxable year preceding the date of the statement was 
effectively connected with the conduct of trade or business in the 
United States, such person must attach to the notification a copy of the 
Form W-9 (or substitute form that is substantially similar to Form W-9 
and completed under penalties of perjury) provided by the beneficial 
owner. When a person that provides the U.S. beneficial ownership 
notification does not attach to it a copy of such Form W-9 (or 
substitute form that is substantially similar to Form W-9 and completed 
under penalties of perjury), such person must state that it is either a 
controlled foreign corporation within the meaning of section 957(a), or 
a foreign corporation 50-percent or more of the gross income of which 
from all sources for the three-year period ending with the close of its 
taxable year preceding the date of the statement was effectively 
connected with the conduct of a trade or business in the United States. 
A withholding agent that receives a Form W-9 (or a substitute form that 
is substantially similar to Form W-9 and completed under penalties of 
perjury) must send a copy of such form to the IRS, at such address as 
the IRS shall indicate, within 30 days after receiving it and must 
attach a statement that the Form W-9 or substitute form was provided 
pursuant to this paragraph (e)(4) with respect to a U.S. person that has 
owned a foreign-targeted registered obligation on one or more interest 
payment dates.
    (D) Failure to provide notification. If either a Form W-9 (or a 
substitute form that is substantially similar to a Form W-9 and 
completed under penalties of perjury) or the statement described in 
paragraph (e)(4)(i)(C) of this section is not attached to the U.S. 
beneficial ownership notification provided pursuant to paragraph 
(e)(4)(i)(B) of this section, the withholding agent is required to 
withhold under section 1441, 1442, or 1443 on a payment of interest made 
after the withholding agent has received the notification unless such 
form or statement (or a statement that the beneficial owner of the 
obligation is no longer a U.S. person) is received before the interest 
payment date from the person who provided the notification (or 
transferee). If, during the period beginning on the next January 15 and 
ending on the next January 31, such person certifies as set out in 
paragraph (e)(3)(i) of this section (subject to paragraph 
(e)(3)(i)(A)(2) of this section) then the withholding agent is not 
required to withhold during the year following such certification 
(unless such person again provides a U.S. beneficial ownership 
notification without attaching a Form W-9 or substitute form that is 
substantially similar to Form W-9 and completed under penalties of 
perjury or the statement described in paragraph (e)(4)(i)(C) of this 
section).
    (E) Procedures for clearing organizations. Within the period 
beginning 10 days before the end of the calendar quarter and ending on 
the last day of each calendar quarter, any clearing organization 
(including a clearing organization that is a withholding agent) relying 
on annual certificates or statements from its member organizations, as 
set forth in paragraph (e)(3)(i) of this section, must send each member 
organization having submitted such certificate or statement a reminder 
that the member organization must give the clearing organization a U.S. 
beneficial ownership notification in the circumstances described in 
paragraph (e)(4)(i)(B) of this section.
    (F) Retention of certificates. The certificate described in 
paragraph (e)(3)(i) of this section must be retained in the records of 
the withholding agent for four years from the end of the calendar year 
in which it was received. The statement described in paragraph

[[Page 396]]

(e)(3)(i) of this section that is received by a clearing organization 
from a member organization must be retained in the records of the 
clearing organization for four years from the end of the calendar year 
in which it was received.
    (G) No reporting requirement. The withholding agent who receives the 
certificate described in paragraph (e)(3)(i) of this section is not 
required to file Form 1042S to report payments under Sec.  1.1461-1 (b) 
or (c) of interest that are made with respect to foreign-targeted 
registered obligations held by the person providing the certificate and 
are made within the period beginning with the certificate date and 
ending on the last date for filing the next certificate.
    (ii) Procedures regarding certificates required under paragraph 
(e)(3)(ii) of this section--(A) Time for providing certificate. The 
statement described in paragraph (e)(3)(ii) of this section must be 
provided to the withholding agent within the period beginning 90 days 
prior to and ending on the first interest payment date on which the 
withholding agent pays interest to the beneficial owner. The withholding 
agent may, in its discretion, withhold under section 1441(a), 1442(a), 
or 1443 if the statement is not received by the date 30 days prior to 
the interest payment. The beneficial owner must confirm to the 
withholding agent the continuing validity of the documentary evidence 
within the period beginning 90 days prior to the first day of the third 
calendar year following the provision of such evidence and during the 
same period every three years thereafter while the owner still owns the 
obligation. The withholding agent who receives the statement described 
in paragraph (e)(3)(ii) of this section is not required to report 
payments of interest under Sec.  1.1461-1(b) or (c) if the payments are 
made with respect to foreign-targeted registered obligations held by the 
person who provides the statement and are made within the period 
beginning with the date on which the statement is provided and ending on 
the last date for confirming the validity of the statement. The 
statement received for purposes of paragraph (e)(3)(ii) of this section 
is subject to the applicable procedures set forth in Sec.  1.1441-
1(e)(4).
    (B) Change of status notification on Form W-9. If on any interest 
payment date after the obligation was acquired by the person providing 
the statement described in paragraph (e)(3)(ii) of this section, the 
beneficial owner of the obligation is a U.S. person, then the beneficial 
owner must so inform the withholding agent within 30 days after such 
interest payment date and must provide a Form W-9 (or substitute form 
that is substantially similar completed under penalties of perjury) to 
the withholding agent. However, the beneficial owner is not required to 
provide another Form W-9 (or substitute form that is substantially 
similar and completed under penalties of perjury) if such person has 
already provided it to the withholding agent within the same calendar 
year.
    (iii) Disqualification of documentation. In accordance with the 
provisions of section 871(h)(4), the Secretary may make a determination 
in appropriate cases that a certificate or statement by any person, or 
class of persons, does not satisfy the requirements of that section. 
Should that determination be made, all payments of interest that 
otherwise qualify as portfolio interest to that person would become 
subject to 30-percent withholding under section 1441(a), 1442(a), or 
1443.
    (5) Information reporting. See Sec.  1.6049-5(b)(7) for special 
information reporting rules applicable to interest on foreign-targeted 
registered obligations. See Sec.  1.6045-1(g)(1)(ii) for information 
reporting rules applicable to the redemption, retirement, or sale of 
foreign-targeted registered obligations.
    (f) Securities lending transactions. For applicable rules regarding 
substitute interest payments received pursuant to a securities lending 
transaction or a sale-repurchase transaction, see Sec. Sec.  1.871-
7(b)(2) and 1.881-2(b)(2).
    (g) Portfolio interest not to include interest received by 10-
percent shareholders--(1) In general. For purposes of section 871(h), 
the term portfolio interest shall not include any interest received by a 
10-percent shareholder.
    (2) Ten-percent shareholder--(i) In general. The term 10-percent 
shareholder means--
    (A) In the case of an obligation issued by a corporation, any person 
who owns

[[Page 397]]

10-percent or more of the total combined voting power of all classes of 
stock of such corporation entitled to vote; or
    (B) In the case of an obligation issued by a partnership, any person 
who owns 10-percent or more of the capital or profits interest in such 
partnership.
    (ii) Ownership--(A) Stock ownership. For purposes of paragraph 
(g)(2)(i)(A) of this section, stock owned means stock directly or 
indirectly owned and stock owned by reason of the attribution rules of 
section 318(a), as modified by section 871(h)(3)(C).
    (B) Ownership of partnership interest. For purposes of paragraph 
(g)(2)(i)(B) of this section, rules similar to the rules in paragraph 
(g)(2)(ii)(A) of this section shall be applied in determining the 
ownership of a capital or profits interest in a partnership.
    (3) Application of 10-percent shareholder test to partners receiving 
interest through a partnership--(i) Partner level test. Whether interest 
paid to a partnership and included in the distributive share of a 
partner that is a nonresident alien individual or foreign corporation is 
received by a 10 percent shareholder shall be determined by applying the 
rules of this paragraph (g) only at the partner level.
    (ii) Time at which 10-percent shareholder test is applied. The 
determination of whether a nonresident alien individual or foreign 
corporation that is a partner in a partnership is a 10-percent 
shareholder under the rules of section 871(h)(3), section 881(c)(3), and 
this paragraph (g) with respect to interest paid to such partnership 
shall be made at the time that the withholding agent, absent the 
provisions of section 871(h), 881(c) and the rules of this paragraph, 
would otherwise be required to withhold under sections 1441 and 1442 
with respect to such interest. For example, in the case of U.S. source 
interest paid by a domestic corporation to a domestic partnership or 
withholding foreign partnership (as defined in Sec.  1.1441-5(c)(2)), 
the 10-percent shareholder test is applied when any distributions that 
include the interest are made to a foreign partner and, to the extent 
that a foreign partner's distributive share of the interest has not 
actually been distributed, on the earlier of the date that the statement 
required under section 6031(b) is mailed or otherwise provided to such 
partner, or the due date for furnishing such statement. See Sec.  
1.1441-5(b)(2) and (c)(2)(iii).
    (4) Application of 10-percent shareholder test to interest paid to a 
simple trust or grantor trust. Whether interest paid to a simple trust 
or grantor trust and distributed to or included in the gross income of a 
nonresident alien individual or foreign corporation that is a 
beneficiary or owner of such trust, as the case may be, is received by a 
10-percent shareholder shall be determined by applying the rules of this 
paragraph (g) only at the beneficiary or owner level. The 10-percent 
shareholder test is applied with respect to a nonresident alien 
individual or foreign corporation that is a beneficiary of a simple 
trust or an owner of a grantor trust at the time that a withholding 
agent, absent any exceptions, would otherwise be required to withhold 
under sections 1441 and 1442 with respect to such interest.
    (h) Portfolio interest not to include certain contingent interest--
(1) Dividend equivalents. Contingent interest does not qualify as 
portfolio interest to the extent that the interest is a dividend 
equivalent within the meaning of section 871(m).
    (2) Amount of dividend equivalent that is not portfolio interest. 
The amount that does not qualify as portfolio interest because it is a 
dividend equivalent equals the amount of the dividend equivalent 
determined pursuant to Sec.  1.871-15(j). Unless otherwise excluded 
pursuant to section 871(h), any other interest paid on an obligation 
that is not a dividend equivalent may qualify as portfolio interest.
    (i) Definitions. For purposes of this section, the terms U.S. person 
and foreign person have the meaning set forth in Sec.  1.1441-1(c)(2), 
the term beneficial owner has the meaning set forth in Sec.  1.1441-
1(c)(6), the term withholding agent has the meaning set forth in Sec.  
1.1441-7(a); the term payee has the meaning set forth in Sec.  1.1441-
1(b)(2); and the term payment has the meaning set forth in Sec.  1.1441-
2(e).
    (j) Effective/applicability date--(1) In general. Except as 
otherwise provided

[[Page 398]]

in paragraph (j)(2) and (3) of this section, this section applies to 
payments of interest made on or after January 6, 2017. (For the rules 
that apply after June 30, 2014, and before January 6, 2017, see this 
section as in effect and contained in 26 CFR part 1, as revised April 1, 
2016. For payments of interest made after December 31, 2000, and before 
July 1, 2014, see this section as in effect and contained in 26 CFR part 
1, as revised April 1, 2013.)
    (2) Portfolio interest not to include interest received by 10-
percent shareholders. Paragraph (g) applies to interest paid after April 
12, 2007. Taxpayers may choose to apply the rules of paragraph (g) to 
interest paid in any taxable year not closed by the period of 
limitations as of April 12, 2007, provided they do so consistently for 
all relevant partnerships during such years.
    (3) Portfolio interest not to include certain contingent interest. 
The rules of paragraph (h) of this section apply beginning September 18, 
2015.

[T.D. 8734, 62 FR 53416, Oct. 14, 1997, as amended by T.D. 8804, 63 FR 
72184, 72187, Dec. 31, 1998; T.D. 8856, 64 FR 73409, 73412, Dec. 30, 
1999; T.D. 9323, 72 FR 18387, Apr. 12, 2007; 72 FR 26543, May 10, 2007. 
T.D. 9658, 79 FR 12746, Mar. 6, 2013; 79 FR 37182, July 1, 2014; T.D. 
9734, 80 FR 56879, Sept. 18, 2015; T.D. 9808, 82 FR 2055, Jan. 6, 2017]



Sec.  1.871-15  Treatment of dividend equivalents.

    (a) Definitions. For purposes of this section, the following terms 
have the meanings described in this paragraph (a).
    (1) Broker. [Reserved]. For further guidance, see Sec.  1.871-
15T(a)(1).
    (2) Dealer. A dealer is a dealer in securities within the meaning of 
section 475(c)(1).
    (3) Dividend. A dividend is a dividend as described in section 316 
(even if there is no actual distribution of cash or property).
    (4) Equity-linked instrument. An equity-linked instrument (ELI) is a 
financial transaction, other than a securities lending or sale-
repurchase transaction or an NPC, that references the value of one or 
more underlying securities. For example, a futures contract, forward 
contract, option, debt instrument, or other contractual arrangement that 
references the value of one or more underlying securities is an ELI.
    (5) Initial hedge. An initial hedge is the number of underlying 
security shares that a short party would need to fully hedge an NPC or 
ELI (whether the NPC or ELI is a complex contract or a simple contract 
benchmark (within the meaning of paragraph (h)(2) of this section), as 
appropriate) with respect to an underlying security at the calculation 
time for the NPC or ELI, even if the short party does not in fact fully 
hedge the NPC or ELI.
    (6) Issue. An NPC or ELI is treated as issued at inception, original 
issuance, or at the time of an issuance as a result of a deemed exchange 
pursuant to section 1001.
    (7) Notional principal contract. A notional principal contract (NPC) 
is a notional principal contract as defined in Sec.  1.446-3(c).
    (8) Option. An option includes an option embedded in any debt 
instrument, forward contract, NPC, or other potential section 871(m) 
transaction.
    (9) Parties to the transaction--(i) Long party. A long party is the 
party to a potential section 871(m) transaction with respect to an 
underlying security that would be entitled to receive a payment of a 
dividend equivalent (within the meaning of paragraph (i) of this 
section) described in paragraph (c) of this section.
    (ii) Short party. A short party is the party to a potential section 
871(m) transaction with respect to an underlying security that would be 
obligated to make a payment of a dividend equivalent (within the meaning 
of paragraph (i) of this section) described in paragraph (c) of this 
section.
    (iii) Party to the transaction. A party to the transaction is any 
person that is a long party or a short party to a potential section 
871(m) transaction, any agent acting on behalf of the long party or 
short party, or any person acting as an intermediary with respect to the 
potential section 871(m) transaction.
    (iv) Party to the transaction that is both a long party and a short 
party--(A) In general. If a potential section 871(m) transaction 
references more than one underlying security, the long party and short 
party are determined separately

[[Page 399]]

with respect to each underlying security. A party to a potential section 
871(m) transaction is both a long party and a short party when the party 
is entitled to a payment that references a dividend payment on an 
underlying security and the same party is obligated to make a payment 
that references a dividend payment on another underlying security 
pursuant to the potential section 871(m) transaction.
    (B) Example. The following example illustrates the definitions in 
paragraph (a)(9) of this section:

    Example. (i) Stock X and Stock Y are underlying securities. A and B 
enter into an NPC that entitles A to receive payments from B based on 
any appreciation in the value of Stock X and dividends paid on Stock X 
during the term of the contract and obligates A to make payments to B 
based on any depreciation in the value of Stock X during the term of the 
contract. In return, the NPC entitles B to receive payments from A based 
on any appreciation in the value of Stock Y and dividends paid on Stock 
Y during the term of the contract and obligates B to make payments to A 
based on any depreciation in the value of Stock Y during the term of the 
contract.
    (ii) A is the long party with respect to Stock X, and the short 
party with respect to Stock Y. B is the long party with respect to Stock 
Y, and the short party with respect to Stock X.

    (10) Payment. A payment has the meaning provided in paragraph (i) of 
this section.
    (11) Reference. To reference means to be contingent upon or 
determined by reference to, directly or indirectly, whether in whole or 
in part.
    (12) Section 871(m) transaction and potential section 871(m) 
transaction. A section 871(m) transaction is any securities lending or 
sale-repurchase transaction, specified NPC, or specified ELI. A 
potential section 871(m) transaction is any securities lending or sale-
repurchase transaction, NPC, or ELI that references one or more 
underlying securities.
    (13) Securities lending or sale-repurchase transaction. A securities 
lending or sale-repurchase transaction is any securities lending 
transaction, sale-repurchase transaction, or substantially similar 
transaction that references an underlying security. Securities lending 
transaction and sale-repurchase transaction have the same meaning as 
provided in Sec.  1.861-3(a)(6).
    (14) Simple contracts and complex contracts-- (i) Simple contract. A 
simple contract is an NPC or ELI for which, with respect to each 
underlying security, all amounts to be paid or received on maturity, 
exercise, or any other payment determination date are calculated by 
reference to a single, fixed number of shares (as determined in 
paragraph (j)(3) of this section) of the underlying security, provided 
that the number of shares can be ascertained at the calculation time for 
the contract, and there is a single maturity or exercise date with 
respect to which all amounts (other than any upfront payment or any 
periodic payments) are required to be calculated with respect to the 
underlying security. For purposes of this section, a contract that 
provides an adjustment to the number of shares of the underlying 
security for a merger, stock split, cash dividend, or similar corporate 
action that affects all holders of the underlying securities 
proportionately will not cease to be treated as referencing a single, 
fixed number of shares solely as a result of that provision. A contract 
has a single exercise date even though it may be exercised by the holder 
at any time on or before the stated expiration of the contract. An NPC 
or ELI that includes a term that discontinuously increases or decreases 
the amount paid or received (such as a digital option), or that 
accelerates or extends the maturity is not a simple contract. A simple 
contract that is an NPC is a simple NPC. A simple contract that is an 
ELI is a simple ELI.
    (ii) Complex contract--(A) In general. A complex contract is any NPC 
or ELI that is not a simple contract. A complex contract that is an NPC 
is a complex NPC. A complex contract that is an ELI is a complex ELI.
    (B) Example. An ELI entitles the long party to a return equal to 200 
percent of the appreciation on 100 shares of Stock X, and obligates the 
long party to pay an amount equal to the actual depreciation on 100 
shares of Stock X. Pursuant to paragraph (j)(3) of the section, the ELI 
references 200 shares when Stock X appreciates, but only 100

[[Page 400]]

shares when Stock X depreciates. Because the ELI does not provide the 
long party with an amount that is calculated by reference to a single, 
fixed number of shares of Stock X on the maturity date that can be 
ascertained at the calculation time, it is not a simple ELI. More 
specifically, upon maturity the ELI will either entitle the long party 
to receive a payment that is, in substance, measured by reference to 200 
shares of stock or obligate the long party to make a payment measured by 
reference to 100 shares of stock. The ELI is a complex ELI because it is 
not a simple ELI.
    (15) Underlying security. An underlying security is any interest in 
an entity if that interest could give rise to a U.S. source dividend 
pursuant to Sec.  1.861-3, where applicable taking into account 
paragraph (m) of this section. Except as provided in paragraph (l) of 
this section, if a potential section 871(m) transaction references an 
interest in more than one entity described in the preceding sentence or 
different interests in the same entity, each referenced interest is a 
separate underlying security for purposes of applying the rules of this 
section.
    (b) Source of a dividend equivalent. A dividend equivalent is 
treated as a dividend from sources within the United States for purposes 
of sections 871(a), 881, 892, 894, and 4948(a), and chapters 3 and 4 of 
subtitle A of the Internal Revenue Code.
    (c) Dividend equivalent--(1) In general. Except as provided in 
paragraph (c)(2) of this section, dividend equivalent means--
    (i) Any payment that references a dividend from an underlying 
security pursuant to a securities lending or sale-repurchase 
transaction;
    (ii) Any payment that references a dividend from an underlying 
security pursuant to a specified NPC described in paragraph (d) of this 
section;
    (iii) Any payment that references a dividend from an underlying 
security pursuant to a specified ELI described in paragraph (e) of this 
section; and
    (iv) Any other substantially similar payment as described in 
paragraph (f) of this section.
    (2) Exceptions--(i) Not a dividend. A payment that references a 
distribution with respect to an underlying security is not a dividend 
equivalent to the extent that the distribution would not be subject to 
tax pursuant to section 871(a) or section 881 if the long party owned 
the underlying security. For example, if an NPC references stock in a 
regulated investment company that pays a dividend that includes a 
capital gains dividend described in section 852(b)(3)(C) that would not 
be subject to tax under section 871(a) or section 881 if paid directly 
to the long party, then an NPC payment is not a dividend equivalent to 
the extent that it is determined by reference to the capital gains 
dividend.
    (ii) Section 305 coordination. A dividend equivalent received by a 
long party, who is a shareholder as defined in Sec.  1.305-1(d) of an 
instrument that gives rise to a dividend pursuant to sections 305(b) and 
(c) (including a debt instrument that is convertible into shares of 
stock and stock that is convertible into shares of another class of 
stock) that is also a section 871(m) transaction, is reduced by any 
amount treated as a dividend by sections 305(b) and (c) to the long 
party. For other section 871(m) transactions that reference an 
underlying security that is an instrument treated as paying a dividend 
pursuant to sections 305(b) and (c) and for which the long party is not 
a shareholder as defined in Sec.  1.305-1(d), the dividend equivalent 
received by the long party with respect to the section 871(m) 
transaction includes (and is not reduced by) any amount treated as a 
dividend pursuant to sections 305(b) and (c).
    (iii) Due bills. A dividend equivalent does not include a payment 
made pursuant to a due bill arising from the actions of a securities 
exchange that apply to all transactions in the stock with respect to the 
dividend. For purposes of this section, a stock will be considered to 
trade with a due bill only when the relevant securities exchange has set 
an ex-dividend date with respect to a dividend that occurs after the 
record date.
    (iv) Payments made pursuant to annuity, endowment, and life 
insurance contracts--(A) Insurance contracts issued by domestic 
insurance companies. A payment made pursuant to a contract that

[[Page 401]]

is an annuity, endowment, or life insurance contract issued by a 
domestic corporation (including its foreign or U.S. possession branch) 
that is a life insurance company described in section 816(a) does not 
include a dividend equivalent if the payment is subject to tax under 
section 871(a) or section 881.
    (B) Insurance contracts issued by foreign insurance companies. A 
payment does not include a dividend equivalent if it is made pursuant to 
a contract that is an annuity, endowment, or life insurance contract 
issued by a foreign corporation that would be subject to tax under 
subchapter L if it were a domestic corporation.
    (C) Insurance contracts held by foreign insurance companies. A 
payment made pursuant to a policy of insurance (including a policy of 
reinsurance) does not include a dividend equivalent if it is made to a 
foreign corporation that would be subject to tax under subchapter L if 
it were a domestic corporation.
    (v) Certain payments pursuant to employee compensation arrangements. 
A dividend equivalent does not include the portion of equity-based 
compensation for personal services of a nonresident alien individual 
that is--
    (A) Wages subject to withholding under section 3402 and the 
regulations under that section;
    (B) Excluded from the definition of wages under Sec.  31.3401(a)(6)-
1; or
    (C) Exempt from withholding under Sec.  1.1441-4(b).
    (d) Specified NPCs--(1) Specified NPCs entered into before January 
1, 2017--(i) In general. For payments made after March 18, 2012, and 
before January 1, 2017, a specified NPC is any NPC if--
    (A) In connection with entering into the contract, any long party to 
the contract transfers the underlying security to any short party to the 
contract;
    (B) In connection with the termination of the contract, any short 
party to the contract transfers the underlying security to any long 
party to the contract;
    (C) The underlying security is not readily tradable on an 
established securities market; or
    (D) In connection with entering into the contract, the underlying 
security is posted as collateral by any short party to the contract with 
any long party to the contract.
    (ii) Specified NPC status as of January 1, 2017. An NPC that is 
treated as a specified NPC pursuant to paragraph (d)(1)(i) of this 
section will remain a specified NPC on or after January 1, 2017.
    (2) Specified NPCs on or after January 1, 2017--(i) Simple NPCs. A 
simple NPC that has a delta of 0.8 or greater with respect to an 
underlying security at the calculation time for the NPC is a specified 
NPC.
    (ii) Complex NPCs. A complex NPC that meets the substantial 
equivalence test described in paragraph (h) of this section with respect 
to an underlying security at the calculation time for the NPC is a 
specified NPC.
    (e) Specified ELIs--(1) Simple ELIs. A simple ELI that has a delta 
of 0.8 or greater with respect to an underlying security at the 
calculation time for the ELI is a specified ELI.
    (2) Complex ELIs. A complex ELI that meets the substantial 
equivalence test described in paragraph (h) of this section with respect 
to an underlying security at the calculation time for the ELI is a 
specified ELI.
    (f) Other substantially similar payments. For purposes of this 
section, any payment made in satisfaction of a tax liability of the long 
party with respect to a dividend equivalent by a withholding agent is a 
dividend equivalent received by the long party. The amount of that 
dividend equivalent constitutes additional income to the payee to the 
extent provided in Sec.  1.1441-3(f)(1).
    (g) Delta--(1) In general. Delta is the ratio of the change in the 
fair market value of an NPC or ELI to a small change in the fair market 
value of the number of shares of the underlying security (as determined 
under paragraph (j)(3) of this section) referenced by the NPC or ELI. If 
an NPC or ELI contains more than one reference to a single underlying 
security, all references to that underlying security are taken into 
account in determining the delta with respect to that underlying 
security. If an NPC or ELI references more than one underlying security 
or other property, the delta with respect to each underlying security 
must be determined without taking into account any other

[[Page 402]]

underlying security or property. The delta of an equity derivative that 
is embedded in a debt instrument or other derivative is determined 
without taking into account changes in the market value of the debt 
instrument or other derivative that are not directly related to the 
equity element of the instrument. Thus, for example, the delta of an 
option embedded in a convertible note is determined without regard to 
the debt component of the convertible note. For purposes of this 
section, delta must be determined in a commercially reasonable manner. 
If a taxpayer calculates delta for non-tax business purposes, that delta 
ordinarily is the delta used for purposes of this section.
    (2) Time for determining delta--(i) In general. Except as provided 
in paragraph (g)(4) of this section, the delta of a potential section 
871(m) transaction is determined at the calculation time for the 
potential section 871(m) transaction.
    (ii) Calculation time. The calculation time for a potential section 
871(m) transaction is the earlier of when the potential section 871(m) 
transaction is priced and when the potential section 871(m) transaction 
is issued. Notwithstanding the preceding sentence, if the pricing time 
is more than 14 calendar days before the potential section 871(m) 
transaction is issued, the calculation time is when the potential 
section 871(m) transaction is issued.
    (iii) Pricing time. A potential section 871(m) transaction is priced 
when all material economic terms for the transaction have been agreed 
upon, including the price at which the transaction is sold.
    (3) Simplified delta calculation for certain simple contracts that 
reference multiple underlying securities. If an NPC or ELI references 10 
or more underlying securities and an exchange-traded security (for 
example, an exchange-traded fund) is available that would fully hedge 
the NPC or ELI at the calculation time, the delta of the NPC or ELI may 
be calculated by determining the ratio of the change in the fair market 
value of the simple contract to a small change in the fair market value 
of the exchange-traded security. A delta determined under this paragraph 
(g)(3) must be used as the delta for each underlying security for 
purposes of calculating the amount of a dividend equivalent as provided 
in paragraph (j)(1)(ii) of this section.
    (4) Delta calculation for listed options--(i) In general. The delta 
of an option contract that is listed on a regulated exchange described 
in paragraph (g)(4)(ii) of this section is the delta of that option at 
the close of business on the business day before the date of issuance. 
On the date an option contract is listed for the first time, the delta 
is the delta of that option at the close of business on the date of 
issuance. Notwithstanding the preceding two sentences, the delta of a 
listed option that is also a customized option is determined under the 
rules of paragraphs (g)(2) and (g)(3) of this section.
    (ii) Regulated exchange. For purposes of paragraph (g)(4)(i) of this 
section, a regulated exchange is any exchange that is either:
    (A) Described in paragraph (l)(3)(vii) of this section; or
    (B) [Reserved]. For further guidance, see Sec.  1.871-
15T(g)(4)(ii)(B).
    (5) Examples. The following examples illustrate the rules of this 
paragraph (g). For purposes of these examples, Stock X and Stock Y are 
common stock of domestic corporations X and Y. LP is the long party to 
the transaction.

    Example 1. Delta calculation for an NPC. The terms of an NPC require 
LP to pay the short party an amount equal to all of the depreciation in 
the value of 100 shares of Stock X and an interest-rate based return. In 
return, the NPC requires the short party to pay LP an amount equal to 
all of the appreciation in the value of 100 shares of Stock X and any 
dividends paid by X on those shares. The value of the NPC will change by 
$1 for each $0.01 change in the price of a share of Stock X. When LP 
entered into the NPC, Stock X had a fair market value of $50 per share. 
The NPC therefore has a delta of 1.0 ($1.00/($0.01 x 100)).
    Example 2. Delta calculation for an option. LP purchases a call 
option that references 100 shares of Stock Y. At the time LP purchases 
the call option, the value of the option is expected to change by $0.30 
for a $0.01 change in the price of a share of Stock Y. When LP purchases 
the option, Stock Y has a fair market value of $100 per share. The call 
option has a delta of 0.3 ($0.30/($0.01 x 100)).


[[Page 403]]


    (h) Substantial equivalence test--(1) In general. The substantial 
equivalence test described in this paragraph (h) applies to determine 
whether a complex contract is a section 871(m) transaction. The 
substantial equivalence test assesses whether a complex contract 
substantially replicates the economic performance of the underlying 
security by comparing, at various testing prices for the underlying 
security, the differences between the expected changes in value of that 
complex contract and its initial hedge with the differences between the 
expected changes in value of a simple contract benchmark (as described 
in paragraph (h)(2) of this section) and its initial hedge. If the 
complex contract contains more than one reference to a single underlying 
security, all references to that underlying security are taken into 
account for purposes of applying the substantial equivalence test with 
respect to that underlying security. With respect to an equity 
derivative that is embedded in a debt instrument or other derivative, 
the substantial equivalence test is applied to the complex contract 
without taking into account changes in the market value of the debt 
instrument or other derivative that are not directly related to the 
equity element of the instrument. The complex contract is a section 
871(m) transaction with respect to an underlying security if, for that 
underlying security, the expected change in value of the complex 
contract and its initial hedge is equal to or less than the expected 
change in value of the simple contract benchmark and its initial hedge 
when the substantial equivalence test described in this paragraph (h) is 
calculated at the calculation time for the complex contract. To the 
extent that the steps of the substantial equivalence test set out in 
this paragraph (h) cannot be applied to a particular complex contract, a 
taxpayer must use the principles of the substantial equivalence test to 
reasonably determine whether the complex contract is a section 871(m) 
transaction with respect to each underlying security. For purposes of 
this section, the test must be applied and the inputs must be determined 
in a commercially reasonable manner. The term of the simple contract 
benchmark must be, and the inputs must use, a reasonable time period, 
consistently applied (for example, in determining the standard deviation 
and probability). If a taxpayer calculates any relevant input for non-
tax business purposes, that input ordinarily is the input used for 
purposes of this section.
    (2) Simple contract benchmark. The simple contract benchmark is an 
actual or hypothetical simple contract that, at the calculation time for 
the complex contract, has a delta of 0.8, references the applicable 
underlying security referenced by the complex contract, and has terms 
that are consistent with all the material terms of the complex contract, 
including the maturity date. If an actual simple contract does not 
exist, the taxpayer must create a hypothetical simple contract. 
Depending on the complex contract, the simple contract benchmark might 
be, for example, a call option, a put option, or a collar.
    (3) Substantial equivalence. A complex contract is a section 871(m) 
transaction with respect to an underlying security if the complex 
contract calculation described in paragraph (h)(4) of this section 
results in an amount that is equal to or less than the amount of the 
benchmark calculation described in paragraph (h)(5) of this section.
    (4) Complex contract calculation--(i) In general. The complex 
contract calculation for each underlying security referenced by a 
potential section 871(m) transaction that is a complex contract is 
computed by:
    (A) Determining the change in value (as described in paragraph 
(h)(4)(ii) of this section) of the complex contract with respect to the 
underlying security at each testing price (as described in paragraph 
(h)(4)(iii) of this section);
    (B) Determining the change in value of the initial hedge for the 
complex contract at each testing price;
    (C) Determining the absolute value of the difference between the 
change in value of the complex contract determined in paragraph 
(h)(4)(i)(A) of this section and the change in value of the initial 
hedge determined in paragraph (h)(4)(i)(B) of this section at each 
testing price;

[[Page 404]]

    (D) Determining the probability (as described in paragraph 
(h)(4)(iv) of this section) associated with each testing price;
    (E) Multiplying the absolute value for each testing price determined 
in paragraph (h)(4)(i)(C) of this section by the corresponding 
probability for that testing price determined in paragraph (h)(4)(i)(D) 
of this section;
    (F) Adding the product of each calculation determined in paragraph 
(h)(4)(i)(E) of this section; and
    (G) Dividing the sum determined in paragraph (h)(4)(i)(F) of this 
section by the initial hedge for the complex contract.
    (ii) Determining the change in value. The change in value of a 
complex contract is the difference between the value of the complex 
contract with respect to the underlying security at the calculation time 
for the complex contract and the value of the complex contract with 
respect to the underlying security if the price of the underlying 
security were equal to the testing price at the calculation time for the 
complex contract. The change in value of the initial hedge of a complex 
contract with respect to the underlying security is the difference 
between the value of the initial hedge at the calculation time for the 
complex contract and the value of the initial hedge if the price of the 
underlying security were equal to the testing price at the calculation 
time for the complex contract.
    (iii) Testing price. The testing prices must include the prices of 
the underlying security if the price of the underlying security at the 
calculation time for the complex contract were alternatively increased 
by one standard deviation and decreased by one standard deviation, each 
of which is a separate testing price. In circumstances where using only 
two testing prices is reasonably likely to provide an inaccurate measure 
of substantial equivalence, a taxpayer must use additional testing 
prices as necessary to determine whether a complex contract satisfies 
the substantial equivalence test. If additional testing prices are used 
for the substantial equivalence test, the probabilities as described in 
paragraph (h)(4)(iv) of this section must be adjusted accordingly.
    (iv) Probability. For purposes of paragraphs (h)(4)(i)(D) and (E) of 
this section, the probability of an increase by one standard deviation 
is the measure of the likelihood that the price of the underlying 
security will increase by any amount from its price at the calculation 
time for the complex contract. For purposes of paragraphs (h)(4)(i)(D) 
and (E) of this section, the probability of a decrease by one standard 
deviation is the measure of the likelihood that the price of the 
underlying security will decrease by any amount from its price at the 
calculation time for the complex contract.
    (5) Benchmark calculation. The benchmark calculation with respect to 
each underlying security referenced by the potential section 871(m) 
transaction is determined by using the computation methodology described 
in paragraph (h)(4) of this section with respect to a simple contract 
benchmark for the underlying security.
    (6) Substantial equivalence calculation for certain complex 
contracts that reference multiple underlying securities. If a complex 
contract references 10 or more underlying securities and an exchange-
traded security (for example, an exchange-traded fund) is available that 
would fully hedge the complex contract at its calculation time, the 
substantial equivalence calculations for the complex contract may be 
calculated by treating the exchange-traded security as the underlying 
security. When the exchange-traded security is used for the substantial 
equivalence calculation pursuant to this paragraph (h)(6), the initial 
hedge is the number of shares of the exchange-traded security for 
purposes of calculating the amount of a dividend equivalent as provided 
in paragraph (j)(1)(iii) of this section.
    (7) Example. The following example illustrates the rules of 
paragraph (h) of this section. For purposes of this example, Stock X is 
common stock of domestic corporation X. FI is the financial institution 
that structures the transaction described in the example, and is the 
short party to the transaction. Investor is a nonresident alien 
individual.


[[Page 405]]


    Example. Complex contract that is not substantially equivalent. (i) 
FI issues an investment contract (the Contract) that has a stated 
maturity of one year, and Investor purchases the Contract from FI at 
issuance for $10,000. At maturity, the Contract entitles Investor to a 
return of $10,000 (i) plus 200 percent of any appreciation in Stock X 
above $100 per share, capped at $110, on 100 shares or (ii) minus 100 
percent of any depreciation in Stock X below $90 on 100 shares. At the 
calculation time for the Contract, the price of Stock X is $100 per 
share. Thus, for example, Investor will receive $11,000 if the price of 
Stock X is $105 per share at maturity of the Contract, but Investor will 
receive $9,000 if the price of Stock X is $80 per share when the 
Contract matures. At issuance, FI acquires 64 shares of Stock X to fully 
hedge the Contract issued to Investor. The calculation time for this 
example is the issuance.
    (ii) The Contract references an underlying security and is not an 
NPC, so it is classified as an ELI under paragraph (a)(4) of this 
section. At the calculation time for the Contract, the Contract does not 
provide for an amount paid at maturity that is calculated by reference 
to a single, fixed number of shares of Stock X. When the Contract 
matures, the amount paid is effectively calculated based on either 200 
shares of Stock X (if the price of Stock X has appreciated up to $110) 
or 100 shares of Stock X (if the price of Stock X has declined below 
$90). Consequently, the Contract is a complex contract described in 
paragraph (a)(14) of this section.
    (iii) Because it is a complex ELI, FI applies the substantial 
equivalence test described in paragraph (h) of this section to determine 
whether the Contract is a specified ELI. FI determines that the price of 
Stock X would be $120 if the price of Stock X were increased by one 
standard deviation, and $79 if the price of Stock X were decreased by 
one standard deviation. Based on these results, FI next determines the 
change in value of the Contract to be $2000 at the testing price that 
represents an increase by one standard deviation ($12,000 testing price 
minus $10,000 issue price) and a negative $1,100 at the testing price 
that represents a decrease by one standard deviation ($10,000 issue 
price minus $8,900 testing price). FI performs the same calculations for 
the 64 shares of Stock X that constitute the initial hedge, determining 
that the change in value of the initial hedge is $1,280 at the testing 
price that represents an increase by one standard deviation ($6,400 at 
issuance compared to $7,680 at the testing price) and negative $1,344 at 
the testing price that represents a decrease by one standard deviation 
($6,400 at issuance compared to $5,056 at the testing price).
    (iv) FI then determines the absolute value of the difference between 
the change in value of the initial hedge and the Contract at the testing 
price that represents an increase by one standard deviation and a 
decrease by one standard deviation. Increased by one standard deviation, 
the absolute value of the difference is $720 ($2,000-$1,280); decreased 
by one standard deviation, the absolute value of the difference is $244 
(negative $1,100 minus negative $1,344). FI determines that there is a 
52% chance that the price of Stock X will have increased in value when 
the Contract matures and a 48% chance that the price of Stock X will 
have decreased in value at that time. FI multiplies the absolute value 
of the difference between the change in value of the initial hedge and 
the Contract at the testing price that represents an increase by one 
standard deviation by 52%, which equals $374.40. FI multiplies the 
absolute value of the difference between the change in value of the 
initial hedge and the Contract at the testing price that represents a 
decrease by one standard deviation by 48%, which equals $117.12. FI adds 
these two numbers and divides by the number of shares that constitute 
the initial hedge to determine that the transaction calculation is 7.68 
((374.40 plus 117.12) divided by 64).
    (v) FI then performs the same calculation with respect to the simple 
contract benchmark, which is a one-year call option that references one 
share of Stock X, settles on the same date as the Contract, and has a 
delta of 0.8. The one-year call option has a strike price of $79 and has 
a cost (the purchase premium) of $22. The initial hedge for the one-year 
call option is 0.8 shares of Stock X.
    (vi) FI first determines that the change in value of the simple 
contract benchmark is $19.05 if the testing price is increased by one 
standard deviation ($22.00 at issuance to $41.05 at the testing price) 
and negative $20.95 if the testing price is decreased by one standard 
deviation ($22.00 at issuance to $1.05 at the testing price). Second, FI 
determines that the change in value of the initial hedge is $16.00 at 
the testing price that represents an increase by one standard deviation 
($80 at issuance to $96 at the testing price) and negative $16.80 at the 
testing price that represents a decrease by one standard deviation 
($80.00 at issuance to $63.20 at the testing price).
    (vii) FI determines the absolute value of the difference between the 
change in value of the initial hedge and the one-year call option at the 
testing price that represents an increase by one standard deviation is 
$3.05 ($16.00 minus $19.05). FI next determines the absolute value of 
the difference between the change in value of the initial hedge and the 
option at the testing price that represents a decrease by one standard 
deviation is $4.15 (negative $16.80 minus negative $20.95). FI 
multiplies the absolute value of the difference between the change in 
value of the initial hedge and the option at the testing

[[Page 406]]

price that represents an increase by one standard deviation by 52%, 
which equals $1.586. FI multiplies the absolute value of the difference 
between the change in value of the initial hedge and the option at the 
testing price that represents a decrease by one standard deviation by 
48%, which equals $1.992. FI adds these two numbers and divides by the 
number of shares that constitute the initial hedge to determine that the 
benchmark calculation is 4.473 ((1.586 plus 1.992) divided by .8).
    (viii) FI concludes that the Contract is not a section 871(m) 
transaction because the transaction calculation of 7.68 exceeds the 
benchmark calculation of 4.473.
    (i) Payment of a dividend equivalent--(1) Payments determined on 
gross basis. For purposes of this section, a payment includes any gross 
amount that references a dividend and that is used in computing any net 
amount transferred to or from the long party even if the long party 
makes a net payment to the short party or no amount is paid because the 
net amount is zero.
    (2) Actual and estimated dividends--(i) In general. A payment 
includes any amount that references an actual or estimated dividend, 
whether the reference is explicit or implicit. If a potential section 
871(m) transaction provides for a payment based on an estimated dividend 
that adjusts to account for the amount of an actual dividend paid, the 
payment is treated as referencing the actual dividend amount and not an 
estimated dividend amount.
    (ii) Implicit dividends. A payment includes an actual or estimated 
dividend that is implicitly taken into account in computing one or more 
of the terms of a potential section 871(m) transaction, including 
interest rate, notional amount, purchase price, premium, upfront 
payment, strike price, or any other amount paid or received pursuant to 
the potential section 871(m) transaction.
    (iii) Actual dividend presumption. A short party to a section 871(m) 
transaction is treated as paying a per-share dividend amount equal to 
the actual dividend amount unless the short party to the section 871(m) 
transaction identifies a reasonable estimated dividend amount in writing 
at the calculation time. For this purpose, a reasonable estimated 
dividend amount stated in an offering document or the documents 
governing the terms at the calculation time will establish the estimated 
dividend amount. To qualify as an estimated dividend amount, the written 
estimated dividend amount must separately state the amount estimated for 
each anticipated dividend or state a formula that allows each dividend 
to be determined. If an underlying security is not expected to have a 
dividend, a reasonable estimate of the dividend amount may be zero.
    (iv) Additions to estimated payments. If a section 871(m) 
transaction provides for any payment in addition to an estimated 
dividend and that additional payment is determined by reference to a 
dividend (for example, a special dividend), both the estimated dividend 
and the additional payment are used to determine the per-share dividend 
amount.
    (3) Dividends for certain baskets--(i) In general. If a section 
871(m) transaction references long positions in more than 25 underlying 
securities, the short party may treat the dividends with respect to the 
referenced underlying securities as paid at the end of the applicable 
calendar quarter to compute the per-share dividend amount.
    (ii) Publicly available dividend amount. For purposes of paragraph 
(i)(3)(i) of this section, if a section 871(m) transaction references 
the same underlying securities as a security (for example, stock in an 
exchange-traded fund) or index for which there is a publicly available 
quarterly dividend amount, the publicly available dividend amount may be 
used to determine the per-share dividend amount for the section 871(m) 
transaction with any adjustment for special dividends.
    (iii) Dividend amount for a section 871(m) transaction using the 
simplified delta calculation. When the delta of a section 871(m) 
transaction is determined under paragraph (g)(3) of this section, the 
per-share dividend amount for that section 871(m) transaction must be 
determined using the dividend amount for the exchange-traded security 
that would fully hedge the section 871(m) transaction (whether or not 
the exchange-traded security is actually acquired).
    (4) Examples. The following examples illustrate the rules of this 
paragraph (i). For purposes of these examples,

[[Page 407]]

Stock X is common stock of Corporation X, a domestic corporation, that 
historically pays quarterly dividends on Stock X. The parties anticipate 
that Corporation X will continue to pay quarterly dividends.

    Example 1. Forward contract to purchase domestic stock. (i) When 
Stock X is trading at $50 per share, Foreign Investor enters into a 
forward contract to purchase 100 shares of Stock X in one year. 
Reasonable estimates of the quarterly dividend are specified in the 
transaction documents. The price in the forward contract is determined 
by multiplying the number of shares referenced in the contract by the 
current price of the shares and an interest rate, and subtracting the 
value of any dividends expected to be paid during the term of the 
contract. Assuming that the forward contract is priced using an interest 
rate of 4 percent and total estimated dividends with a future value of 
$1 per share during the term of the forward contract, the purchase price 
set in the forward contract is $5,100 (100 shares x $50 per share x 1.04 
- ($1 x 100)).
    (ii) Subject to paragraph (i)(2)(iv) of this section, the estimated 
dividend amounts are the per-share dividend amounts because the 
estimates are reasonable and specified in accordance with paragraph 
(i)(2)(iii) of this section. The estimated per-share dividend amounts 
are dividend equivalents for purposes of this section.
    Example 2. Price return only swap contract. (i) Foreign Investor 
enters into a price return swap contract that entitles Foreign Investor 
to receive payments based on the appreciation in the value of 100 shares 
of Stock X and requires Foreign Investor to pay an amount based on LIBOR 
plus any depreciation in the value of Stock X. The swap contract neither 
explicitly entitles Foreign Investor to payments based on dividends paid 
on Stock X during the term of the contract nor references an estimated 
dividend amount. The LIBOR rate in the swap contract, however, is 
reduced to reflect expected annual dividends on Stock X.
    (ii) Because the LIBOR leg of the swap contract is reduced to 
reflect estimated dividends and the estimated dividend amounts are not 
specified, Foreign Investor is treated as receiving the actual dividend 
amounts are in accordance with paragraph (i)(2) of this section. The 
actual per-share dividend amounts are dividend equivalents for purposes 
of this section.

    (j) Amount of dividend equivalent-- (1) Calculation of the amount of 
a dividend equivalent. The long party is liable for tax on any dividend 
equivalents required to be determined pursuant to paragraph (j)(2) of 
this section only with respect to dividend equivalents that arise while 
the long party is a party to the transaction. The amount of any dividend 
equivalent is determined as follows:
    (i) Securities lending or sale-repurchase transactions. For a 
securities lending or sale-repurchase transaction, the amount of the 
dividend equivalent for each dividend on an underlying security equals 
the amount of the actual per-share dividend paid on the underlying 
security multiplied by the number of shares of the underlying security.
    (ii) Simple contracts. For a simple contract that is a section 
871(m) transaction, the amount of the dividend equivalent for each 
dividend on an underlying security equals:
    (A) The per-share dividend amount (as determined under either 
paragraph (i)(2) or (i)(3) of this section) with respect to the 
underlying security multiplied by;
    (B) The number of shares of the underlying security multiplied by;
    (C) The delta of the section 871(m) transaction with respect to the 
underlying security.
    (iii) Complex contracts. For a complex contract that is a section 
871(m) transaction, the amount of the dividend equivalent for each 
dividend on an underlying security equals:
    (A) The per-share dividend amount (as determined under paragraph 
(i)(2) or (i)(3) of this section) with respect to the underlying 
security multiplied by;
    (B) The initial hedge for the underlying security.
    (iv) Other substantially similar payments. In addition to any amount 
determined pursuant to paragraph (j)(1)(i), (ii), or (iii), the amount 
of a dividend equivalent includes the amount of any payment described in 
paragraph (f) of this section.
    (2) Time for determining the amount of a dividend equivalent. The 
amount of a dividend equivalent is determined on the earlier of the date 
that is the record date of the dividend and the day prior to the ex-
dividend date with respect to the dividend. For example, if a specified 
NPC provides for a payment at settlement that takes into account an 
earlier dividend payment, the amount of the dividend equivalent is

[[Page 408]]

determined on the earlier of the record date or the day prior to the ex-
dividend date for that dividend.
    (3) Number of shares. The number of shares of an underlying security 
generally is the number of shares of the underlying security stated in 
the contract. If the transaction modifies that number by a factor or 
fraction or otherwise alters the amount of any payment, the number of 
shares is adjusted to take into account the factor, fraction, or other 
modification. For example, in a transaction in which the long party 
receives or makes payments based on 200 percent of the appreciation or 
depreciation (as applicable) of 100 shares of stock, the number of 
shares of the underlying security is 200 shares of the stock.
    (4) Taxable year of a dividend equivalent. A long party is liable 
for tax on a dividend equivalent in the year the dividend equivalent is 
subject to withholding pursuant to Sec.  1.1441-2(e)(7). Notwithstanding 
the preceding sentence, a long party that is a qualified derivatives 
dealer is liable for tax on a dividend equivalent when the applicable 
dividend on the underlying security would be subject to withholding 
pursuant to Sec.  1.1441-2(e)(4). The amount of the long party's tax 
liability, however, is determined by reference to the amount that would 
have been due at the time the dividend equivalent amount is determined 
pursuant to paragraph (j)(2) of this section based on the beneficial 
owners at that time (for example, based on the tax rate at that time, 
whether the long party qualified for a treaty benefit at that time, and 
in the case of a partnership, based on the partners at that time).
    (k) Limitation on the treatment of certain corporate acquisitions as 
section 871(m) transactions. A potential section 871(m) transaction is 
not a section 871(m) transaction with respect to an underlying security 
if the transaction obligates the long party to acquire ownership of the 
underlying security as part of a plan pursuant to which one or more 
persons (including the long party) are obligated to acquire underlying 
securities representing more than 50 percent of the value of the entity 
issuing the underlying securities.
    (l) Rules relating to indices--(1) Purpose. The purpose of this 
paragraph (l) is to provide a safe harbor for potential section 871(m) 
transactions that reference certain passive indices that are based on a 
diverse basket of publicly-traded securities and that are widely used by 
numerous market participants. Notwithstanding any other provision in 
this paragraph (l), an index is not a qualified index if treating the 
index as a qualified index would be contrary to the purpose described in 
this paragraph (l)(1).
    (2) Qualified index not treated as an underlying security--(i) In 
general. For purposes of this section, a qualified index is treated as a 
single security that is not an underlying security. The determination of 
whether an index referenced in a potential section 871(m) transaction is 
a qualified index is made at the calculation time for the transaction 
based on whether the index is a qualified index on the first business 
day of the calendar year containing the calculation time.
    (ii) Rule for the first year of an index. In the case of an index 
that was not in existence on the first business day of the calendar year 
containing the calculation time for the transaction, paragraph (l)(2) of 
this section is applied by testing the index on the first business day 
it is created, and the dividend yield calculation required by paragraph 
(l)(3)(vi) of this section is determined by using the dividend yield 
that the index would have had in the immediately preceding year if it 
had the same components throughout that year that it has on the day it 
is created.
    (3) Qualified index. A qualified index means an index that--
    (i) References 25 or more component securities (whether or not the 
security is an underlying security);
    (ii) Except as provided in paragraph (l)(6)(ii) of this section, 
references only long positions in component securities;
    (iii) References no component underlying security that represents 
more than 15 percent of the weighting of the component securities in the 
index;
    (iv) References no five or fewer component underlying securities 
that together represent more than 40 percent of the weighting of the 
component securities in the index;

[[Page 409]]

    (v) Is modified or rebalanced only according to publicly stated, 
predefined criteria, which may require interpretation by the index 
provider or a board or committee responsible for maintaining the index;
    (vi) Did not provide an annual dividend yield in the immediately 
preceding calendar year from component underlying securities that is 
greater than 1.5 times the annual dividend yield of the S&P 500 Index as 
reported for the immediately preceding calendar year; and
    (vii) Is traded through futures contracts or option contracts 
(regardless of whether the contracts provide price only or total return 
exposure to the index or provide for dividend reinvestment in the index) 
on--
    (A) A national securities exchange that is registered with the 
Securities and Exchange Commission or a domestic board of trade 
designated as a contract market by the Commodity Futures Trading 
Commission; or
    (B) A foreign exchange or board of trade that is a qualified board 
or exchange as determined by the Secretary pursuant to section 
1256(g)(7)(C) or that has a staff no action letter from the CFTC 
permitting direct access from the United States that is effective on the 
applicable testing date, provided that the referenced component 
underlying securities, in the aggregate, comprise less than 50 percent 
of the weighting of the component securities in the index.
    (4) Safe harbor for certain indices that reference assets other than 
underlying securities. Notwithstanding paragraph (l)(3) of this section, 
an index is a qualified index if the index is widely traded, the 
referenced component underlying securities in the aggregate comprise 10 
percent or less of the weighting of the component securities in the 
index, and the index was not formed or availed of with a principal 
purpose of avoiding U.S. withholding tax.
    (5) Weighting of component securities. For purposes of this 
paragraph (l), the weighting of a component security of an index is the 
percentage of the index's value represented, or accounted for, by the 
component security.
    (6) Transactions that reference a qualified index and one or more 
component securities or indices--(i) In general. When a potential 
section 871(m) transaction references a qualified index and one or more 
component securities or other indices, the qualified index remains a 
qualified index only if the potential section 871(m) transaction does 
not reference a short position in any referenced component security of 
the qualified index, other than a short position with respect to the 
entire qualified index (for example, a cap or floor) or a de minimis 
short position described in paragraph (l)(6)(ii) of this section. If, in 
connection with a potential section 871(m) transaction that references a 
qualified index, a taxpayer (or a related person within the meaning of 
section 267(b) or section 707(b)) enters into one or more transactions 
that reduce exposure to any referenced component security of the index, 
other than transactions that reduce exposure to the entire index, then 
the potential section 871(m) transaction is not treated as referencing a 
qualified index.
    (ii) Safe harbor for de minimis short positions. Notwithstanding 
paragraphs (l)(3)(ii) and (l)(6)(i) of this section, an index may be a 
qualified index if the short position (whether part of the index or 
entered into separately by the taxpayer or related person within the 
meaning of section 267(b) or section 707(b)) reduces exposure to 
referenced component securities of a qualified index (excluding any 
short positions with respect to the entire qualified index) by five 
percent or less of the value of the long positions in component 
securities in the qualified index.
    (7) Transactions that indirectly reference a qualified index. If a 
potential section 871(m) transaction references an exchange-traded fund 
that tracks a qualified index, the potential section 871(m) transaction 
will be treated as referencing a qualified index.
    (m) Rules relating to derivatives that reference partnerships--(1) 
In general. When a potential section 871(m) transaction references a 
partnership interest, the assets of the partnership will be treated as 
referenced by the potential section 871(m) transaction only if the 
partnership carries on a trade or

[[Page 410]]

business of dealing or trading in securities, holds significant 
investments in securities (either of which is a covered partnership), or 
directly or indirectly holds an interest in a lower-tier partnership 
that is a covered partnership. For purposes of this section, if a 
covered partnership directly or indirectly holds assets that are 
underlying securities or potential section 871(m) transactions, any 
potential section 871(m) transaction that references an interest in the 
covered partnership is treated as referencing the shares of the 
underlying securities, including underlying securities of potential 
section 871(m) transactions, directly or indirectly allocable to that 
partnership interest. For purposes of this paragraph (m), a security is 
defined in section 475(c).
    (2) Significant investments in securities--(i) In general. For 
purposes of this paragraph (m), a partnership holds significant 
investments in securities if either--
    (A) 25 percent or more of the value of the partnership's assets 
consist of underlying securities or potential section 871(m) 
transactions; or
    (B) The value of the underlying securities or potential section 
871(m) transactions equals or exceeds $25 million.
    (ii) Determining the value of the partnership's assets. For purposes 
of this paragraph (m)(2)(i) of this section, the value of a 
partnership's assets is determined at the calculation time for the 
potential section 871(m) transaction referencing that partnership 
interest based on the value of the assets held by the partnership on the 
last day of the partnership's prior taxable year unless the long party 
or the short party has actual knowledge that a subsequent transaction 
has caused the partnership to cross either of the thresholds described 
in paragraph (m)(2)(i). The value of a partnership's assets is equal to 
their fair market value, except that the value of any NPC, futures 
contract, forward contract, option, and any similar financial instrument 
held by the partnership is deemed to be the value of the notional 
securities referenced by the transaction.
    (n) Combined transactions--(1) In general. For purposes of 
determining whether a potential section 871(m) transaction is a section 
871(m) transaction, two or more potential section 871(m) transactions 
are treated as a single transaction with respect to an underlying 
security when--
    (i) A person (or a related person within the meaning of section 
267(b) or section 707(b)) is the long party with respect to the 
underlying security for each potential section 871(m) transaction;
    (ii) The potential section 871(m) transactions reference the same 
underlying security;
    (iii) The potential section 871(m) transactions, when combined, 
replicate the economics of a transaction that would be a section 871(m) 
transaction if the transactions had been entered into as a single 
transaction; and
    (iv) The potential section 871(m) transactions are entered into in 
connection with each other (regardless of whether the transactions are 
entered into simultaneously or with the same counterparty).
    (2) Section 871(m) transactions. If a potential section 871(m) 
transaction is a section 871(m) transaction, either by itself or as a 
result of a combination with one or more other potential section 871(m) 
transactions, it does not cease to be a section 871(m) transaction as a 
result of applying paragraph (n) of this section or disposing of one or 
more of the potential section 871(m) transaction with which it is 
combined.
    (3) Short party presumptions regarding combined transactions--(i) In 
general. If a short party relies on the presumption provided in 
paragraph (n)(3)(ii) of this section or in paragraph (n)(3)(iii) of this 
section, the short party is not required to treat those potential 
section 871(m) transactions as part of a single transaction pursuant to 
paragraph (n)(1) of this section.
    (ii) Transactions in separate accounts. A short party that is a 
broker may presume that transactions are not entered into in connection 
with each other for purposes of paragraph (n)(1) of this section if a 
long party holds or reflects the transactions in separate accounts 
maintained by the short party, unless the short party has actual 
knowledge that the transactions held or reflected in separate accounts 
by the long party were entered into in connection with each other or 
that separate accounts

[[Page 411]]

were created or used to avoid section 871(m).
    (iii) Transactions separated by at least two business days. A short 
party that is a broker may presume that transactions entered into two or 
more business days apart are not entered into in connection with each 
other for purposes of paragraph (n)(1) of this section unless the short 
party has actual knowledge that the transactions were entered into in 
connection with each other.
    (4) Presumptions Commissioner will apply to long party--(i) 
Transactions in separate trading books. The Commissioner will presume 
that a long party did not enter into two or more transactions in 
connection with each other for purposes of paragraph (n)(1) of this 
section if the long party properly reflected those transactions on 
separate trading books. The Commissioner may rebut this presumption with 
facts and circumstances showing that transactions reflected on separate 
trading books were entered into in connection with each other or that 
separate trading books were created or used to avoid section 871(m).
    (ii) Transactions separated by at least two days. The Commissioner 
will presume that a long party did not enter into two or more 
transactions in connection with each other for purposes of paragraph 
(n)(1) of this section if the long party entered into the transactions 
two or more business days apart. The Commissioner may rebut this 
presumption with facts and circumstances showing that the transactions 
entered into two or more business days apart were entered into in 
connection with each other.
    (iii) Transactions separated by fewer than two days and reflected in 
the same trading book. The Commissioner will presume that transactions 
that are entered into fewer than two business days apart and reflected 
on the same trading book are entered into in connection with each other. 
A long party can rebut this presumption with facts and circumstances 
showing that the transactions were not entered into in connection with 
each other.
    (5) Rules of application--(i) Two business days rule. For the 
purpose of determining the number of business days between transactions, 
the short party may, and the Commissioner will, assume that all 
transactions are entered into at 4:00 p.m. on the date the transaction 
becomes effective in the jurisdiction of the long party.
    (ii) No long party presumptions. Notwithstanding the presumptions 
described in paragraphs (n)(3) and (n)(4) of this section, the long 
party must treat two or more transactions as combined transactions if 
the transactions are described in paragraph (n)(1) of section.
    (6) Ordering rule for transactions entered into in connection with 
each other. If a long party enters into more than two potential section 
871(m) transactions that could be combined under this paragraph (n), a 
short party is required to apply paragraph (n)(1) of this section by 
combining transactions in a manner that results in the most transactions 
with a delta of 0.8 or higher with respect to the referenced underlying 
security. Thus, for example, if a taxpayer has sold one at-the-money put 
and purchased two at-the-money calls, each with respect to 100 shares of 
the same underlying security, the put and one call are combined. 
Similarly, a purchased call on 100 shares and a sold put on 200 shares 
of the same underlying security can be combined for 100 shares with 100 
shares of the put remaining separate. The two calls are not combined 
because they do not provide the long party with economic exposure to 
depreciation in the underlying security. Similarly, if a long party 
enters into more than two potential section 871(m) transactions that 
could be combined under this paragraph (n), but have not been combined 
by a short party, the long party is required to apply paragraph (n)(1) 
of this section by combining transactions in a manner that results in 
the most transactions with a delta of 0.8 or higher with respect to the 
referenced underlying security.
    (7) More than one underlying security referenced. If potential 
section 871(m) transactions reference more than one underlying security, 
paragraph (n)(1) of this section applies separately with respect to each 
underlying security.
    (o) Anti-abuse rule. If a taxpayer (directly or through the use of a 
related

[[Page 412]]

person within the meaning of section 267(b) or section 707(b)) acquires 
(whether by entering into, purchasing, accepting by transfer, by 
exchange, or by conversion, or otherwise acquiring) or disposes of 
(whether by sale, offset, exercise, termination, expiration, maturity, 
or other means) a transaction or transactions with a principal purpose 
of avoiding the application of this section, the Commissioner may treat 
any payment (as described in paragraph (i) of this section) made with 
respect to that transaction or transactions as a dividend equivalent to 
the extent necessary to prevent the avoidance of this section. 
Therefore, notwithstanding any other provision of this section, the 
Commissioner may, for example, adjust the delta of a transaction, change 
the number of shares, adjust an estimated dividend amount, change the 
maturity, adjust the timing of payments, treat a transaction that 
references a partnership interest as referencing the assets of the 
partnership, combine, separate, or disregard transactions, indices, or 
components of indices to reflect the substance of the transaction or 
transactions, or otherwise depart from the rules of this section as 
necessary to determine whether the transaction includes a dividend 
equivalent or the amount or timing of a dividend equivalent. A purpose 
may be a principal purpose even though it is outweighed by other 
purposes (taken together or separately). When a withholding agent knows 
that the taxpayer acquired or disposed of a transaction or transactions 
with a principal purpose of avoiding the application of this section and 
the Commissioner treats a payment made with respect to any transaction 
as a dividend equivalent, the withholding agent may be liable for any 
tax pursuant to section 1461.
    (p) Information required to be reported regarding a potential 
section 871(m) transaction-- (1) Responsible party--(i) In general. If a 
broker or dealer is a party to a potential section 871(m) transaction 
with a counterparty or customer that is not a broker or dealer, the 
broker or dealer is required to determine whether the potential section 
871(m) transaction is a section 871(m) transaction. If both parties to a 
potential section 871(m) transaction are brokers or dealers, or neither 
party to a potential section 871(m) transaction is a broker or dealer, 
the short party must determine whether the potential section 871(m) 
transaction is a section 871(m) transaction.
    (ii) [Reserved]. For further guidance, see Sec.  1.871-
15T(p)(1)(ii).
    (iii) [Reserved]. For further guidance, see Sec.  1.871-
15T(p)(1)(iii).
    (iv) [Reserved]. For further guidance, see Sec.  1.871-
15T(p)(1)(iv).
    (v) Obligations of the responsible party. The party to the 
transaction that is required to determine whether a transaction is a 
section 871(m) transaction must also determine and report to the 
counterparty or customer the timing and amount of any dividend 
equivalent (as described in paragraphs (i) and (j) of this section). 
Except as otherwise provided in paragraph (n)(3) of this section, the 
party required to make the determinations described in this paragraph is 
required to exercise reasonable diligence to determine whether a 
transaction is a section 871(m) transaction, the amount of any dividend 
equivalents, and any other information necessary to apply the rules of 
this section. The information must be provided in the manner prescribed 
in paragraphs (p)(2) and (p)(3) of this section. The determinations 
required by paragraph (p) of this section are binding on the parties to 
the potential section 871(m) transaction and on any person who is a 
withholding agent with respect to the potential section 871(m) 
transaction unless the person knows or has reason to know that the 
information received is incorrect. The determinations are not binding on 
the Commissioner.
    (2) Reporting requirements. For rules regarding the reporting 
requirements of withholding agents with respect to dividend equivalents 
described in this section, see Sec. Sec.  1.1461-1(b) and (c) and 
1.1474-1(c) and (d).
    (3) Additional information available to a party to a potential 
section 871(m) transaction--(i) In general. Upon request by any person 
described in paragraph (p)(3)(ii) of this section, the party required to 
report information pursuant to paragraph (p)(1) of this section must 
provide the requester with information regarding the amount of each 
dividend

[[Page 413]]

equivalent, the delta of the potential section 871(m) transaction, the 
amount of any tax withheld and deposited, the estimated dividend amount 
if specified in accordance with paragraph (i)(2)(iii) of this section, 
the identity of any transactions combined pursuant to paragraph (n) of 
this section, and any other information necessary to apply the rules of 
this section. The information requested must be provided within a 
reasonable time, not to exceed 10 business days, and communicated in one 
or more of the following ways:
    (A) By telephone, and confirmed in writing;
    (B) By written statement sent by first class mail to the address 
provided by the requesting party;
    (C) By electronic publication available to all persons entitled to 
request information; or
    (D) By any other method agreed to by the parties, and confirmed in 
writing.
    (ii) Persons entitled to request information. Any party to the 
transaction described in paragraph (a)(9) of this section may request 
the information specified in paragraph (p) of this section with respect 
to a potential section 871(m) transaction from the party required by 
paragraph (p)(3)(i) of this section to provide the information.
    (iii) Reliance on information received. A person described in 
paragraph (p)(1) or (p)(3)(ii) of this section that receives information 
described in paragraph (p)(1) or (p)(3)(i) of this section may rely on 
that information to provide information to any other person unless the 
recipient knows or has reason to know that the information received is 
incorrect. When the recipient knows or has reason to know that the 
information received is incorrect, the recipient must make a reasonable 
effort to determine and provide the information described in paragraph 
(p)(1) or (p)(3)(i) of this section to any person described in paragraph 
(p)(1) or (p)(3)(ii) of this section that requests information from the 
recipient.
    (4) Recordkeeping rules--(i) In general. For rules regarding 
recordkeeping requirements sufficient to establish whether a transaction 
is a section 871(m) transaction and whether a payment is a dividend 
equivalent and the amount of gross income treated as a dividend 
equivalent, see Sec.  1.6001-1.
    (ii) Records sufficient to establish whether a transaction is a 
section 871(m) transaction and any dividend equivalent amount. Any 
person required to retain records must keep sufficient information to 
establish whether a transaction is a section 871(m) transaction and the 
amount of a dividend equivalent (if any), including documentation and 
work papers supporting the delta calculation or the substantial 
equivalence test (including the number of shares of the initial hedge), 
as applicable, and written estimated dividends (if any). The records and 
documentation must be created substantially contemporaneously. A record 
will be considered to have been created substantially contemporaneously 
if it was created within 10 business days of the date containing the 
calculation time for the potential section 871(m) transaction.
    (iii) Recordkeeping required for certain options. With respect to 
any option to which paragraph (g)(4) of this section applies, 
contemporaneous documentation is not required to be retained provided 
that there is a pre-existing documented methodology that is sufficient 
to permit the delta for the transaction to be verified at a later time.
    (5) [Reserved]. For further guidance, see Sec.  1.871-15T(p)(5).
    (q) Dividend and dividend equivalent payments to a qualified 
derivatives dealer--(1) In general. Except as otherwise provided in this 
paragraph (q), a qualified derivatives dealer described in Sec.  1.1441-
1(e)(6) that receives a payment (within the meaning of paragraph (i) of 
this section) of a dividend equivalent in its equity derivatives dealer 
capacity will not be liable for tax under section 881 on that dividend 
equivalent, provided that the qualified derivatives dealer complies with 
its obligations under the qualified intermediary withholding agreement 
described in Sec. Sec.  1.1441-1(e)(5) and 1.1441-1(e)(6). A qualified 
derivatives dealer is liable for tax under section 881(a)(1) on its 
section 871(m) amount for each dividend on each underlying security. 
This tax liability is reduced (but not below zero) by the amount of tax 
paid by the qualified derivatives dealer under section 881(a)(1) on 
dividends it receives with

[[Page 414]]

respect to that underlying security on that same dividend in its 
capacity as an equity derivatives dealer. In addition, a qualified 
derivatives dealer is liable for tax under section 881(a)(1) for all 
dividend equivalents it receives that are not received in its equity 
derivatives dealer capacity. A qualified derivatives dealer also is 
liable for tax under section 881(a)(1) for all dividends it receives, 
other than dividends received in 2017 in its equity derivatives dealer 
capacity. This paragraph does not apply for a qualified derivatives 
dealer that is a foreign branch of a United States financial institution 
(within the meaning of Sec.  1.1471-5(e)).
    (2) Transactions on the books of an equity derivatives dealer. 
Transactions properly reflected in a qualified derivatives dealer's 
equity derivatives dealer book are presumed to be held by the dealer in 
its equity derivatives dealer capacity for purposes of determining the 
qualified derivatives dealer's tax liability. For purposes of 
determining whether a dealer is acting in its equity derivatives dealer 
capacity, only the dealer's activities as an equity derivatives dealer 
are taken into account. Accordingly, for purposes of this paragraph (q), 
a dividend or dividend equivalent is treated as received by a qualified 
derivatives dealer acting in its non-equity derivatives dealer capacity 
if the dividend or dividend equivalent is received by a qualified 
derivatives dealer acting as a proprietary trader.
    (3) Section 871(m) amount. For each dividend on each underlying 
security, the section 871(m) amount is the product of:
    (i) The qualified derivatives dealer's net delta exposure to the 
underlying security for the applicable dividend, multiplied by;
    (ii) The applicable dividend amount per share.
    (4) Net delta exposure. The net delta exposure to an underlying 
security is the amount (measured in number of shares) by which (A) the 
aggregate number of shares of an underlying security that the qualified 
derivatives dealer has exposure to as a result of positions in the 
underlying security (including as a result of owning the underlying 
security) with values that move in the same direction as the underlying 
security (the long positions) exceeds (B) the aggregate number of shares 
of an underlying security that the qualified derivatives dealer has 
exposure to as a result of positions in the underlying security with 
values that move in the opposite direction from the underlying security 
(the short positions). The net delta exposure calculation only includes 
long positions and short positions that the qualified derivatives dealer 
holds in its equity derivatives dealer capacity (as described in 
paragraph (q)(2) of this section). Any long positions or short positions 
that are treated as effectively connected with the qualified derivatives 
dealer's conduct of a trade or business in the United States for U.S. 
federal income tax purposes are excluded from the net delta exposure 
computation. The net delta exposure to an underlying security is 
determined at the end of the day on the date provided in Sec.  1.871-
15(j)(2) for the applicable dividend. For purposes of this calculation, 
net delta must be determined in a commercially reasonable manner. If a 
qualified derivatives dealer calculates net delta for non-tax business 
purposes, the net delta ordinarily will be the delta used for that 
purpose, subject to the modifications required by this definition. Each 
qualified derivatives dealer must determine its net delta exposure 
separately only taking into account transactions that are recognized and 
are attributable to that qualified derivatives dealer for U.S. federal 
income tax purposes.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (q):

    Example 1. Forward contract entered into by a foreign equity 
derivatives dealer. (i) Facts. FB is a foreign bank that is a qualified 
intermediary that acts as a qualified derivatives dealer. On April 1, 
Year 1, FB enters into a cash settled forward contract initiated by a 
foreign customer (Customer) that entitles Customer to receive from FB 
all of the appreciation and dividends on 100 shares of Stock X, and 
obligates Customer to pay FB any depreciation on 100 shares of Stock X, 
at the end of three years. FB hedges the forward contract by entering 
into a total return swap contract with a domestic broker (U.S. Broker) 
and maintains the swap contract as a hedge for the duration of the 
forward contract. The swap contract entitles FB to receive an amount 
equal to all of the dividends

[[Page 415]]

on 100 shares of Stock X and obligates FB to pay an amount referenced to 
a floating interest rate each quarter, and also entitles FB to receive 
from or pay to U.S. Broker, as the case may be, the difference between 
the value of 100 shares of Stock X at the inception of the swap and the 
value of 100 shares of Stock X at the end of 3 years. Stock X pays a 
quarterly dividend of $0.25 per share. At the end of the day on the date 
provided in paragraph (j)(2) of this section for the dividend, FB owns 
the forward contract and total return swap; FB does not own any shares 
of Stock X or any other transactions that reference Stock X. FB provides 
valid documentation to U.S. Broker that FB will receive payments under 
the swap contract in its capacity as a qualified derivatives dealer, and 
FB contemporaneously enters both the swap contract with U.S. Broker and 
the forward contract with Customer on its equity derivatives dealer 
books.
    (ii) Application of rules. At the end of the day on the date 
provided in paragraph (j)(2) of this section for the dividend, FB is a 
long party on a delta one contract (the total return swap) and a short 
party on a delta one contract (the forward contract with Customer). 
Pursuant to Sec.  1.1441-1(b)(4)(xxii), U.S. Broker is not obligated to 
withhold on the dividend equivalent payments to FB on the swap contract 
that are referenced to Stock X dividends because U.S. Broker has 
received valid documentation that it may rely upon to treat the payment 
as made to FB acting as a qualified derivatives dealer. Pursuant to 
paragraph (q)(1) of this section, FB is not liable for tax under 
sections 871(m) and 881 on the payments it receives from U.S. Broker 
referenced to Stock X dividends because FB's net delta exposure with 
respect to 100 shares of Stock X is zero at the end of the day on the 
date provided in paragraph (j)(2) of this section for the dividend. The 
net delta exposure is zero because the taxpayer has 100 shares of Stock 
X long position exposure as a result of the total return swap that is 
reduced by 100 shares of Stock X short position exposure as a result of 
the forward contract. FB is required to withhold on dividend equivalent 
payments to Customer on the forward contract in accordance with Sec.  
1.1441-2(e)(7).
    Example 2. At-the-money option contract entered into by a foreign 
equity derivatives dealer. (i) Facts. The facts are the same as Example 
1, but Customer purchases from FB an at-the-money call option on 100 
shares of Stock X with a term of one year. The call option has a delta 
of 0.5, and FB hedges the call option by entering into a total return 
swap that references 50 shares of Stock X with U.S. Broker. At the end 
of the day on the date provided in paragraph (j)(2) of this section for 
the dividend, the call option has a delta of 0.6, FB hedges the call 
option with a total return swap that references 60 shares of Stock X 
with U.S. Broker, and FB has no shares of Stock X or other transactions 
that reference Stock X.
    (ii) Application of rules. At the end of the day on the date 
provided in paragraph (j)(2) of this section for the dividend, FB is a 
long party on 60 shares of Stock X through the total return swap and a 
short party on an option. Because the option has a delta of less than 
0.8 at the calculation time, it is not a section 871(m) transaction. 
Therefore, there will be no dividend equivalent payments made by FB to 
Customer that are subject to withholding. Pursuant to Sec.  1.1441-
1(b)(4)(xxii), U.S. Broker is not obligated to withhold on the dividend 
equivalents with respect to Stock X paid to FB because U.S. Broker has 
received valid documentation that it may rely upon to treat the dividend 
equivalents as paid to FB acting as a qualified derivatives dealer. The 
net delta exposure is zero at the end of the day on the date provided in 
paragraph (j)(2) of this section for the dividend because FB has a long 
position of 60 shares as a result of the total return swap, which is 
reduced by FB's short position of 60 shares as a result of the option.
    Example 3. In-the-money option contract entered into by a foreign 
equity derivatives dealer. (i) Facts. The facts are the same as Example 
2, but Customer purchases from FB an in-the-money call option on 100 
shares of Stock X with a term of one year. The call option has a delta 
of 0.8 and FB hedges the call option by purchasing 80 shares of Stock X, 
which are held in an account with U.S. Broker, who also acts as paying 
agent. The price of Stock X declines substantially and the option lapses 
unexercised. At the end of the day on the date provided in paragraph 
(j)(2) of this section for the dividend, the call option has a delta of 
0.48 and FB has reduced its hedge to 50 shares of Stock X with U.S. 
Broker. In addition, on that date, FB owns no other shares of Stock X or 
any other transactions that reference Stock X in its equity derivatives 
dealer capacity.
    (ii) Application of rules. At the end of the day on the date 
provided in paragraph (j)(2) of this section for the dividend, FB is a 
long party on 50 shares of Stock X and a short party on an option. 
Because the option has a delta of 0.8 at the calculation time, it is a 
section 871(m) transaction. Therefore, FB is required to withhold on 
dividend equivalent payments to Customer on the option contract in 
accordance with Sec.  1.1441-2(e)(7). U.S. Broker is required to 
withhold on the Stock X dividends paid to FB. Assuming that FB is a 
qualified resident of a country with a treaty that provides withholding 
on dividends at a 15 percent rate, U.S. Broker is required withhold on 
the dividends with respect to the 50 shares of stock held by FB. FB's 
net delta exposure is two shares of Stock X at the end of the day on the 
date provided in paragraph (j)(2) of this section because FB has a long 
position of 50 shares, reduced by

[[Page 416]]

FB's short position of 48 shares as a result of the option. FB's section 
881 tax on the $0.50 (two shares multiplied by a dividend of $0.25 per 
share) is reduced (but not below zero) by the section 881 tax amount 
paid by the qualified derivatives dealer on the 50 shares. Therefore, 
FB's section 871(m) amount is zero.
    (r) Effective/applicability date--(1) In general. This section 
applies to payments made on or after January 19, 2017 except as provided 
in paragraphs (r)(2), (3), and (4) of this section.
    (2) Effective/applicability date for paragraphs (d)(2) and (e). 
Paragraphs (d)(2) and (e) of this section apply to any payment made on 
or after January 1, 2017, with respect to any transaction with a delta 
of one issued on or after January 1, 2017. Paragraphs (d)(2) and (e) of 
this section apply to any payment made on or after January 1, 2018, with 
respect to any other transaction issued on or after January 1, 2018. 
Notwithstanding the prior sentence, paragraphs (d)(2) and (e) of this 
section will apply to any payments made on or after January 1, 2020, 
with respect to the exchange-traded notes issued on or after January 1, 
2017, that are identified in a separate notice, and not payments made 
before January 1, 2020, with respect to those notes. Notwithstanding the 
first sentence of this paragraph (r)(3), paragraphs (d)(2) and (e) of 
this section do not apply to payments made in 2017 to a qualified 
derivatives dealer in its equity derivatives dealer capacity to hedge 
transactions that have a delta of less than one.
    (3) Effective/applicability date for paragraphs (g)(4)(ii)(B), 
(p)(1)(ii) through (iv), and (p)(5) of this section. Paragraphs 
(c)(2)(iv), (h), and (q) of this section apply to payments made on or 
after January 1, 2017.
    (4) Effective/applicability date for paragraphs (g)(4)(ii)(B), 
(p)(1)(ii) through (iv), and (p)(5) of this section. [Reserved]. For 
further guidance, see Sec.  1.871-15T(r)(5).

[T.D. 9648, 78 FR 73080, Dec. 5, 2013, as amended by T.D. 9734, 80 FR 
56879, Sept. 18, 2015; 80 FR 75946, Dec. 7, 2015; T.D. 9815, 82 FR 8155, 
8160, Jan. 24, 2017; T.D. 9815, 82 FR 49508, Oct. 26, 2017]



Sec.  1.871-15T  Treatment of dividend equivalents (temporary).

    (a) [Reserved]. For further guidance, see Sec.  1.871-15(a).
    (1) Broker. A broker is a broker within the meaning provided in 
section 6045(c), except that the term does not include any corporation 
that is a broker solely because it regularly redeems its own shares.
    (a)(2) through (g)(4)(ii)(A) [Reserved]. For further guidance, see 
Sec.  1.871-15(a)(2) through (g)(4)(ii)(A).
    (B) A foreign securities exchange that:
    (1) Is regulated or supervised by a governmental authority of the 
country in which the market is located;
    (2) Has trading volume, listing, financial disclosure, surveillance, 
and other requirements designed to prevent fraudulent and manipulative 
acts and practices, to remove impediments to and perfect the mechanism 
of a free and open, fair and orderly market, and to protect investors, 
and the laws of the country in which the exchange is located and the 
rules of the exchange ensure that those requirements are actually 
enforced;
    (3) Has rules that effectively promote active trading of listed 
options on the exchange; and
    (4) Has an average daily trading volume on the exchange exceeding 
$10 billion during the immediately preceding calendar year. If an 
exchange in a foreign country has more than one tier or market level on 
which listed options may be separately listed or traded, each tier or 
market level is treated as a separate exchange.
    (g)(5) through (p)(1)(i) [Reserved]. For further guidance, see Sec.  
1.871-15(g)(5) through (p)(1)(i).
    (ii) Transactions with multiple brokers. For a potential section 
871(m) transaction in which both the short party and an agent or 
intermediary acting on behalf of the short party are a broker or dealer, 
the short party must determine whether the potential section 871(m) 
transaction is a section 871(m) transaction. For a potential section 
871(m) transaction in which the short party is not a broker or dealer 
and more than one agent or intermediary acting on behalf of the short 
party is a broker or dealer, the broker or dealer that is a party to the 
transaction and closest to the short party in the payment chain must 
determine whether

[[Page 417]]

the potential section 871(m) transaction is a section 871(m) 
transaction. For a potential section 871(m) transaction in which neither 
the short party nor any agent or intermediary acting on behalf of the 
short party is a broker or dealer, and the long party and an agent or 
intermediary acting on behalf of the long party are a broker or dealer, 
or more than one agent or intermediary acting on behalf of the long 
party is a broker or dealer, the broker or dealer that is a party to the 
transaction and closest to the long party in the payment chain must 
determine whether the potential section 871(m) transaction is a section 
871(m) transaction.
    (iii) Responsible party for transactions traded on an exchange and 
cleared by a clearing organization. Except as provided in paragraph 
(p)(1)(iv) of this section, for a potential section 871(m) transaction 
that is traded on an exchange and cleared by a clearing organization, 
and for which more than one broker-dealer acts as an agent or 
intermediary between the short party and a foreign payee, the broker or 
dealer that has an ongoing customer relationship with the foreign payee 
with respect to that transaction (generally the clearing firm) must 
determine whether the potential section 871(m) transaction is a section 
871(m) transaction.
    (iv) Responsible party for certain structured notes, warrants, and 
convertible instruments. When a potential section 871(m) transaction is 
a structured note, warrant, convertible stock, or convertible debt, the 
issuer is the party responsible for determining whether a potential 
section 871(m) transaction is a section 871(m) transaction.
    (p)(1)(v) through (p)(4) [Reserved]. For further guidance, see Sec.  
1.871-15(p)(1)(v) through (p)(4).
    (5) Example. The following example illustrates the rules of 
paragraph (p) of this section:

    Example. CO is a domestic clearing organization and is not a broker 
as defined in Sec.  1.871-15(a)(1). CO serves as a central counterparty 
clearing and settlement service provider for derivatives exchanges in 
the United States. EB and CB are brokers organized in the United States 
and members of CO. FC, a foreign corporation, instructs EB to execute 
the purchase of a call option that is a specified ELI (as described in 
Sec.  1.871-15(e)). EB effects the trade for FC on the exchange and 
then, as instructed by FC, transfers the option to CB to be cleared with 
CO. The exchange matches FC's order with an order for a written call 
option with the same terms and then sends the matched trade to CO, which 
clears the trade. CB and the clearing member representing the person who 
sold the call option settle the trade with CO. Upon receiving the 
matched trade, the option contracts are novated and CO becomes the 
counterparty to CB and the counterparty to the clearing member 
representing the person who sold the call option. Both EB and CB are 
broker-dealers acting on behalf of FC for a potential section 871(m) 
transaction. Under paragraph (p)(1)(iii) of this section, however, only 
CB is required to make the determinations described in Sec.  1.871-
15(p).

    (q) through (r)(3) [Reserved]. For further guidance, see Sec.  
1.871-15(q) through (r)(3).
    (4) Effective/applicability date. This section applies to payments 
made on or after January 19, 2017.
    (s) Expiration date. This section expires January 17, 2020.

[T.D. 9815, 82 FR 8161, Jan. 24, 2017; T.D. 9815, 82 FR 49509, Oct. 26, 
2017]



Sec.  1.872-1  Gross income of nonresident alien individuals.

    (a) In general--(1) Inclusions. The gross income of a nonresident 
alien individual for any taxable year includes only (i) the gross income 
which is derived from sources within the United States and which is not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that individual and (ii) the gross 
income, irrespective of whether such income is derived from sources 
within or without the United States, which is effectively connected for 
the taxable year with the conduct of a trade or business in the United 
States by that individual. For the determination of the sources of 
income, see sections 861 through 863 and the regulations thereunder. For 
the determination of whether income from sources within or without the 
United States is effectively connected for the taxable year with the 
conduct of a trade or business in the United States, see sections 864(c) 
and 871 (c) and (d), Sec. Sec.  1.864-3 through 1.864-7, and Sec. Sec.  
1.871-9

[[Page 418]]

and 1.871-10. For special rules for determining the income of an alien 
individual who changes his residence during the taxable year, see Sec.  
1.871-13.
    (2) Exchange transactions. Even though a nonresident alien 
individual who effects certain transactions in the United States in 
stocks, securities, or commodities during the taxable year may not, by 
reason of section 864(b)(2) and paragraph (c) or (d) of Sec.  1.864-2, 
be engaged in trade or business in the United States during the taxable 
year through the effecting of such transactions, nevertheless he shall 
be required to include in gross income for the taxable year the gains 
and profits from those transactions to the extent required by Sec.  
1.871-7 or Sec.  1.871-8.
    (3) Exclusions. For exclusions from gross income, see Sec.  1.872-2.
    (b) Individuals not engaged in U.S. business. In the case of a 
nonresident alien individual who at no time during the taxable year is 
engaged in trade or business in the United States, the gross income 
shall include only (1) the gross income from sources within the United 
States which is described in section 871(a) and paragraphs (b), (c), and 
(d) of Sec.  1.871-7, and (2) the gross income from sources within the 
United States which, by reason of section 871 (c) or (d) and Sec.  
1.871-9 or Sec.  1.871-10, is treated as effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by that individual.
    (c) Individuals engaged in U.S. business. In the case of a 
nonresident alien individual who is engaged in trade or business in the 
United States at any time during the taxable year, the gross income 
shall include (1) the gross income from sources within and without the 
United States which is effectively connected for the taxable year with 
the conduct of a trade or business in the United States by that 
individual, (2) the gross income from sources within the United States 
which, by reason of the election provided in section 871(d) and Sec.  
1.871-10, is treated as effectively connected for the taxable year with 
the conduct of a trade or business in the United States by that 
individual, and (3) the gross income from sources within the United 
States which is described in section 871(a) and paragraphs (b), (c), and 
(d) of Sec.  1.871-7 and is not effectively connected for the taxable 
year with the conduct of a trade or business in the United States by 
that individual.
    (d) Special rules applicable to certain expatriates. For special 
rules for determining the gross income of a nonresident alien individual 
who has lost U.S. citizenship with a principal purpose of avoiding 
certain taxes, see section 877(b)(1).
    (e) Alien resident of Puerto Rico. This section shall not apply in 
the case of a nonresident alien individual who is a bona fide resident 
of Puerto Rico during the entire taxable year. See section 876 and Sec.  
1.876-1.
    (f) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. For corresponding rules applicable to 
taxable years beginning before January 1, 1967, see 26 CFR 1.872-1 
(Revised as of January 1, 1971).

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7332, 39 FR 
44228, Dec. 23, 1974]



Sec.  1.872-2  Exclusions from gross income of nonresident alien individuals.

    (a) Earnings of foreign ships or aircraft--(1) Basic rule. So much 
of the income from sources within the United States of a nonresident 
alien individual as consists of earnings derived from the operation of a 
ship or ships documented, or of aircraft registered, under the laws of a 
foreign country which grants an equivalent exemption to citizens of the 
United States nonresident in that foreign country and to corporations 
organized in the United States shall not be included in gross income.
    (2) Equivalent exemption--(i) Ships. A foreign country which either 
imposes no income tax, or, in imposing an income tax, exempts from 
taxation so much of the income of a citizen of the U.S. nonresident in 
that foreign country and of a corporation organized in the United States 
as consists of earnings derived from the operation of a ship or ships 
documented under the laws of the United States is considered as granting 
an equivalent exemption for purposes of the exclusion from gross income 
of the earnings of a foreign ship or ships.
    (ii) Aircraft. A foreign country which either imposes no income tax, 
or, in

[[Page 419]]

imposing an income tax, exempts from taxation so much of the income of a 
citizen of the U.S. nonresident in that foreign country and of a 
corporation organized in the United States as consists of earnings 
derived from the operation of aircraft registered under the laws of the 
United States is considered as granting an equivalent exemption for 
purposes of the exclusion from gross income of the earnings of foreign 
aircraft.
    (3) Definition of earnings. For purposes of subparagraphs (1) and 
(2) of this paragraph, compensation for personal services performed by 
an individual aboard a ship or aircraft does not constitute earnings 
derived by such individual from the operation of ships or aircraft.
    (b) Compensation paid by foreign employer to participants in certain 
exchange or training programs--(1) Exclusion from income. Compensation 
paid to a nonresident alien individual for the period that the 
nonresident alien individual is temporarily present in the United States 
as a nonimmigrant under subparagraph (F) (relating to the admission of 
students into the United States) or subparagraph (J) (relating to the 
admission of teachers, trainees, specialists, etc., into the United 
States) of section 101(a)(15) of the Immigration and Nationality Act (8 
U.S.C. 1101(a)(15) (F) or (J)) shall be excluded from gross income if 
the compensation is paid to such alien by his foreign employer. 
Compensation paid to a nonresident alien individual by the U.S. office 
of a domestic bank which is acting as paymaster on behalf of a foreign 
employer constitutes compensation paid by a foreign employer for 
purposes of this paragraph if the domestic bank is reimbursed by the 
foreign employer for such payment. A nonresident alien individual who is 
temporarily present in the United States as a nonimmigrant under such 
subparagraph (J) includes a nonresident alien individual admitted to the 
United States as an ``exchange visitor'' under section 201 of the U.S. 
Information and Educational Exchange Act of 1948 (22 U.S.C. 1446), which 
section was repealed by section 111 of the Mutual Education and Cultural 
Exchange Act of 1961 (75 Stat. 538).
    (2) Definition of foreign employer. For purposes of this paragraph, 
the term ``foreign employer'' means a nonresident alien individual, a 
foreign partnership, a foreign corporation, or an office or place of 
business maintained in a foreign country or in a possession of the 
United States by a domestic corporation, a domestic partnership, or an 
individual who is a citizen or resident of the United States. The term 
does not include a foreign government. However, see section 893 and 
Sec.  1.893-1. Thus, if a French citizen employed in the Paris branch of 
a banking company incorporated in the State of New York were admitted to 
the United States under section 101(a)(15)(J) of the Immigration and 
Nationality Act to study monetary theory and continued to receive a 
salary from such foreign branch while studying in the United States, 
such salary would not be includable in his gross income.
    (c) Tax convention. Income of any kind which is exempt from tax 
under the provisions of a tax convention or treaty to which the United 
States is a party shall not be included in the gross income of a 
nonresident alien individual. Income on which the tax is limited by tax 
convention shall be included in the gross income of a nonresident alien 
individual if it is not otherwise excluded from gross income. See 
Sec. Sec.  1.871-12 and 1.894-1.
    (d) Certain bond income of residents of the Ryukyu Islands or the 
Trust Territory of the Pacific Islands. Income derived by a nonresident 
alien individual from a series E or series H U.S. savings bond shall not 
be included in gross income if such individual acquired the bond while 
he was a resident of the Ryukyu Islands or the Trust Territory of the 
Pacific Islands. It is not necessary that the individual continue to be 
a resident of such Islands or Trust Territory for the period when, 
without regard to section 872(b)(4) and this paragraph, the income from 
the bond would otherwise be includible in his gross income under the 
provisions of section 446 or 454.
    (e) Certain annuities received under qualified plans. Pursuant to 
section 871(f), income received by a nonresident alien individual as an 
annuity

[[Page 420]]

under a qualified annuity plan described in section 403(a)(1) (relating 
to taxation of employee annuities), or from a qualified trust described 
in section 401(a) (relating to qualified pension, profit-sharing, and 
stock bonus plans) which is exempt from tax under section 501(a) 
(relating to exemption from tax on corporations, certain trusts, etc.), 
shall not be included in gross income, and shall be exempt from tax, for 
purposes of section 871 and Sec. Sec.  1.871-7 and 1.871-8, if--
    (1) All of the personal services by reason of which the annuity is 
payable were either--
    (i) Personal services performed outside the United States by an 
individual (whether or not the annuitant) who, at the time of 
performance of the services, was a nonresident alien individual, or
    (ii) Personal services performed in the United States by a 
nonresident alien individual (whether or not the annuitant) which, by 
reason of section 864(b)(1) (or corresponding provision of any prior 
law), were not personal services causing such individual to be engaged 
in trade or business in the United States during the taxable year, and
    (2) At the time the first amount is paid (even though paid in a 
taxable year beginning before January 1, 1967) as such annuity under 
such annuity plan, or by such trust, to (i) the individual described in 
subparagraph (1) of this paragraph, or (ii) his nonresident alien 
beneficiary if such beneficiary is entitled to receive such first 
amount, 90 percent or more of the employees or annuitants for whom 
contributions or benefits are provided under the annuity plan, or under 
the plan or plans of which the trust is a part, are citizens or 
residents of the United States.


This paragraph shall apply whether or not the taxpayer is engaged in 
trade or business in the United States at any time during the taxable 
year in which the annuity is received. This paragraph shall not apply to 
distributions by an employees' trust or from an annuity plan which give 
rise to gains described in section 402(a)(2) or 403(a)(2), whichever 
applies. See section 871(a)(1)(B) and paragraph (c)(1)(i) of Sec.  
1.871-7. For exemption from withholding of tax at source on an annuity 
which is exempt from tax under section 871(f) and this paragraph, see 
paragraph (g) of Sec.  1.1441-4.
    (f) Other exclusions. Income which is from sources without the 
United States, as determined under the provisions of sections 861 
through 863, and the regulations thereunder, is not included in the 
gross income of a nonresident alien individual unless such income is 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that individual. To determine 
specific exclusions in the case of other items which are from sources 
within the United States, see the applicable sections of the Code. For 
special rules under a tax convention for determining the sources of 
income and for excluding, from gross income, income from sources without 
the United States which is effectively connected with the conduct of a 
trade or business in the United States, see the applicable tax 
convention. For determining which income from sources without the United 
States is effectively connected with the conduct of a trade or business 
in the United States, see section 864(c)(4) and Sec.  1.864-5.
    (g) Effective date. This section shall apply for taxable years 
beginning after December 31, 1966. For corresponding rules applicable to 
taxable years beginning before January 4, 1967 see 26 CFR 1.872-2 
(Revised as of January 1, 1971).

[T.D. 7332, 39 FR 44228, Dec. 23, 1974]



Sec.  1.873-1  Deductions allowed nonresident alien individuals.

    (a) General provisions--(1) Allocation of deductions. In computing 
the taxable income of a nonresident alien individual the deductions 
otherwise allowable shall be allowed only if, and to the extent that, 
they are connected with income from sources within the United States. No 
deduction shall be allowed in respect of any item, or portion thereof, 
which is not connected with income from such sources. For this purpose, 
the proper apportionment and allocation of the deductions with respect 
to sources of income within and without the United States shall be 
determined as provided in part I (section

[[Page 421]]

861 and following), subchapter N, chapter 1 of the Code, and the 
regulations thereunder, except as may otherwise be provided by tax 
convention. Thus, from the items of gross income specifically from 
sources within the United States and from the items allocated thereto 
under the provisions of section 863(a), there shall be deducted (i) the 
expenses, losses, and other deductions which are connected with those 
items of income and are properly apportioned or allocated thereto, and 
(ii) a ratable part of any other expenses, losses, or deductions which 
are connected with those items of income but cannot definitely be 
allocated to some item or class of gross income. The ratable part shall 
be based upon the ratio of gross income from sources within the United 
States to the total gross income. See Sec. Sec.  1.861-8 and 1.863-1. In 
the case of income partly from within and partly from without the United 
States the expenses, losses, and other deductions connected with income 
from sources within the United States shall also be deducted in the 
manner prescribed by Sec. Sec.  1.863-2 through 1.863-5 in order to 
ascertain under section 863 the portion of the taxable income 
attributable to sources within the United States.
    (2) Personal exemptions. The deductions for the personal exemptions 
allowed by section 151 or 642(b) shall not be taken into account for 
purposes of subparagraph (1) of this paragraph but shall be allowed to 
the extent provided by paragraphs (b) and (c) of this section.
    (3) Adjusted gross income. The adjusted gross income of a 
nonresident alien individual shall be the gross income from sources 
within the United States, determined in accordance with Sec.  1.871-7, 
minus the deductions prescribed by section 62 to the extent such 
deductions are allowed under this section in computing taxable income.
    (4) Standard deduction. The standard deduction shall not be allowed 
in computing the taxable income of a nonresident alien individual. See 
section 142(b)(1) and the regulations thereunder.
    (5) Exempt income. No deduction shall be allowed under this section 
for the amount of any item or part thereof allocable to a class or 
classes of exempt income, including income exempt by tax convention. See 
section 265 and the regulations thereunder.
    (b) No United States business--(1) Income of not more than $15,400--
(i) Deduction for losses only. A nonresident alien individual within 
class 1 shall not be allowed any deductions other than the deduction for 
losses from sales or exchanges of capital assets determined in the 
manner prescribed by paragraph (b)(4)(vii) of Sec.  1.871-7. Thus, an 
individual within this class shall not be allowed any deductions for the 
personal exemptions otherwise allowed by section 151 or 642(b).
    (ii) Source of losses. Notwithstanding the provisions of section 
873(b)(1), losses from sales or exchanges of capital assets shall be 
allowed under this subparagraph only if allocable to sources within the 
United States. See paragraph (b)(4)(i) of Sec.  1.871-7.
    (2) Aggregate more than $15,400--(i) Deductions allowed. In 
computing the income subject to tax under section 1 or section 1201(b), 
a nonresident alien individual within class 2 shall be allowed 
deductions to the extent prescribed by paragraph (c)(3) of Sec.  1.871-
7, but subject to the limitations of this section. For this purpose, the 
deduction for the personal exemptions shall be allowed in accordance 
with subdivision (iii) of this subparagraph.
    (ii) Deductions disallowed. In computing the minimum tax prescribed 
by section 871(b)(3), that individual shall not be allowed any 
deductions other than the deduction for losses from sales or exchanges 
of capital assets determined in the manner prescribed by paragraph 
(b)(4)(vii) of Sec.  1.871-7. For this purpose, the deductions for the 
personal exemptions shall not be allowed. See paragraph (c)(4) of Sec.  
1.871-7.
    (iii) Personal exemptions. When the deductions for personal 
exemptions are allowed under this subparagraph, only one exemption under 
section 151 shall be allowed in the case of an individual who is not a 
resident of Canada or Mexico. A resident of either of those countries 
shall be allowed all the exemptions granted by section 151 to the extent 
prescribed therein. An estate or trust, whether or not a resident of 
Canada or Mexico, shall determine its deduction for the personal 
exemption in

[[Page 422]]

accordance with section 642(b) and the regulations thereunder.
    (iv) Source of losses. Notwithstanding the provisions of section 
873(b), losses from sales or exchanges of capital assets shall be 
allowed under this subparagraph only if allocable to sources within the 
United States. See paragraph (c)(3)(i) of Sec.  1.871-7.
    (3) Election to be taxed on a net basis. Notwithstanding the other 
provisions of this paragraph, a nonresident alien individual within 
class 1 or 2 shall be allowed the deductions allowed by paragraph (c) of 
this section, if pursuant to a tax convention he is entitled, and does 
elect, to be subject to United States tax on a net basis as though he 
were engaged in trade or business within the United States through a 
permanent establishment situated therein.
    (c) United States business--(1) Deductions in general. For purposes 
of computing the income subject to tax, a nonresident alien individual 
within class 3 shall be allowed deductions to the extent prescribed by 
paragraph (d) of Sec.  1.871-7, but subject to the limitations of this 
section. For this purpose, the deductions for the personal exemptions 
shall be allowed in accordance with subparagraph (3) of this paragraph.
    (2) Special deductions. Notwithstanding the rule of source 
prescribed in paragraph (a) of this section, an individual within class 
3 shall be allowed the following deductions whether or not they are 
connected with income from sources within the United States:
    (i) Losses on transactions for profit. Any loss sustained during the 
taxable year and not compensated for by insurance or otherwise, if 
incurred in any transaction entered into for profit, though not 
connected with a trade or business, shall be allowed to the extent 
allowed by section 165(c)(2), but only if and to the extent that the 
profit, if the transaction had resulted in a profit, would be taxable to 
such individual. Losses allowed under this subdivision shall be deducted 
in full, as provided in Sec. Sec.  1.861-8 and 1.863-1, when the profit 
from the transaction, if it had resulted in a profit, would, under the 
provisions of section 861(a) or 863(a), have been taxable in full as 
income from sources within the United States; but shall be deducted 
under the provisions of Sec.  1.863-3 when the profit from the 
transaction, if it had resulted in profit, would have been taxable only 
in part.
    (ii) Casualty losses. Any loss of property not connected with a 
trade or business, sustained during the taxable year and not compensated 
for by insurance or otherwise, if the loss arises from fire, storm, 
shipwreck, or other casualty, or from theft, shall be allowed to the 
extent allowed by section 165(c)(3), but only if the loss is of property 
within the United States. Losses allowed under this subdivision shall be 
deducted in full, as provided in Sec. Sec.  1.861-8 and 1.863-1, from 
the items of gross income specified under sections 861(a) and 863(a) as 
being derived in full from sources within the United States; but, if 
greater than the sum of those items, the unabsorbed loss shall be 
deducted from the income apportioned under the provisions of Sec.  
1.863-3 to sources within the United States.
    (iii) Charitable contributions. The deduction for charitable 
contributions and gifts, to the extent allowed by section 170, shall be 
allowed under this subparagraph, but only as to contributions or gifts 
made to domestic corporations, or to community chests, funds, or 
foundations, created in the United States.
    (3) Personal exemptions. Only one exemption under section 151 shall 
be allowed in the case of an individual who is not a resident of Canada 
or Mexico. A resident of either of those countries shall be allowed all 
the exemptions granted by section 151 to the extent prescribed therein. 
An estate or trust, whether or not a resident of Canada or Mexico, shall 
determine its deduction for the personal exemption in accordance with 
section 642(b) and the regulations thereunder.



Sec.  1.874-1  Allowance of deductions and credits to nonresident 
alien individuals.

    (a) Return required. A nonresident alien individual shall receive 
the benefit of the deductions and credits otherwise allowable with 
respect to the income tax, only if the nonresident alien individual 
timely files or causes to be filed with the Philadelphia Service Center, 
in the manner prescribed in

[[Page 423]]

subtitle F, a true and accurate return of the income which is 
effectively connected, or treated as effectively connected, with the 
conduct of a trade or business within the United States by the 
nonresident alien individual. No provision of this section (other than 
paragraph (c)(2)) shall be construed, however, to deny the credits 
provided by sections 31, 32, 33, 34 and 852(b)(3)(D)(ii). In addition, 
notwithstanding the requirement that a nonresident alien must file a 
timely return in order to receive the benefit of the deductions and 
credits otherwise allowable with respect to the income tax, the 
nonresident alien individual may, for purposes of determining the amount 
of tax to be withheld under section 1441 from remuneration paid for 
labor or personal services performed within the United States, receive 
the benefit of the deduction for personal exemptions provided in section 
151, to the extent allowable under section 873(b)(3) and paragraph 
(c)(3) of Sec.  1.873-1, or in any applicable tax convention, by filing 
a claim therefore with the withholding agent. The amount of the 
deduction for the personal exemptions and the amount of the tax to be 
withheld under those circumstances shall be determined in accordance 
with paragraph (e)(2) of Sec.  1.1441-3. The deductions and credits 
allowed such a nonresident alien individual electing under a tax 
convention to be subject to tax on a net basis may be obtained by filing 
a return of income in the manner prescribed in the regulations (if any) 
under the tax convention or under any other guidance issued by the 
Commissioner.
    (b) Filing deadline for return--(1) General rule. As provided in 
paragraph (a) of this section, for purposes of computing the nonresident 
alien individual's taxable income for any taxable year, otherwise 
allowable deductions and credits will be allowed only if a true and 
accurate return for that taxable year is filed by the nonresident alien 
individual on a timely basis. For taxable years of a nonresident alien 
individual ending after July 31, 1990, whether a return for the current 
taxable year has been filed on a timely basis is dependent upon whether 
the nonresident alien individual filed a return for the taxable year 
immediately preceding the current taxable year. If a return was filed 
for that immediately preceding taxable year, or if the current taxable 
year is the first taxable year of the nonresident alien individual for 
which a return is required to be filed, the required return for the 
current taxable year must be filed within 16 months of the due date, as 
set forth in section 6072 and the regulations under that section, for 
filing the return for the current taxable year. If no return for the 
taxable year immediately preceding the current taxable year has been 
filed, the required return for the current taxable year (other than the 
first taxable year of the nonresident alien individual for which a 
return is required to be filed) must have been filed no later than the 
earlier of the date which is 16 months after the due date, as set forth 
in section 6072, for filing the return for the current taxable year or 
the date the Internal Revenue Service mails a notice to the nonresident 
alien individual advising the nonresident alien individual that the 
current year tax return has not been filed and that no deductions or 
credits (other than those provided in sections 31, 32, 33, 34 and 
852(b)(3)(D)(ii)) may be claimed by the nonresident alien individual.
    (2) Waiver. The filing deadlines set forth in paragraph (b)(1) of 
this section may be waived if the nonresident alien individual 
establishes to the satisfaction of the Commissioner or his or her 
delegate that the individual, based on the facts and circumstances, 
acted reasonably and in good faith in failing to file a U.S. income tax 
return (including a protective return (as described in paragraph (b)(6) 
of this section)). For this purpose, a nonresident alien individual 
shall not be considered to have acted reasonably and in good faith if 
the individual knew that he or she was required to file the return and 
chose not to do so. In addition, a nonresident alien individual shall 
not be granted a waiver unless the individual cooperates in determining 
his or her U.S. income tax liability for the taxable year for which the 
return was not filed. The Commissioner or his or her delegate shall 
consider the following factors in determining whether the nonresident

[[Page 424]]

alien individual, based on the facts and circumstances, acted reasonably 
and in good faith in failing to file a U.S. income tax return--
    (i) Whether the individual voluntarily identifies himself or herself 
to the Internal Revenue Service as having failed to file a U.S. income 
tax return before the Internal Revenue Service discovers the failure to 
file;
    (ii) Whether the individual did not become aware of his or her 
ability to file a protective return (as described in paragraph (b)(6) of 
this section) by the deadline for filing the protective return;
    (iii) Whether the individual had not previously filed a U.S. income 
tax return;
    (iv) Whether the individual failed to file a U.S. income tax return 
because, after exercising reasonable diligence (taking into account his 
or her relevant experience and level of sophistication), the individual 
was unaware of the necessity for filing the return;
    (v) Whether the individual failed to file a U.S. income tax return 
because of intervening events beyond the individual's control; and
    (vi) Whether other mitigating or exacerbating factors existed.
    (3) Examples. The following examples illustrate the provisions of 
paragraph (b). In all examples, A is a nonresident alien individual and 
uses the calendar year as A's taxable year. The examples are as follows:

    Example 1. Nonresident alien individual discloses own failure to 
file. In Year 1, A became a limited partner with a passive investment in 
a U.S. limited partnership that was engaged in a U.S. trade or business. 
During Year 1 through Year 4, A incurred losses with respect to A's U.S. 
partnership interest. A's foreign tax advisor incorrectly concluded that 
because A was a limited partner and had only losses from A's partnership 
interest, A was not required to file a U.S. income tax return. A was 
aware neither of A's obligation to file a U.S. income tax return for 
those years nor of A's ability to file a protective return for those 
years. A had never filed a U.S. income tax return before. In Year 5, A 
began realizing a profit rather than a loss with respect to the 
partnership interest and, for this reason, engaged a U.S. tax advisor to 
handle A's responsibility to file U.S. income tax returns. In preparing 
A's U.S. income tax return for Year 5, A's U.S. tax advisor discovered 
that returns were not filed for Year 1 through Year 4. Therefore, with 
respect to those years for which applicable filing deadlines in 
paragraph (b)(1) of this section were not met, A would be barred by 
paragraph (a) of this section from claiming any deductions that 
otherwise would have given rise to net operating losses on returns for 
these years, and that would have been available as loss carryforwards in 
subsequent years. At A's direction, A's U.S. tax advisor promptly 
contacted the appropriate examining personnel and cooperated with the 
Internal Revenue Service in determining A's income tax liability, for 
example, by preparing and filing the appropriate income tax returns for 
Year 1 through Year 4 and by making A's books and records available to 
an Internal Revenue Service examiner. A has met the standard described 
in paragraph (b)(2) of this section for waiver of any applicable filing 
deadlines in paragraph (b)(1) of this section.
    Example 2. Nonresident alien individual refuses to cooperate. Same 
facts as in Example 1, except that while A's U.S. tax advisor contacted 
the appropriate examining personnel and filed the appropriate income tax 
returns for Year 1 through Year 4, A refused all requests by the 
Internal Revenue Service to provide supporting information (for example, 
books and records) with respect to those returns. Because A did not 
cooperate in determining A's U.S. tax liability for the taxable years 
for which an income tax return was not timely filed, A is not granted a 
waiver as described in paragraph (b)(2) of this section of any 
applicable filing deadlines in paragraph (b)(1) of this section.
    Example 3. Nonresident alien individual fails to file a protective 
return. Same facts as in Example 1, except that in Year 1 through Year 
4, A also consulted a U.S. tax advisor, who advised A that it was 
uncertain whether U.S. income tax returns were necessary for those years 
and that A could protect A's right subsequently to claim the loss 
carryforwards by filing protective returns under paragraph (b)(6) of 
this section. A did not file U.S. income tax returns or protective 
returns for those years. A did not present evidence that intervening 
events beyond A's control prevented A from filing an income tax return, 
and there were no other mitigating factors. A has not met the standard 
described in paragraph (b)(2) of this section for waiver of any 
applicable filing deadlines in paragraph (b)(1) of this section.
    Example 4. Nonresident alien with effectively connected income. In 
Year 1, A, a computer programmer, opened an office in the United States 
to market and sell a software program that A had developed outside the 
United States. A had minimal business or tax experience internationally, 
and no such experience in the United States. Through A's personal 
efforts, U.S. sales of the software produced income effectively 
connected with a U.S. trade or business. A, however, did not

[[Page 425]]

file U.S. income tax returns for Year 1 or Year 2. A was aware neither 
of A's obligation to file a U.S. income tax return for those years, nor 
of A's ability to file a protective return for those years. A had never 
filed a U.S. income tax return before. In November of Year 3, A engaged 
U.S. counsel in connection with licensing software to an unrelated U.S. 
company. U.S. counsel reviewed A's U.S. activities and advised A that A 
should have filed U.S. income tax returns for Year 1 and Year 2. A 
immediately engaged a U.S. tax advisor who, at A's direction, promptly 
contacted the appropriate examining personnel and cooperated with the 
Internal Revenue Service in determining A's income tax liability, for 
example, by preparing and filing the appropriate income tax returns for 
Year 1 and Year 2 and by making A's books and records available to an 
Internal Revenue Service examiner. A has met the standard described in 
paragraph (b)(2) of this section for waiver of any applicable filing 
deadlines in paragraph (b)(1) of this section.
    Example 5. IRS discovers nonresident alien's failure to file. In 
Year 1, A, a computer programmer, opened an office in the United States 
to market and sell a software program that A had developed outside the 
United States. Through A's personal efforts, U.S. sales of the software 
produced income effectively connected with a U.S. trade or business. A 
had extensive experience conducting similar business activities in other 
countries, including making the appropriate tax filings. A, however, was 
aware neither of A's obligation to file a U.S. income tax return for 
those years, nor of A's ability to file a protective return for those 
years. A had never filed a U.S. income tax return before. Despite A's 
extensive experience conducting similar business activities in other 
countries, A made no effort to seek advice in connection with A's U.S. 
tax obligations. A failed to file either U.S. income tax returns or 
protective returns for Year 1 and Year 2. In November of Year 3, an 
Internal Revenue Service examiner asked A for an explanation of A's 
failure to file U.S. income tax returns. A immediately engaged a U.S. 
tax advisor, and cooperated with the Internal Revenue Service in 
determining A's income tax liability, for example, by preparing and 
filing the appropriate income tax returns for Year 1 and Year 2 and by 
making A's books and records available to the examiner. A did not 
present evidence that intervening events beyond A's control prevented A 
from filing a return, and there were no other mitigating factors. A has 
not met the standard described in paragraph (b)(2) of this section for 
waiver of any applicable filing deadlines in paragraph (b)(1) of this 
section.
    Example 6. Nonresident alien with prior filing history. A began a 
U.S. trade or business in Year 1 as a sole proprietorship. A's tax 
advisor filed the appropriate U.S. income tax returns for Year 1 through 
Year 6, reporting income effectively connected with A's U.S. trade or 
business. In Year 7, A replaced this tax advisor with a tax advisor 
unfamiliar with U.S. tax law. A did not file a U.S. income tax return 
for any year from Year 7 through Year 10, although A had effectively 
connected income for those years. A was aware of A's ability to file a 
protective return for those years. In Year 11, an Internal Revenue 
Service examiner contacted A and asked for an explanation of A's failure 
to file income tax returns after Year 6. A immediately engaged a U.S. 
tax advisor and cooperated with the Internal Revenue Service in 
determining A's income tax liability, for example, by preparing and 
filing the appropriate income tax returns for Year 7 through Year 10 and 
by making A's books and records available to the examiner. A did not 
present evidence that intervening events beyond A's control prevented A 
from filing a return, and there were no other mitigating factors. A has 
not met the standard described in paragraph (b)(2) of this section for 
waiver of any applicable filing deadlines in paragraph (b)(1) of this 
section.

    (4) Effective date. Paragraphs (b)(2) and (3) of this section are 
applicable to open years for which a request for a waiver is filed on or 
after January 29, 2002.
    (5) Income tax treaties. A nonresident alien individual who has a 
permanent establishment or fixed base, as defined in an income tax 
treaty between the United States and the country of residence of the 
nonresident alien individual, in the United States is subject to the 
filing deadlines as set forth in paragraph (b)(1) of this section.
    (6) Protective return. If a nonresident alien individual conducts 
limited activities in the United States in a taxable year which the 
nonresident alien individual determines does not give rise to gross 
income which is effectively connected with the conduct of a trade or 
business within the United States as defined in sections 871(b) and 864 
(b) and (c) and the regulations under those sections, the nonresident 
alien individual may nonetheless file a return for that taxable year on 
a timely basis under paragraph (b)(1) of this section and thereby 
protect the right to receive the benefit of the deductions and credits 
attributable to that gross income if it is later determined, after the 
return was filed, that the original determination was incorrect. On that 
timely filed return, the nonresident

[[Page 426]]

alien individual is not required to report any gross income as 
effectively connected with a United States trade or business or any 
deductions or credits but should attach a statement indicating that the 
return is being filed for the reason set forth in this paragraph (b)(4). 
If the nonresident alien individual determines that part of the 
activities which he or she conducts in the United States in a taxable 
year gives rise to gross income which is effectively connected with the 
conduct of a trade or business and part does not, the nonresident alien 
individual must timely file a return for that taxable year to report the 
gross income determined to be effectively connected, or treated as 
effectively connected, with the conduct of that trade or business within 
the United States and the deductions and credits attributable to the 
gross income. In addition, the nonresident alien individual should 
attach to that return the statement described in this paragraph (b)(4) 
with regard to the other activities. The nonresident alien individual 
may follow the same procedure if the nonresident alien individual 
determines initially that he or she has no United States tax liability 
under the provisions of an applicable income tax treaty. In the event 
the nonresident alien individual relies on the provisions of an income 
tax treaty to reduce or eliminate the income subject to taxation, or to 
reduce the rate of tax to which that income is subject, disclosure may 
be required pursuant to section 6114.
    (c) Allowed deductions and credits--(1) In general. Except for 
losses of property located within the United States, charitable 
contributions and personal exemptions (see section 873(b)), deductions 
are allowed to a nonresident alien individual only to the extent they 
are connected with gross income which is effectively connected, or 
treated as effectively connected, with the conduct of the nonresident 
alien individual's trade or business in the United States. Other than 
credits allowed by sections 31, 32, 33, 34, and 852(b)(3)(D)(ii), the 
nonresident alien individual is entitled to credits only if they are 
attributable to effectively connected income. See paragraph (a) of this 
section for the requirement that a return be timely filed. Except as 
provided by section 906, a nonresident alien individual shall not be 
allowed the credit against the tax for taxes of foreign countries and 
possessions of the United States allowed by section 901.
    (2) Verification. At the request of the Internal Revenue Service, a 
nonresident alien individual claiming deductions from gross income which 
is effectively connected or treated as effectively connected, with the 
conduct of a trade or business in the United States and credits 
attributable to that income must furnish at the place designated 
pursuant to Sec.  301.7605-1(a) information sufficient to establish that 
the nonresident alien individual is entitled to the deductions and 
credits in the amounts claimed. All information must be furnished in a 
form suitable to permit verification of the claimed deductions and 
credits. The Internal Revenue Service may require, as appropriate, that 
an English translation be provided with any information in a foreign 
language. If a nonresident alien individual fails to furnish sufficient 
information, the Internal Revenue Service may in its discretion disallow 
any claimed deductions and credits in full or in part.
    (d) Return by Internal Revenue Service. If a nonresident alien 
individual has various sources of income within the United States, so 
that from any one source, or from all sources combined, the amount of 
income shall call for the assessment of a tax greater than that withheld 
at the source in the case of that individual, and a return of income has 
not been filed in the manner prescribed by subtitle F, including the 
filing deadlines set forth in paragraph (b)(1) of this section, the 
Internal Revenue Service shall:
    (1) Cause a return of income to be made,
    (2) Include on the return the income described in Sec.  1.871-7 or 
Sec.  1.871-8 of that individual from all sources concerning which it 
has information, and
    (3) Assess the tax. If the nonresident alien individual is not 
engaged in, or does not receive income that is treated as being 
effectively connected with, a United States trade or business and Sec.  
1.871-7 is applicable, the tax shall be assessed on the basis of gross 
income

[[Page 427]]

without allowance for deductions or credits (other than the credits 
provided by sections 31, 32, 33, 34 and 852(b)(3)(D)(ii)) and collected 
from one or more sources of income within the United States. If the 
nonresident alien individual is engaged in a United States trade or 
business or is treated as having effectively connected income and Sec.  
1.871-8 applies, the tax on the income of the nonresident alien 
individual that is not effectively connected, or treated as effectively 
connected with the conduct of a United States trade or business shall be 
assessed on the basis of gross income, determined in accordance with the 
rules of Sec.  1.871-7, without allowance for deductions or credits 
(other than the credits provided by sections 31, 32, 33, 34 and 
852(b)(3)(D)(ii)) and collected from one or more of the sources of 
income within the United States. Tax on income that is effectively 
connected, or treated as effectively connected, with the conduct of a 
United States trade or business shall be assessed in accordance with 
either section 1, 55 or 402(e)(1) without allowance for deductions or 
credits (other than the credits provided by sections 31, 32, 33, 34 and 
852(b)(3)(D)(ii)) and collected from one or more of the sources of 
income within the United States.
    (e) Alien resident of Puerto Rico, Guam, American Samoa, or the 
Commonwealth of the Northern Mariana Islands. This section shall not 
apply to a nonresident alien individual who is a bona fide resident of 
Puerto Rico, Guam, American Samoa, or the Commonwealth of the Northern 
Mariana Islands during the entire taxable year. See section 876 and 
Sec.  1.876-1.

[T.D. 8322, 55 FR 50828, Dec. 11, 1990; 56 FR 1361, Jan. 14, 1991, as 
amended by T.D. 8981, 67 FR 4174, Jan. 29, 2002; T.D. 9043, 68 FR 11313, 
Mar. 10, 2003]



Sec.  1.875-1  Partnerships.

    Whether a nonresident alien individual who is a member of a 
partnership is taxable in accordance with subsection (a), (b), or (c) of 
section 871 may depend on the status of the partnership. A nonresident 
alien individual who is a member of a partnership which is not engaged 
in trade or business within the United States is subject to the 
provisions of section 871 (a) or (b), as the case may be, depending on 
whether or not he receives during the taxable year an aggregate of more 
than $15,400 gross income described in section 871(a), if he is not 
otherwise engaged in trade or business within the United States. A 
nonresident alien individual who is a member of a partnership which at 
any time within the taxable year is engaged in trade or business within 
the United States is considered as being engaged in trade or business 
within the United States and is therefore taxable under section 871(c). 
For definition of what the term ``partnership'' includes, see section 
7701(a)(2) and the regulations in part 301 of this chapter (Regulations 
on Procedure and Administration). The test of whether a partnership is 
engaged in trade or business within the United States is the same as in 
the case of a nonresident alien individual. See Sec.  1.871-8.



Sec.  1.875-2  Beneficiaries of estates or trusts.

    (a) [Reserved]
    (b) Exception for certain taxable years. Notwithstanding paragraph 
(a) of this section, for any taxable year beginning before January 1, 
1975, the grantor of a trust, whether revocable or irrevocable, is not 
deemed to be engaged in trade or business within the United States 
merely because the trustee is engaged in trade or business within the 
United States.
    (c) [Reserved]

[T.D. 7332, 39 FR 44233, Dec. 23, 1974]



Sec.  1.876-1  Alien residents of Puerto Rico, Guam, American Samoa, 
or the Northern Mariana Islands.

    (a) Scope. Section 876 and this section apply to any nonresident 
alien individual who is a bona fide resident of Puerto Rico or of a 
section 931 possession during the entire taxable year.
    (b) In general. An individual to whom this section applies is, in 
accordance with the provisions of section 876, subject to tax under 
sections 1 and 55 in generally the same manner as an alien resident of 
the United States. See Sec. Sec.  1.1-1(b) and 1.871-1. The tax 
generally is imposed upon the taxable income of

[[Page 428]]

such individual, determined in accordance with section 63(a) and the 
regulations under that section, from sources both within and without the 
United States, except for amounts excluded from gross income under the 
provisions of section 931 or 933. For determining the form of return to 
be used by such an individual, see section 6012 and the regulations 
under that section.
    (c) Exceptions. Though subject to the tax imposed by section 1, an 
individual to whom this section applies will nevertheless be treated as 
a nonresident alien individual for the purpose of many provisions of the 
Internal Revenue Code (Code) relating to nonresident alien individuals. 
Thus, for example, such an individual is not allowed the standard 
deduction (section 63(c)(6)); is subject to withholding of tax at source 
under chapter 3 of the Code (for example, section 1441(e)); is generally 
excepted from the collection of income tax at source on wages for 
services performed in the possession (section 3401(a)(6)); is not 
allowed to make a joint return (section 6013(a)(1)); and, if described 
in section 6072(c), must pay his first installment of estimated income 
tax on or before the 15th day of the 6th month of the taxable year 
(section 6654(j) and (k)) and must pay his income tax on or before the 
15th day of the 6th month following the close of the taxable year 
(sections 6072(c) and 6151(a)). In addition, under section 152(b)(3), an 
individual is not allowed a deduction for a dependent who is a resident 
of the relevant possession unless the dependent is a citizen or national 
of the United States.
    (d) Credits against tax. (1) Certain credits under the Internal 
Revenue Code are available to any taxpayer subject to the tax imposed by 
section 1, including individuals to whom this section applies. For 
example, except as otherwise provided under section 931 or 933, the 
credits provided by the following sections are allowable to the extent 
provided under such sections against the tax determined in accordance 
with this section--
    (i) Section 23 (relating to the credit for adoption expenses);
    (ii) Section 31 (relating to the credit for tax withheld on wages);
    (iii) Section 33 (relating to the credit for tax withheld at source 
on nonresident aliens); and
    (iv) Section 34 (relating to the credit for certain uses of gasoline 
and special fuels).
    (2) Certain credits under the Internal Revenue Code are not 
available to nonresident aliens or are subject to limitations based on 
such factors as principal place of abode in the United States. For 
example, the credits provided by the following sections are not 
allowable against the tax determined in accordance with this section 
except to the extent otherwise provided under such sections--
    (i) Section 22 (relating to the credit for the elderly and 
disabled);
    (ii) Section 25A (relating to the Hope Scholarship and Lifetime 
Learning Credits); and
    (iii) Section 32 (relating to the earned income credit).
    (e) Definitions. For purposes of this section--
    (1) ``Bona fide resident'' is defined in Sec.  1.937-1; and
    (2) ``Section 931 possession'' is defined in Sec.  1.931-1(c)(1).
    (f) Effective/applicability date. This section applies to taxable 
years ending after April 9, 2008.

[T.D. 9391, 73 FR 19358, Apr. 9, 2008]



Sec.  1.879-1  Treatment of community income.

    (a) Treatment of community income--(1) In general. For taxable years 
beginning after December 31, 1976, community income of a citizen or 
resident of the United States who is married to a nonresident alien 
individual, and the deductions properly allocable to that income, shall 
be divided between the U.S. citizen or resident spouse in accordance 
with the rules in section 879 and paragraph (a)(2) through (a)(6) of 
this section. This section does not apply for any taxable year with 
respect to which an election under section 6013 (g) or (h) is in effect. 
Community income for this purpose includes all gross income, whether 
derived from sources within or without the United States, which is 
treated as community income of the spouses under the community property 
laws of the State, foreign country, or possession of the United States 
in

[[Page 429]]

which the recipient of the income is domiciled. Income from real 
property also may be community income if so treated under the laws of 
the jurisdiction in which the real property is located.
    (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 paragraph (a)(2) does not apply, however, to the 
following items of community income:
    (i) Community income derived from any trade or business carried on 
by the husband or the wife.
    (ii) Community income attributable to a spouse's distributive share 
of the income of a partnership to which paragraph (a)(4) of this section 
applies.
    (iii) Community income 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, 
but not including any income that would be treated as earned income 
under the second sentence of section 911(b).
    (iv) Community income derived from property which is acquired as 
consideration for personal services performed.


These items of community income are divided in accordance with the rules 
in paragraph (a)(3) through (a)(6) of this section.
    (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 that income, shall be treated as the gross income and deductions of 
the husband. However, if the wife exercises substantially all of the 
management and control of the trade or business, all of the gross income 
and deductions shall be treated as the gross income and deductions of 
the wife. This paragraph (a)(3) 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 (see paragraph (a)(4) of this section). 
For purposes of this paragraph (a)(3), 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 State, foreign country or 
possession of the United States. For example, a wife who operates a 
pharmacy 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 State, foreign country, or possession of the United States, vesting in 
the husband the right of management and control of community property. 
The income and deductions attributable to the operation of the pharmacy 
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 the 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 the income 
of a partnership that is community income 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 879(a) (1) or (2) 
and paragraph (a) (2), (3), or (4) of this section, 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 State, foreign country, or possession of

[[Page 430]]

the United States in which, in accordance with paragraph (a)(1) of this 
section, the recipient of the income is domiciled or, in the case of 
income from real property, in which the real property is located.
    (6) Other community income. Any community income for the taxable 
year, other than income described in section 879(a) (1), (2), or (3), 
and paragraph (a) (2), (3), (4), or (5) of this section, shall be 
treated as income of that spouse who has a proprietary vested interest 
in that income under the laws of the state, foreign country, or 
possession of the United States in which, in accordance with paragraph 
(a)(1) of this section, the recipient of the income is domiciled or, in 
the case of income from real property, in which the real property is 
located. Thus, for example, this paragraph (a)(6) applies to community 
income not described in paragraph (a) (2), (3), (4), or (5) of this 
section 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 U.S. citizen, and W, a nonresident alien individual, 
each of whose taxable years is the calendar year, were married 
throughout 1977. H and W were residents of, and domiciled in, foreign 
country Z during the entire taxable year. No election under section 6013 
(g) or (h) is in effect for 1977. During 1977, 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 1977. Under the community property laws of country Z 
all income earned by either spouse is considered to be community income, 
and one-half of this income is considered to belong to the other spouse. 
In addition, the 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 1977, even though Z's laws 
recognize the stock as the separate property of H. Under the rules of 
paragraph (a) (2) and (5) of this section all of the income of $10,500 
derived during 1977 is treated, for U.S. income tax purposes, as the 
income of H.
    Example 2. (a) The facts are the same as in example 1, except that H 
is the sole proprietor of a retail merchandising company, which has a 
$10,000 profit during 1977. 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 these laws both H 
and W are treated as realizing $7,500 of the income. Under the rule of 
paragraph (a) (3) and (4) of this section all $15,000 of the income is 
treated as the income of H for U.S. income tax purposes.
    (b) If W exercises substantially all of the management and control 
over the retail merchandising company, then for U.S. income tax purposes 
the $10,000 profit is treated as the income of W.
    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, the dividends to be community income, and one-
half of the income to be the income of each spouse. Under the rule of 
paragraph (a)(6) of this section, $500 of the dividend income is 
treated, for U.S. income tax purposes, as the income of each spouse.

    (b) Definitions and other special rules--(1) Spouses with different 
taxable years. A special rule applies if the nonresident alien and the 
United States citizen or resident spouse of the alien do not have the 
same taxable years, as defined in section 441(b) and the regulations 
thereunder. The special rule is as follows. With respect to the U.S. 
citizen or resident spouse, section 879 and this section shall apply to 
each taxable year of the U.S. citizen or resident spouse for which no 
election under section 6013 (g) or (h) is in effect. With respect to the 
nonresident alien spouse, section 879 and this section apply to each 
period falling within the consecutive taxable years of the nonresident 
alien spouse which coincides with a taxable year of the U.S. citizen or 
resident spouse to which section 879 and this section apply.
    (2) Determination of marital status. For purposes of this section, 
marital status shall be determined under section 143(a).

[T.D. 7670, 45 FR 6928, Jan. 31, 1980]

[[Page 431]]

                          foreign corporations



Sec.  1.881-0  Table of contents.

    This section lists the major headings for Sec. Sec.  1.881-1 through 
1.881-4.

           Sec.  1.881-1 Manner of Taxing Foreign Corporations

    (a) Classes of foreign corporations.
    (b) Manner of taxing.
    (1) Foreign corporations not engaged in U.S. business.
    (2) Foreign corporations engaged in U.S. business.
    (c) Meaning of terms.
    (d) Rules applicable to foreign insurance companies.
    (1) Corporations qualifying under subchapter L.
    (2) Corporations not qualifying under subchapter L.
    (e) Other provisions applicable to foreign corporations.
    (1) Accumulated earnings tax.
    (2) Personal holding company tax.
    (3) Foreign personal holding companies.
    (4) Controlled foreign corporations.
    (i) Subpart F income and increase of earnings invested in U.S. 
property.
    (ii) Certain accumulations of earnings and profits.
    (5) Changes in tax rate.
    (6) Consolidated returns.
    (7) Adjustment of tax of certain foreign corporations.
    (f) Effective date.

   Sec.  1.881-2 Taxation of Foreign Corporations Not Engaged in U.S. 
                                Business

    (a) Imposition of tax.
    (b) Fixed or determinable annual or periodical income.
    (c) Other income and gains.
    (1) Items subject to tax.
    (2) Determination of amount of gain.
    (d) Credits against tax.
    (e) Effective date.

              Sec.  1.881-3 Conduit Financing Arrangements

    (a) General rules and definitions.
    (1) Purpose and scope.
    (2) Definitions.
    (i) Financing arrangement.
    (A) In general.
    (B) Special rule for related parties.
    (ii) Financing transaction.
    (A) In general.
    (B) Limitation on inclusion of stock or similar interests.
    (iii) Conduit entity.
    (iv) Conduit financing arrangement.
    (v) Related.
    (3) Disregard of participation of conduit entity.
    (i) Authority of district director.
    (ii) Effect of disregarding conduit entity.
    (A) In general.
    (B) Character of payments made by the financed entity.
    (C) Effect of income tax treaties.
    (D) Effect on withholding tax.
    (E) Special rule for a financing entity that is unrelated to both 
intermediate entity and financed entity.
    (iii) Limitation on taxpayers's use of this section.
    (4) Standard for treatment as a conduit entity.
    (i) In general.
    (ii) Multiple intermediate entities.
    (A) In general.
    (B) Special rule for related persons.
    (b) Determination of whether participation of intermediate entity is 
pursuant to a tax avoidance plan.
    (1) In general.
    (2) Factors taken into account in determining the presence or 
absence of a tax avoidance purpose.
    (i) Significant reduction in tax.
    (ii) Ability to make the advance.
    (iii) Time period between financing transactions.
    (iv) Financing transactions in the ordinary course of business.
    (3) Presumption if significant financing activities performed by a 
related intermediate entity.
    (i) General rule.
    (ii) Significant financing activities.
    (A) Active rents or royalties.
    (B) Active risk management.
    (c) Determination of whether an unrelated intermediate entity would 
not have participated in financing arrangement on substantially same 
terms.
    (1) In general.
    (2) Effect of guarantee.
    (i) In general.
    (ii) Definition of guarantee.
    (d) Determination of amount of tax liability.
    (1) Amount of payment subject to recharacterization.
    (i) In general.
    (ii) Determination of principal amount.
    (A) In general.
    (B) Debt instruments and certain stock.
    (C) Partnership and trust interests.
    (D) Leases and licenses.
    (2) Rate of tax.
    (e) Examples.
    (f) Effective date.

 Sec.  1.881-4 Recordkeeping Requirements Concerning Conduit Financing 
                              Arrangements

    (a) Scope.
    (b) Recordkeeping requirements.
    (1) In general.
    (2) Application of sections 6038 and 6038A.
    (c) Records to be maintained.
    (1) In general.

[[Page 432]]

    (2) Additional documents.
    (3) Effect of record maintenance requirement.
    (d) Effective date.

[T.D. 8611, 60 FR 41005, Aug. 11, 1995]



Sec.  1.881-1  Manner of taxing foreign corporations.

    (a) Classes of foreign corporations. For purposes of the income tax, 
foreign corporations are divided into two classes, namely, foreign 
corporations which at no time during the taxable year are engaged in 
trade or business in the United States and foreign corporations which, 
at any time during the taxable year, are engaged in trade or business in 
the United States.
    (b) Manner of taxing--(1) Foreign corporations not engaged in U.S. 
business. A foreign corporation which at no time during the taxable year 
is engaged in trade or business in the United States is taxable, as 
provided in Sec.  1.881-2, on all income received from sources within 
the United States which is fixed or determinable annual or periodical 
income and on other items of income enumerated under section 881(a). 
Such a foreign corporation is also taxable on certain income from 
sources within the United States which, pursuant to Sec.  1.882-2, is 
treated as effectively connected for the taxable year with the conduct 
of a trade or business in the United States.
    (2) Foreign corporations engaged in U.S. business. A foreign 
corporation which at any time during the taxable year is engaged in 
trade or business in the United States is taxable, as provided in Sec.  
1.882-1, on all income from whatever source derived, whether or not 
fixed or determinable annual or periodical income, which is effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States. Such a foreign corporation is also taxable, as 
provided in Sec.  1.882-1, on income received from sources within the 
United States which is not effectively connected for the taxable year 
with the conduct of a trade or business in the United States and 
consists of (i) fixed or determinable annual or periodical income, or 
(ii) other items of income enumerated in section 881(a). A foreign 
corporation which at any time during the taxable year is engaged in 
trade or business in the United States is also taxable on certain income 
from sources within the United States which, pursuant to Sec.  1.882-2, 
is treated as effectively connected for the taxable year with the 
conduct of a trade or business in the United States.
    (c) Meaning of terms. For the meaning of the term ``engaged in trade 
or business within the United States'', as used in section 881 and this 
section, see section 864(b) and the regulations thereunder. For 
determining when income, gain, or loss of a foreign corporation for a 
taxable year is effectively connected for that year with the conduct of 
a trade or business in the United States, see section 864(c), the 
regulations thereunder, and Sec.  1.882-2. The term foreign corporation 
has the meaning assigned to it by section 7701(a)(3) and (5) and the 
regulations thereunder. However, for special rules relating to 
possessions of the United States, see Sec.  1.881-5.
    (d) Rules applicable to foreign insurance companies--(1) 
Corporations qualifying under subchapter L. A foreign corporation 
carrying on an insurance business in the United States at any time 
during the taxable year, which, without taking into account its income 
not effectively connected for the taxable year with the conduct of a 
trade or business in the United States, would qualify for the taxable 
year under part I, II, or III of subchapter L if it were a domestic 
corporation, shall be taxable for such year under that part on its 
entire taxable income (whether derived from sources within or without 
the United States) which is, or which pursuant to section 882 (d) or (e) 
and Sec.  1.882-2 is treated as, effectively connected for the taxable 
year with the conduct of a trade or business (whether or not its 
insurance business) in the United States. Any income derived by that 
foreign corporation from sources within the United States which is not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States is taxable as provided in section 
881(a) and Sec.  1.882-1. See sections 842 and 861 through 864, and the 
regulations thereunder.
    (2) Corporations not qualifying under subchapter L. A foreign 
corporation which carries on an insurance business

[[Page 433]]

in the United States at any time during the taxable year, and which, 
without taking into account its income not effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States, would not qualify for the taxable year under part I, II, or III 
of subchapter L if it were a domestic corporation, and a foreign 
insurance company which does not carry on an insurance business in the 
United States at any time during the taxable year, shall be taxable--
    (i) Under section 881(a) and Sec.  1.881-2 or Sec.  1.882-1 on its 
income from sources within the United States which is not effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States,
    (ii) Under section 882(a)(1) and Sec.  1.882-1 on its income 
(whether derived from sources within or without the United States) which 
is effectively connected for the taxable year with the conduct of a 
trade or business in the United States, and
    (iii) Under section 882(a)(1) and Sec.  1.882-1 on its income from 
sources within the United States which pursuant to section 882 (d) or 
(e) and Sec.  1.882-2, is treated as effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States.
    (e) Other provisions applicable to foreign corporations--(1) 
Accumulated earnings tax. For the imposition of the accumulated earnings 
tax upon the accumulated taxable income of a foreign corporation formed 
or availed of for tax avoidance purposes, whether or not such 
corporation is engaged in trade or business in the United States, see 
section 532 and the regulations thereunder.
    (2) Personal holding company tax. For the imposition of the personal 
holding company tax upon the undistributed personal holding company 
income of a foreign corporation which is a personal holding company, 
whether or not such corporation is engaged in trade or business in the 
United States, see sections 541 through 547, and the regulations 
thereunder. Except in the case of a foreign corporation having personal 
service contract income to which section 543(a)(7) applies, a foreign 
corporation is not a personal holding company if all of its stock 
outstanding during the last half of the taxable year is owned by 
nonresident alien individuals, whether directly or indirectly through 
foreign estates, foreign trusts, foreign partnerships, or other foreign 
corporations. See section 542(c)(7).
    (3) Foreign personal holding companies. For the mandatory inclusion 
in the gross income of the United States shareholders of the 
undistributed foreign personal holding company income of a foreign 
personal holding company, see section 551 and the regulations 
thereunder.
    (4) Controlled foreign corporations--(i) 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, of the previously excluded subpart F income withdrawn from 
investment in less developed countries, of the previously excluded 
subpart F income withdrawn from investment in foreign base company 
shipping operations, and of the increase in earnings invested in U.S. 
property, of a controlled foreign corporation, see sections 951 through 
964, and the regulations thereunder.
    (ii) Certain accumulations of earnings and profits. For the 
inclusion in the gross income of U.S. persons as a dividend of the gain 
recognized on certain sales or exchanges of stock in a foreign 
corporation, to the extent of certain earnings and profits attributable 
to the stock which were accumulated while the corporation was a 
controlled foreign corporation, see section 1248 and the regulations 
thereunder.
    (5) Changes in tax rate. For provisions respecting the effect of any 
change in rate of tax during the taxable year on the income of a foreign 
corporation, see section 21 and the regulations thereunder.
    (6) Consolidated returns. Except in the case of certain corporations 
organized under the laws of Canada or Mexico and maintained solely for 
the purpose of complying with the laws of that country as to title and 
operation of property, a foreign corporation is not an includible 
corporation for purposes of the privilege of making a consolidated 
return by an affiliated group of

[[Page 434]]

corporations. See section 1504 and the regulations thereunder.
    (7) Adjustment of tax of certain foreign corporations. For the 
application of pre-1967 income tax provisions to corporations of a 
foreign country which imposes a more burdensome income tax than the 
United States, and for the adjustment of the income tax of a corporation 
of a foreign country which imposes a discriminatory income tax on the 
income of citizens of the United States or domestic corporations, see 
section 896.
    (f) Effective/applicability date. This section applies for taxable 
years beginning after December 31, 1966. For corresponding rules 
applicable to taxable years beginning before January 1, 1967, see 26 CFR 
1.881-1 (Revised as of January 1, 1971).

(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. 7293, 38 FR 32795, Nov. 28, 1973, as amended by T.D. 7385, 40 FR 
50260, Oct. 29, 1975; T.D. 7893, 48 FR 22507, May 19, 1983; T.D. 9194, 
70 FR 18929, Apr. 11, 2005; T.D. 9391, 73 FR 19359, Apr. 9, 2008]



Sec.  1.881-2  Taxation of foreign corporations not engaged in U.S. business.

    (a) Imposition of tax. (1) This section applies for purposes of 
determining the tax of a foreign corporation which at no time during the 
taxable year is engaged in trade or business in the United States. 
However, see also Sec.  1.882-2 where such corporation has an election 
in effect for the taxable year in respect to real property income or 
receives interest on obligations of the United States. Except as 
otherwise provided in Sec.  1.871-12, a foreign corporation to which 
this section applies is not subject to the tax imposed by section 11 or 
section 1201(a) but, pursuant to the provisions of section 881(a), is 
liable to a flat tax of 30 percent upon the aggregate of the amounts 
determined under paragraphs (b) and (c) of this section which are 
received during the taxable year from sources within the United States. 
Except as specifically provided in such paragraphs, such amounts do not 
include gains from the sale or exchange of property. To determine the 
source of such amounts, see sections 861 through 863, and the 
regulations thereunder.
    (2) The tax of 30 percent is imposed by section 881(a) upon an 
amount only to the extent the amount constitutes gross income.
    (3) Deductions shall not be allowed in determining the amount 
subject to tax under this section.
    (4) Except as provided in Sec.  1.882-2, a foreign corporation which 
at no time during the taxable year is engaged in trade or business in 
the United States has no income, gain, or loss for the taxable year 
which is effectively connected for the taxable year with the conduct of 
a trade or business in the United States. See section 864(c)(1)(B) and 
Sec.  1.864-3.
    (5) Gains and losses which, by reason of section 882(d) and Sec.  
1.882-2, are treated as gains or losses which are effectively connected 
for the taxable year with the conduct of a trade or business in the 
United States by such a foreign corporation shall not be taken into 
account in determining the tax under this section. See, for example, 
paragraph (c)(2) of Sec.  1.871-10.
    (6) Interest received by a foreign corporation pursuant to certain 
portfolio debt instruments is not subject to the flat tax of 30 percent 
described in paragraph (a)(1) of this section. For rules applicable to a 
foreign corporation's receipt of interest on certain portfolio debt 
instruments, see sections 871(h), 881(c), and Sec.  1.871-14.
    (b) Fixed or determinable annual or periodical income--(1) General 
rule. The tax of 30 percent imposed by section 881(a) applies to the 
gross amount received from sources within the United States as fixed or 
determinable annual or periodical gains, profits, or income. Specific 
items of fixed or determinable annual or periodical income are 
enumerated in section 881(a)(1) as interest, dividends, rents, salaries, 
wages, premiums, annuities, compensations, remunerations, and 
emoluments, but other items of fixed or determinable annual or 
periodical gains, profits, or income are also subject to the tax as, for 
instance, royalties, including royalties for the use of patents, 
copyrights, secret processes and formulas, and

[[Page 435]]

other like property. As to the determination of fixed or determinable 
annual or periodical income, see paragraph (a) of Sec.  1.1441-2. For 
special rules treating gain on the disposition of section 306 stock as 
fixed or determinable annual or periodical income for purposes of 
section 881(a), see section 306(f) and paragraph (h) of Sec.  1.306-3.
    (2) Substitute payments. For purposes of this section, a substitute 
interest payment (as defined in Sec.  1.861-2(a)(7)) received by a 
foreign person pursuant to a securities lending transaction or a sale-
repurchase transaction (as defined in Sec.  1.861-2(a)(7)) shall have 
the same character as interest income received pursuant to the terms of 
the transferred security. Similarly, for purposes of this section, a 
substitute dividend payment (as defined in Sec.  1.861-3(a)(6)) received 
by a foreign person pursuant to a securities lending transaction or a 
sale-repurchase transaction (as defined in Sec.  1.861-2(a)(7)) shall 
have the same character as a distribution received with respect to the 
transferred security. Where, pursuant to a securities lending 
transaction or a sale-repurchase transaction, a foreign person transfers 
to another person a security in the interest on which would qualify as 
portfolio interest under section 881(c) in the hands of the lender, 
substitute interest payments made with respect to the transferred 
security will be treated as portfolio interest, provided that in the 
case of interest on an obligation in registered form (as defined in 
Sec.  1.871-14(c)(1)(i)), the transferor complies with the documentation 
requirement described in Sec.  1.871-14(c)(1)(ii)(C) with respect to the 
payment of substitute interest and none of the exceptions to the 
portfolio interest exemption in sections 881(c) (3) and (4) apply. See 
also Sec. Sec.  1.871-7(b)(2) and 1.894-1(c).
    (3) Dividend Equivalents. For rules applicable to a foreign 
corporation's receipt of a dividend equivalent, see section 871(m) and 
the regulations thereunder.
    (c) Other income and gains--(1) Items subject to tax. The tax of 30 
percent imposed by section 881(a) also applies to the following gains 
received during the taxable year from sources within the United States:
    (i) Gains described in section 631 (b) or (c), relating to the 
treatment of gain on the disposal of timber, coal, or iron ore with a 
retained economic interest;
    (ii) [Reserved]
    (iii) Gains from the sale or exchange after October 4, 1966, of 
patents, copyrights, secret processes and formulas, goodwill, 
trademarks, trade brands, franchises, or other like property, or of any 
interest in any such property, to the extent the gains are from payments 
(whether in a lump sum or in installments) which are contingent on the 
productivity, use, or disposition of the property or interest sold or 
exchanged, or from payments which are treated under section 871(e) and 
Sec.  1.871-11 as being so contingent.
    (2) Determination of amount of gain. The tax of 30 percent imposed 
upon the gains described in subparagraph (1) of this paragraph applies 
to the full amount of the gains and is determined (i) without regard to 
the alternative tax imposed by section 1201(a) upon the excess of net 
long-term capital gain over the net short-term capital loss; (ii) 
without regard to section 1231, relating to property used in the trade 
or business and involuntary conversions; and (iii) except in the case of 
gains described in subparagraph (1)(ii) of this paragraph, whether or 
not the gains are considered to be gains from the sale or exchange of 
property which is a capital asset.
    (d) Credits against tax. The credits allowed by section 32 (relating 
to tax withheld at source on foreign corporations), by section 39 
(relating to certain uses of gasoline and lubricating oil), and by 
section 6402 (relating to overpayments of tax) shall be allowed against 
the tax of a foreign corporation determined in accordance with this 
section.
    (e) Effective/applicability date. Except as otherwise provided in 
this paragraph, this section applies for taxable years beginning after 
December 31, 1966. Paragraph (b)(2) of this section is applicable to 
payments made after November 13, 1997. For corresponding rules 
applicable to taxable years beginning before January 1, 1967, see 26 CFR 
1.881-2 (Revised as of January 1, 1971). Paragraph (b)(3) of this 
section applies

[[Page 436]]

to payments made on or after January 23, 2012.

[T.D. 7293, 38 FR 32796, Nov. 28, 1973, as amended by T.D. 8735, 62 FR 
53502, Oct. 14, 1997; T.D. 9323, 72 FR 18388, Apr. 12, 2007; T.D. 9572, 
77 FR 3109, Jan. 23, 2012; T.D. 9648, 78 FR 73080, Dec. 5, 2013]



Sec.  1.881-3  Conduit financing arrangements.

    (a) General rules and definitions--(1) Purpose and scope. Pursuant 
to the authority of section 7701(l), this section provides rules that 
permit the director of field operations to disregard, for purposes of 
section 881, the participation of one or more intermediate entities in a 
financing arrangement where such entities are acting as conduit 
entities. For purposes of this section, any reference to tax imposed 
under section 881 includes, except as otherwise provided and as the 
context may require, a reference to tax imposed under sections 871 or 
884(f)(1)(A) or required to be withheld under section 1441 or 1442. See 
Sec.  1.881-4 for recordkeeping requirements concerning financing 
arrangements. See Sec. Sec.  1.1441-3(g) and 1.1441-7(f) for withholding 
rules applicable to conduit financing arrangements.
    (2) Definitions. The following definitions apply for purposes of 
this section and Sec. Sec.  1.881-4, 1.1441-3(g) and 1.1441-7(f).
    (i) Financing arrangement--(A) In general. Financing arrangement 
means a series of transactions by which one person (the financing 
entity) advances money or other property, or grants rights to use 
property, and another person (the financed entity) receives money or 
other property, or rights to use property, if the advance and receipt 
are effected through one or more other persons (intermediate entities) 
and, except in cases to which paragraph (a)(2)(i)(B) of this section 
applies, there are financing transactions linking the financing entity, 
each of the intermediate entities, and the financed entity. A transfer 
of money or other property in satisfaction of a repayment obligation is 
not an advance of money or other property. A financing arrangement 
exists regardless of the order in which the transactions are entered 
into, but only for the period during which all of the financing 
transactions coexist. See Examples 1, 2, 3 and 4 of paragraph (e) of 
this section for illustrations of the term financing arrangement.
    (B) Special rule for related parties. If two (or more) financing 
transactions involving two (or more) related persons would form part of 
a financing arrangement but for the absence of a financing transaction 
between the related persons, the director of field operations may treat 
the related persons as a single intermediate entity if he determines 
that one of the principal purposes for the structure of the financing 
transactions is to prevent the characterization of such arrangement as a 
financing arrangement. This determination shall be based upon all of the 
facts and circumstances, including, without limitation, the factors set 
forth in paragraph (b)(2) of this section. See Examples 5 and 6 of 
paragraph (e) of this section for illustrations of this paragraph 
(a)(2)(i)(B).
    (C) Treatment of disregarded entities. For purposes of this section, 
the term person includes a business entity that is disregarded as an 
entity separate from its single member owner under Sec.  301.7701-1 
through Sec.  301.7701-3.
    (ii) Financing transaction--(A) In general. Financing transaction 
means--
    (1) Debt;
    (2) Stock in a corporation (or a similar interest in a partnership, 
trust, or other person) that meets the requirements of paragraph 
(a)(2)(ii)(B) of this section;
    (3) Any lease or license; or
    (4) Any other transaction (including an interest in a trust 
described in sections 671 through 679) pursuant to which a person makes 
an advance of money or other property or grants rights to use property 
to a transferee who is obligated to repay or return a substantial 
portion of the money or other property advanced, or the equivalent in 
value. This paragraph (a)(2)(ii)(A)(4) shall not apply to the posting of 
collateral unless the collateral consists of cash or the person holding 
the collateral is permitted to reduce the collateral to cash (through a 
transfer, grant of a security interest or similar transaction) prior to 
default on the financing transaction secured by the collateral.

[[Page 437]]

    (B) Limitation on inclusion of stock or similar interests--(1) In 
general. Stock in a corporation (or a similar interest in a partnership, 
trust, or other person) will constitute a financing transaction only if 
one of the following conditions is satisfied--
    (i) The issuer is required to redeem the stock or similar interest 
at a specified time or the holder has the right to require the issuer to 
redeem the stock or similar interest or to make any other payment with 
respect to the stock or similar interest;
    (ii) The issuer has the right to redeem the stock or similar 
interest, but only if, based on all of the facts and circumstances as of 
the issue date, redemption pursuant to that right is more likely than 
not to occur; or
    (iii) The owner of the stock or similar interest has the right to 
require a person related to the issuer (or any other person who is 
acting pursuant to a plan or arrangement with the issuer) to acquire the 
stock or similar interest or make a payment with respect to the stock or 
similar interest.
    (2) Rules of special application--(i) Existence of a right. For 
purposes of this paragraph (a)(2)(ii)(B), a person will be considered to 
have a right to cause a redemption or payment if the person has the 
right (other than rights arising, in the ordinary course, between the 
date that a payment is declared and the date that a payment is made) to 
enforce the payment through a legal proceeding or to cause the issuer to 
be liquidated if it fails to redeem the interest or to make a payment. A 
person will not be considered to have a right to force a redemption or a 
payment if the right is derived solely from ownership of a controlling 
interest in the issuer in cases where the control does not arise from a 
default or similar contingency under the instrument. The person is 
considered to have such a right if the person has the right as of the 
issue date or, as of the issue date, it is more likely than not that the 
person will receive such a right, whether through the occurrence of a 
contingency or otherwise.
    (ii) Restrictions on payment. The fact that the issuer does not have 
the legally available funds to redeem the stock or similar interest, or 
that the payments are to be made in a blocked currency, will not affect 
the determinations made pursuant to this paragraph (a)(2)(ii)(B).
    (iii) Conduit entity means an intermediate entity whose 
participation in the financing arrangement may be disregarded in whole 
or in part pursuant to this section, whether or not the director of 
field operations has made a determination that the intermediate entity 
should be disregarded under paragraph (a)(3)(i) of this section.
    (iv) Conduit financing arrangement means a financing arrangement 
that is effected through one or more conduit entities.
    (v) Related means related within the meaning of sections 267(b) or 
707(b)(1), or controlled within the meaning of section 482, and the 
regulations under those sections. For purposes of determining whether a 
person is related to another person, the constructive ownership rules of 
section 318 shall apply, and the attribution rules of section 267(c) 
also shall apply to the extent they attribute ownership to persons to 
whom section 318 does not attribute ownership.
    (3) Disregard of participation of conduit entity--(i) Authority of 
director of field operations. The director of field operations may 
determine that the participation of a conduit entity in a conduit 
financing arrangement should be disregarded for purposes of section 881. 
For this purpose, an intermediate entity will constitute a conduit 
entity if it meets the standards of paragraph (a)(4) of this section. 
The director of field operations has discretion to determine the manner 
in which the standards of paragraph (a)(4) of this section apply, 
including the financing transactions and parties composing the financing 
arrangement.
    (ii) Effect of disregarding conduit entity--(A) In general. If the 
director of field operations determines that the participation of a 
conduit entity in a financing arrangement should be disregarded, the 
financing arrangement is recharacterized as a transaction directly 
between the remaining parties to the financing arrangement (in most 
cases, the financed entity and the financing entity) for purposes of 
section 881. To the extent that a disregarded

[[Page 438]]

conduit entity actually receives or makes payments pursuant to a conduit 
financing arrangement, it is treated as an agent of the financing 
entity. Except as otherwise provided, the recharacterization of the 
conduit financing arrangement also applies for purposes of sections 871, 
884(f)(1)(A), 1441, and 1442 and other procedural provisions relating to 
those sections. This recharacterization will not otherwise affect a 
taxpayer's Federal income tax liability under any substantive provisions 
of the Internal Revenue Code. Thus, for example, the recharacterization 
generally applies for purposes of section 1461, in order to impose 
liability on a withholding agent who fails to withhold as required under 
Sec.  1.1441-3(g), but not for purposes of Sec.  1.882-5.
    (B) Character of payments made by the financed entity. If the 
participation of a conduit financing arrangement is disregarded under 
this paragraph (a)(3), payments made by the financed entity generally 
shall be characterized by reference to the character (e.g., interest or 
rent) of the payments made to the financing entity. However, if the 
financing transaction to which the financing entity is a party is a 
transaction described in paragraph (a)(2)(ii)(A)(2) or (4) of this 
section that gives rise to payments that would not be deductible if paid 
by the financed entity, the character of the payments made by the 
financed entity will not be affected by the disregard of the 
participation of a conduit entity. The characterization provided by this 
paragraph (a)(3)(ii)(B) does not, however, extend to qualification of a 
payment for any exemption from withholding tax under the Internal 
Revenue Code or a provision of any applicable tax treaty if such 
qualification depends on the terms of, or other similar facts or 
circumstances relating to, the financing transaction to which the 
financing entity is a party that do not apply to the financing 
transaction to which the financed entity is a party. Thus, for example, 
payments made by a financed entity that is not a bank cannot qualify for 
the exemption provided by section 881(i) of the Code even if the loan 
between the financing entity and the conduit entity is a bank deposit.
    (C) Effect of income tax treaties. Where the participation of a 
conduit entity in a conduit financing arrangement is disregarded 
pursuant to this section, it is disregarded for all purposes of section 
881, including for purposes of applying any relevant income tax 
treaties. Accordingly, the conduit entity may not claim the benefits of 
a tax treaty between its country of residence and the United States to 
reduce the amount of tax due under section 881 with respect to payments 
made pursuant to the conduit financing arrangement. The financing entity 
may, however, claim the benefits of any income tax treaty under which it 
is entitled to benefits in order to reduce the rate of tax on payments 
made pursuant to the conduit financing arrangement that are 
recharacterized in accordance with paragraph (a)(3)(ii)(B) of this 
section.
    (D) Effect on withholding tax. For the effect of recharacterization 
on withholding obligations, see Sec. Sec.  1.1441-3(g) and 1.1441-7(f).
    (E) Special rule for a financing entity that is unrelated to both 
intermediate entity and financed entity--(1) Liability of financing 
entity. Notwithstanding the fact that a financing arrangement is a 
conduit financing arrangement, a financing entity that is unrelated to 
the financed entity and the conduit entity (or entities) shall not 
itself be liable for tax under section 881 unless the financing entity 
knows or has reason to know that the financing arrangement is a conduit 
financing arrangement. But see Sec.  1.1441-3(g) for the withholding 
agent's withholding obligations.
    (2) Financing entity's knowledge--(i) In general. A financing entity 
knows or has reason to know that the financing arrangement is a conduit 
financing arrangement only if the financing entity knows or has reason 
to know of facts sufficient to establish that the financing arrangement 
is a conduit financing arrangement, including facts sufficient to 
establish that the participation of the intermediate entity in the 
financing arrangement is pursuant to a tax avoidance plan. A person that 
knows only of the financing transactions that comprise the financing 
arrangement will not be considered to know or have

[[Page 439]]

reason to know of facts sufficient to establish that the financing 
arrangement is a conduit financing arrangement.
    (ii) Presumption regarding financing entity's knowledge. It shall be 
presumed that the financing entity does not know or have reason to know 
that the financing arrangement is a conduit financing arrangement if the 
financing entity is unrelated to all other parties to the financing 
arrangement and the financing entity establishes that the intermediate 
entity who is a party to the financing transaction with the financing 
entity is actively engaged in a substantial trade or business. An 
intermediate entity will not be considered to be engaged in a trade or 
business if its business is making or managing investments, unless the 
intermediate entity is actively engaged in a banking, insurance, 
financing or similar trade or business and such business consists 
predominantly of transactions with customers who are not related 
persons. An intermediate entity's trade or business is substantial if it 
is reasonable for the financing entity to expect that the intermediate 
entity will be able to make payments under the financing transaction out 
of the cash flow of that trade or business. This presumption may be 
rebutted if the director of field operations establishes that the 
financing entity knew or had reason to know that the financing 
arrangement is a conduit financing arrangement. See Example 7 of 
paragraph (e) of this section for an illustration of the rules of this 
paragraph (a)(3)(ii)(E).
    (iii) Limitation on taxpayer's use of this section. A taxpayer may 
not apply this section to reduce the amount of its Federal income tax 
liability by disregarding the form of its financing transactions for 
Federal income tax purposes or by compelling the director of field 
operations to do so. See, however, paragraph (b)(2)(i) of this section 
for rules regarding the taxpayer's ability to show that the 
participation of one or more intermediate entities results in no 
significant reduction in tax.
    (4) Standard for treatment as a conduit entity--(i) In general. An 
intermediate entity is a conduit entity with respect to a financing 
arrangement if--
    (A) The participation of the intermediate entity (or entities) in 
the financing arrangement reduces the tax imposed by section 881 
(determined by comparing the aggregate tax imposed under section 881 on 
payments made on financing transactions making up the financing 
arrangement with the tax that would have been imposed under paragraph 
(d) of this section);
    (B) The participation of the intermediate entity in the financing 
arrangement is pursuant to a tax avoidance plan; and
    (C) Either--
    (1) The intermediate entity is related to the financing entity or 
the financed entity; or
    (2) The intermediate entity would not have participated in the 
financing arrangement on substantially the same terms but for the fact 
that the financing entity engaged in the financing transaction with the 
intermediate entity.
    (ii) Multiple intermediate entities--(A) In general. If a financing 
arrangement involves multiple intermediate entities, the director of 
field operations will determine whether each of the intermediate 
entities is a conduit entity. The director of field operations will make 
the determination by applying the special rules for multiple 
intermediate entities provided in this section or, if no special rules 
are provided, applying principles consistent with those of paragraph 
(a)(4)(i) of this section to each of the intermediate entities in the 
financing arrangement.
    (B) Special rule for related persons. The director of field 
operations may treat related intermediate entities as a single 
intermediate entity if he determines that one of the principal purposes 
for the involvement of multiple intermediate entities in the financing 
arrangement is to prevent the characterization of an intermediate entity 
as a conduit entity, to reduce the portion of a payment that is subject 
to withholding tax or otherwise to circumvent the provisions of this 
section. This determination shall be based upon all of the facts and 
circumstances, including, but not limited to, the factors set forth in 
paragraph (b)(2) of this section. If a director of field operations 
determines that related persons are to be treated as a single 
intermediate entity, financing transactions between such related

[[Page 440]]

parties that are part of the conduit financing arrangement shall be 
disregarded for purposes of applying this section. See Examples 8 and 9 
of paragraph (e) of this section for illustrations of the rules of this 
paragraph (a)(4)(ii).
    (b) Determination of whether participation of intermediate entity is 
pursuant to a tax avoidance plan--(1) In general. A tax avoidance plan 
is a plan one of the principal purposes of which is the avoidance of tax 
imposed by section 881. Avoidance of the tax imposed by section 881 may 
be one of the principal purposes for such a plan even though it is 
outweighed by other purposes (taken together or separately). In this 
regard, the only relevant purposes are those pertaining to the 
participation of the intermediate entity in the financing arrangement 
and not those pertaining to the existence of a financing arrangement as 
a whole. The plan may be formal or informal, written or oral, and may 
involve any one or more of the parties to the financing arrangement. The 
plan must be in existence no later than the last date that any of the 
financing transactions comprising the financing arrangement is entered 
into. The director of field operations may infer the existence of a tax 
avoidance plan from the facts and circumstances. In determining whether 
there is a tax avoidance plan, the director of field operations will 
weigh all relevant evidence regarding the purposes for the intermediate 
entity's participation in the financing arrangement. See Examples 12 and 
13 of paragraph (e) of this section for illustrations of the rule of 
this paragraph (b)(1).
    (2) Factors taken into account in determining the presence or 
absence of a tax avoidance purpose. The factors described in paragraphs 
(b)(2)(i) through (iv) of this section are among the facts and 
circumstances taken into account in determining whether the 
participation of an intermediate entity in a financing arrangement has 
as one of its principal purposes the avoidance of tax imposed by section 
881.
    (i) Significant reduction in tax. The director of field operations 
will consider whether the participation of the intermediate entity (or 
entities) in the financing arrangement significantly reduces the tax 
that otherwise would have been imposed under section 881. The fact that 
an intermediate entity is a resident of a country that has an income tax 
treaty with the United States that significantly reduces the tax that 
otherwise would have been imposed under section 881 is not sufficient, 
by itself, to establish the existence of a tax avoidance plan. The 
determination of whether the participation of an intermediate entity 
significantly reduces the tax generally is made by comparing the 
aggregate tax imposed under section 881 on payments made on financing 
transactions making up the financing arrangement with the tax that would 
be imposed under paragraph (d) of this section. However, the taxpayer is 
not barred from presenting evidence that the financing entity, as 
determined by the director of field operations, was itself an 
intermediate entity and another entity should be treated as the 
financing entity for purposes of applying this test. A reduction in the 
absolute amount of tax may be significant even if the reduction in rate 
is not. A reduction in the amount of tax may be significant if the 
reduction is large in absolute terms or in relative terms. See Examples 
14, 15 and 16 of paragraph (e) of this section for illustrations of this 
factor.
    (ii) Ability to make the advance. The director of field operations 
will consider whether the intermediate entity had sufficient available 
money or other property of its own to have made the advance to the 
financed entity without the advance of money or other property to it by 
the financing entity (or in the case of multiple intermediate entities, 
whether each of the intermediate entities had sufficient available money 
or other property of its own to have made the advance to either the 
financed entity or another intermediate entity without the advance of 
money or other property to it by either the financing entity or another 
intermediate entity).
    (iii) Time period between financing transactions. The director of 
field operations will consider the length of the period of time that 
separates the advances of money or other property, or the grants of 
rights to use property, by

[[Page 441]]

the financing entity to the intermediate entity (in the case of multiple 
intermediate entities, from one intermediate entity to another), and 
ultimately by the intermediate entity to the financed entity. A short 
period of time is evidence of the existence of a tax avoidance plan 
while a long period of time is evidence that there is not a tax 
avoidance plan. See Example 17 of paragraph (e) of this section for an 
illustration of this factor.
    (iv) Financing transactions in the ordinary course of business. If 
the parties to the financing transaction are related, the director of 
field operations will consider whether the financing transaction occurs 
in the ordinary course of the active conduct of complementary or 
integrated trades or businesses engaged in by these entities. The fact 
that a financing transaction is described in this paragraph (b)(2)(iv) 
is evidence that the participation of the parties to that transaction in 
the financing arrangement is not pursuant to a tax avoidance plan. A 
loan will not be considered to occur in the ordinary course of the 
active conduct of complementary or integrated trades or businesses 
unless the loan is a trade receivable or the parties to the transaction 
are actively engaged in a banking, insurance, financing or similar trade 
or business and such business consists predominantly of transactions 
with customers who are not related persons. See Example 18 of paragraph 
(e) of this section for an illustration of this factor.
    (3) Presumption if significant financing activities performed by a 
related intermediate entity--(i) General rule. It shall be presumed that 
the participation of an intermediate entity (or entities) in a financing 
arrangement is not pursuant to a tax avoidance plan if the intermediate 
entity is related to either or both the financing entity or the financed 
entity and the intermediate entity performs significant financing 
activities with respect to the financing transactions forming part of 
the financing arrangement to which it is a party. This presumption may 
be rebutted if the director of field operations establishes that the 
participation of the intermediate entity in the financing arrangement is 
pursuant to a tax avoidance plan. See Examples 22, 23 and 24 of 
paragraph (e) of this section for illustrations of this presumption.
    (ii) Significant financing activities. For purposes of this 
paragraph (b)(3), an intermediate entity performs significant financing 
activities with respect to such financing transactions only if the 
financing transactions satisfy the requirements of either paragraph 
(b)(3)(ii)(A) or (B) of this section.
    (A) Active rents or royalties. An intermediate entity performs 
significant financing activities with respect to leases or licenses if 
rents or royalties earned with respect to such leases or licenses are 
derived in the active conduct of a trade or business within the meaning 
of section 954(c)(2)(A), to be applied by substituting the term 
intermediate entity for the term controlled foreign corporation.
    (B) Active risk management--(1) In general. An intermediate entity 
is considered to perform significant financing activities with respect 
to financing transactions only if officers and employees of the 
intermediate entity participate actively and materially in arranging the 
intermediate entity's participation in such financing transactions 
(other than financing transactions described in paragraph 
(b)(3)(ii)(B)(3) of this section) and perform the business activity and 
risk management activities described in paragraph (b)(3)(ii)(B)(2) of 
this section with respect to such financing transactions, and the 
participation of the intermediate entity in the financing transactions 
produces (or reasonably can be expected to produce) efficiency savings 
by reducing transaction costs and overhead and other fixed costs.
    (2) Business activity and risk management requirements. An 
intermediate entity will be considered to perform significant financing 
activities only if, within the country in which the intermediate entity 
is organized (or, if different, within the country with respect to which 
the intermediate entity is claiming the benefits of a tax treaty), its 
officers and employees--
    (i) Exercise management over, and actively conduct, the day-to-day 
operations of the intermediate entity. Such

[[Page 442]]

operations must consist of a substantial trade or business or the 
supervision, administration and financing for a substantial group of 
related persons; and
    (ii) Actively manage, on an ongoing basis, material market risks 
arising from such financing transactions as an integral part of the 
management of the intermediate entity's financial and capital 
requirements (including management of risks of currency and interest 
rate fluctuations) and management of the intermediate entity's short-
term investments of working capital by entering into transactions with 
unrelated persons.
    (3) Special rule for trade receivables and payables entered into in 
the ordinary course of business. If the activities of the intermediate 
entity consist in whole or in part of cash management for a controlled 
group of which the intermediate entity is a member, then employees of 
the intermediate entity need not have participated in arranging any such 
financing transactions that arise in the ordinary course of a 
substantial trade or business of either the financed entity or the 
financing entity. Officers or employees of the financing entity or 
financed entity, however, must have participated actively and materially 
in arranging the transaction that gave rise to the trade receivable or 
trade payable. Cash management includes the operation of a sweep account 
whereby the intermediate entity nets intercompany trade payables and 
receivables arising from transactions among the other members of the 
controlled group and between members of the controlled group and 
unrelated persons.
    (4) Activities of officers and employees of related persons. Except 
as provided in paragraph (b)(3)(ii)(B)(3) of this section, in applying 
this paragraph (b)(3)(ii)(B), the activities of an officer or employee 
of an intermediate entity will not constitute significant financing 
activities if any officer or employee of a related person participated 
materially in any of the activities described in this paragraph, other 
than to approve any guarantee of a financing transaction or to exercise 
general supervision and control over the policies of the intermediate 
entity.
    (c) Determination of whether an unrelated intermediate entity would 
not have participated in financing arrangement on substantially the same 
terms--(1) In general. The determination of whether an intermediate 
entity would not have participated in a financing arrangement on 
substantially the same terms but for the financing transaction between 
the financing entity and the intermediate entity shall be based upon all 
of the facts and circumstances.
    (2) Effect of guarantee--(i) In general. The director of field 
operations may presume that the intermediate entity would not have 
participated in the financing arrangement on substantially the same 
terms if there is a guarantee of the financed entity's liability to the 
intermediate entity (or in the case of multiple intermediate entities, a 
guarantee of the intermediate entity's liability to the intermediate 
entity that advanced money or property, or granted rights to use other 
property). However, a guarantee that was neither in existence nor 
contemplated on the last date that any of the financing transactions 
comprising the financing arrangement is entered into does not give rise 
to this presumption. A taxpayer may rebut this presumption by producing 
clear and convincing evidence that the intermediate entity would have 
participated in the financing transaction with the financed entity on 
substantially the same terms even if the financing entity had not 
entered into a financing transaction with the intermediate entity.
    (ii) Definition of guarantee. For the purposes of this paragraph 
(c)(2), a guarantee is any arrangement under which a person, directly or 
indirectly, assures, on a conditional or unconditional basis, the 
payment of another person's obligation with respect to a financing 
transaction. The term shall be interpreted in accordance with the 
definition of the term in section 163(j)(6)(D)(iii).
    (d) Determination of amount of tax liability--(1) Amount of payment 
subject to recharacterization--(i) In general. If a financing 
arrangement is a conduit financing arrangement, a portion of each 
payment made by the financed entity

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with respect to the financing transactions that comprise the conduit 
financing arrangement shall be recharacterized as a transaction directly 
between the financed entity and the financing entity. If the aggregate 
principal amount of the financing transaction(s) to which the financed 
entity is a party is less than or equal to the aggregate principal 
amount of the financing transaction(s) linking any of the parties to the 
financing arrangement, the entire amount of the payment shall be so 
recharacterized. If the aggregate principal amount of the financing 
transaction(s) to which the financed entity is a party is greater than 
the aggregate principal amount of the financing transaction(s) linking 
any of the parties to the financing arrangement, then the 
recharacterized portion shall be determined by multiplying the payment 
by a fraction the numerator of which is equal to the lowest aggregate 
principal amount of the financing transaction(s) linking any of the 
parties to the financing arrangement (other than financing transactions 
that are disregarded pursuant to paragraphs (a)(2)(i)(B) and 
(a)(4)(ii)(B) of this section) and the denominator of which is the 
aggregate principal amount of the financing transaction(s) to which the 
financed entity is a party. In the case of financing transactions the 
principal amount of which is subject to adjustment, the fraction shall 
be determined using the average outstanding principal amounts for the 
period to which the payment relates. The average principal amount may be 
computed using any method applied consistently that reflects with 
reasonable accuracy the amount outstanding for the period. See Example 
25 of paragraph (e) of this section for an illustration of the 
calculation of the amount of tax liability.
    (ii) Determination of principal amount--(A) In general. Unless 
otherwise provided in this paragraph (d)(1)(ii), the principal amount 
equals the amount of money advanced, or the fair market value of other 
property advanced or subject to a lease or license, in the financing 
transaction. In general, fair market value is calculated in U.S. dollars 
as of the close of business on the day on which the financing 
transaction is entered into. However, if the property advanced, or the 
right to use property granted, by the financing entity is the same as 
the property or rights received by the financed entity, the fair market 
value of the property or right shall be determined as of the close of 
business on the last date that any of the financing transactions 
comprising the financing arrangement is entered into. In the case of 
fungible property, property of the same type shall be considered to be 
the same property. See Example 26 of paragraph (e) for an illustration 
of the calculation of the principal amount in the case of financing 
transactions involving fungible property. The principal amount of a 
financing transaction shall be subject to adjustments, as set forth in 
this paragraph (d)(1)(ii).
    (B) Debt instruments and certain stock. In the case of a debt 
instrument or of stock that is subject to the current inclusion rules of 
sections 305(c)(3) or (e), the principal amount generally will be equal 
to the issue price. However, if the fair market value on the issue date 
differs materially from the issue price, the fair market value of the 
debt instrument shall be used in lieu of the instrument's issue price. 
Appropriate adjustments will be made for accruals of original issue 
discount and repayments of principal (including accrued original issue 
discount).
    (C) Partnership and trust interests. In the case of a partnership 
interest or an interest in a trust, the principal amount is equal to the 
fair market value of the money or property contributed to the 
partnership or trust in return for that partnership or trust interest.
    (D) Leases or licenses. In the case of a lease or license, the 
principal amount is equal to the fair market value of the property 
subject to the lease or license on the date on which the lease or 
license is entered into. The principal amount shall be adjusted for 
depreciation or amortization, calculated on a basis that accurately 
reflects the anticipated decline in the value of the property over its 
life.
    (2) Rate of tax. The rate at which tax is imposed under section 881 
on the portion of the payment that is recharacterized pursuant to 
paragraph (d)(1) of this section is determined by

[[Page 444]]

reference to the nature of the recharacterized transaction, as 
determined under paragraphs (a)(3)(ii)(B) and (C) of this section.
    (e) Examples. The following examples illustrate this section. For 
purposes of these examples, unless otherwise indicated, it is assumed 
that FP, a corporation organized in country N, owns all of the stock of 
FS, a corporation organized in country T, and DS, a corporation 
organized in the United States. Country T, but not country N, has an 
income tax treaty with the United States. The treaty exempts interest, 
rents and royalties paid by a resident of one state (the source state) 
to a resident of the other state from tax in the source state.

    Example 1. Financing arrangement. (i) On January 1, 1996, BK, a bank 
organized in country T, lends $1,000,000 to DS in exchange for a note 
issued by DS. FP guarantees to BK that DS will satisfy its repayment 
obligation on the loan. There are no other transactions between FP and 
BK.
    (ii) BK's loan to DS is a financing transaction within the meaning 
of paragraph (a)(2)(ii)(A)(1) of this section. FP's guarantee of DS's 
repayment obligation is not a financing transaction as described in 
paragraphs (a)(2)(ii)(A)(1) through (4) of this section. Therefore, 
these transactions do not constitute a financing arrangement as defined 
in paragraph (a)(2)(i) of this section.
    Example 2. Financing arrangement. (i) On January 1, 1996, FP lends 
$1,000,000 to DS in exchange for a note issued by DS. On January 1, 
1997, FP assigns the DS note to FS in exchange for a note issued by FS. 
After receiving notice of the assignment, DS remits payments due under 
its note to FS.
    (ii) The DS note held by FS and the FS note held by FP are financing 
transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of this 
section, and together constitute a financing arrangement within the 
meaning of paragraph (a)(2)(i) of this section.
    Example 3.Participation of a disregarded intermediate entity. The 
facts are the same as in Example 2, except that FS is an entity that is 
disregarded as an entity separate from its owner, FP, under Sec.  
301.7701-3. Under paragraph (a)(2)(i)(C) of this section, FS is a person 
and, therefore, may itself be an intermediate entity that is linked by 
financing transactions to other persons in a financing arrangement. The 
DS note held by FS and the FS note held by FP are financing transactions 
within the meaning of paragraph (a)(2)(ii) of this section, and together 
constitute a financing arrangement within the meaning of paragraph 
(a)(2)(i) of this section.
    Example 4. Financing arrangement. (i) On December 1, 1994 FP creates 
a special purposes subsidiary, FS. On that date FP capitalizes FS with 
$1,000,000 in cash and $10,000,000 in debt from BK, a Country N bank. On 
January 1, 1995, C, a U.S. person, purchases an automobile from DS in 
return for an installment note. On August 1, 1995, DS sells a number of 
installment notes, including C's, to FS in exchange for $10,000,000. DS 
continues to service the installment notes for FS.
    (ii) The C installment note now held by FS (as well as all of the 
other installment notes now held by FS) and the FS note held by BK are 
financing transactions within the meaning of paragraph (a)(2)(ii)(A)(1) 
of this section, and together constitute a financing arrangement within 
the meaning of paragraph (a)(2)(i) of this section.
    Example 5. Related persons treated as a single intermediate entity. 
(i) On January 1, 1996, FP deposits $1,000,000 with BK, a bank that is 
organized in country N and is unrelated to FP and its subsidiaries. M, a 
corporation also organized in country N, is wholly-owned by the sole 
shareholder of BK but is not a bank within the meaning of section 
881(c)(3)(A). On July 1, 1996, M lends $1,000,000 to DS in exchange for 
a note maturing on July 1, 2006. The note is in registered form within 
the meaning of section 881(c)(2)(B)(i) and DS has received from M the 
statement required by section 881(c)(2)(B)(ii). One of the principal 
purposes for the absence of a financing transaction between BK and M is 
the avoidance of the application of this section.
    (ii) The transactions described above would form a financing 
arrangement but for the absence of a financing transaction between BK 
and M. However, because one of the principal purposes for the 
structuring of these financing transactions is to prevent 
characterization of such arrangement as a financing arrangement, the 
director of field operations may treat the financing transactions 
between FP and BK, and between M and DS as a financing arrangement under 
paragraphs (a)(2)(i)(B) of this section. In such a case, BK and M would 
be considered a single intermediate entity for purposes of this section. 
See also paragraph (a)(4)(ii)(B) of this section for the authority to 
treat BK and M as a single intermediate entity.
    Example 6. Related persons treated as a single intermediate entity. 
(i) On January 1, 1995, FP lends $10,000,000 to FS in exchange for a 10-
year note that pays interest annually at a rate of 8 percent per annum. 
On January 2, 1995, FS contributes $10,000,000 to FS2, a wholly-owned 
subsidiary of FS organized in country T, in exchange for common stock of 
FS2. On January 1, 1996, FS2 lends $10,000,000 to DS in exchange for an 
8-year note that pays interest annually at a rate of 10 percent per 
annum. FS is a holding company whose most significant asset is the stock 
of FS2.

[[Page 445]]

Throughout the period that the FP-FS loan is outstanding, FS causes FS2 
to make distributions to FS, most of which are used to make interest and 
principal payments on the FP-FS loan. Without the distributions from 
FS2, FS would not have had the funds with which to make payments on the 
FP-FS loan. One of the principal purposes for the absence of a financing 
transaction between FS and FS2 is the avoidance of the application of 
this section.
    (ii) The conditions of paragraph (a)(4)(i)(A) of this section would 
be satisfied with respect to the financing transactions between FP, FS, 
FS2 and DS but for the absence of a financing transaction between FS and 
FS2. However, because one of the principal purposes for the structuring 
of these financing transactions is to prevent characterization of an 
entity as a conduit, the director of field operations may treat the 
financing transactions between FP and FS, and between FS2 and DS as a 
financing arrangement. See paragraph (a)(4)(ii)(B) of this section. In 
such a case, FS and FS2 would be considered a single intermediate entity 
for purposes of this section. See also paragraph (a)(2)(i)(B) of this 
section for the authority to treat FS and FS2 as a single intermediate 
entity.
    Example 7. Presumption with respect to unrelated financing entity. 
(i) FP is a corporation organized in country T that is actively engaged 
in a substantial manufacturing business. FP has a revolving credit 
facility with a syndicate of banks, none of which is related to FP and 
FP's subsidiaries, which provides that FP may borrow up to a maximum of 
$100,000,000 at a time. The revolving credit facility provides that DS 
and certain other subsidiaries of FP may borrow directly from the 
syndicate at the same interest rates as FP, but each subsidiary is 
required to indemnify the syndicate banks for any withholding taxes 
imposed on interest payments by the country in which the subsidiary is 
organized. BK, a bank that is organized in country N, is the agent for 
the syndicate. Some of the syndicate banks are organized in country N, 
but others are residents of country O, a country that has an income tax 
treaty with the United States which allows the United States to impose a 
tax on interest at a maximum rate of 10 percent. It is reasonable for BK 
and the syndicate banks to have determined that FP will be able to meet 
its payment obligations on a maximum principal amount of $100,000,000 
out of the cash flow of its manufacturing business. At various times 
throughout 1995, FP borrows under the revolving credit facility until 
the outstanding principal amount reaches the maximum amount of 
$100,000,000. On December 31, 1995, FP receives $100,000,000 from a 
public offering of its equity. On January 1, 1996, FP pays BK 
$90,000,000 to reduce the outstanding principal amount under the 
revolving credit facility and lends $10,000,000 to DS. FP would have 
repaid the entire principal amount, and DS would have borrowed directly 
from the syndicate, but for the fact that DS did not want to incur the 
U.S. withholding tax that would have applied to payments made directly 
by DS to the syndicate banks.
    (ii) Pursuant to paragraph (a)(3)(ii)(E)(1) of this section, even 
though the financing arrangement is a conduit financing arrangement 
(because the financing arrangement meets the standards for 
recharacterization in paragraph (a)(4)(i)), BK and the other syndicate 
banks have no section 881 liability unless they know or have reason to 
know that the financing arrangement is a conduit financing arrangement. 
Moreover, pursuant to paragraph (a)(3)(ii)(E)(2)(ii) of this section, BK 
and the syndicate banks are presumed not to know that the financing 
arrangement is a conduit financing arrangement. The syndicate banks are 
unrelated to both FP and DS, and FP is actively engaged in a substantial 
trade or business--that is, the cash flow from FP's manufacturing 
business is sufficient for the banks to expect that FP will be able to 
make the payments required under the financing transaction. See Sec.  
1.1441-3(g) for the withholding obligations of the withholding agents.
    Example 8. Multiple intermediate entities--special rule for related 
persons. (i) On January 1, 1995, FP lends $10,000,000 to FS in exchange 
for a 10-year note that pays interest annually at a rate of 8 percent 
per annum. On January 2, 1995, FS contributes $9,900,000 to FS2, a 
wholly-owned subsidiary of FS organized in country T, in exchange for 
common stock and lends $100,000 to FS2. On January 1, 1996, FS2 lends 
$10,000,000 to DS in exchange for an 8-year note that pays interest 
annually at a rate of 10 percent per annum. FS is a holding company that 
has no significant assets other than the stock of FS2. Throughout the 
period that the FP-FS loan is outstanding, FS causes FS2 to make 
distributions to FS, most of which are used to make interest and 
principal payments on the FP-FS loan. Without the distributions from 
FS2, FS would not have had the funds with which to make payments on the 
FP-FS loan. One of the principal purposes for structuring the 
transactions between FS and FS2 as primarily a contribution of capital 
is to reduce the amount of the payment that would be recharacterized 
under paragraph (d) of this section.
    (ii) Pursuant to paragraph (a)(4)(ii)(B) of this section, the 
director of field operations may treat FS and FS2 as a single 
intermediate entity for purposes of this section since one of the 
principal purposes for the participation of multiple intermediate 
entities is to reduce the amount of the tax liability on any 
recharacterized payment by inserting a financing transaction with a low 
principal amount.

[[Page 446]]

    Example 9. Multiple intermediate entities. (i) On January 1, 1995, 
FP deposits $1,000,000 with BK, a bank that is organized in country T 
and is unrelated to FP and its subsidiaries, FS and DS. On January 1, 
1996, at a time when the FP-BK deposit is still outstanding, BK lends 
$500,000 to BK2, a bank that is wholly-owned by BK and is organized in 
country T. On the same date, BK2 lends $500,000 to FS. On July 1, 1996, 
FS lends $500,000 to DS. FP pledges its deposit with BK to BK2 in 
support of FS' obligation to repay the BK2 loan. FS', BK's and BK2's 
participation in the financing arrangement is pursuant to a tax 
avoidance plan.
    (ii) The conditions of paragraphs (a)(4)(i)(A) and (B) of this 
section are satisfied because the participation of BK, BK2 and FS in the 
financing arrangement reduces the tax imposed by section 881, and FS', 
BK's and BK2's participation in the financing arrangement is pursuant to 
a tax avoidance plan. However, since BK and BK2 are unrelated to FP and 
DS, under paragraph (a)(4)(i)(C)(2) of this section, BK and BK2 will be 
treated as conduit entities only if BK and BK2 would not have 
participated in the financing arrangement on substantially the same 
terms but for the financing transaction between FP and BK.
    (iii) It is presumed that BK2 would not have participated in the 
financing arrangement on substantially the same terms but for the BK-BK2 
financing transaction because FP's pledge of an asset in support of FS' 
obligation to repay the BK2 loan is a guarantee within the meaning of 
paragraph (c)(2)(ii) of this section. If the taxpayer does not rebut 
this presumption by clear and convincing evidence, then BK2 will be a 
conduit entity.
    (iv) Because BK and BK2 are related intermediate entities, the 
director of field operations must determine whether one of the principal 
purposes for the involvement of multiple intermediate entities was to 
prevent characterization of an entity as a conduit entity. In making 
this determination, the director of field operations may consider the 
fact that the involvement of two related intermediate entities prevents 
the presumption regarding guarantees from applying to BK. In the absence 
of evidence showing a business purpose for the involvement of both BK 
and BK2, the director of field operations may treat BK and BK2 as a 
single intermediate entity for purposes of determining whether they 
would have participated in the financing arrangement on substantially 
the same terms but for the financing transaction between FP and BK. The 
presumption that applies to BK2 therefore will apply to BK. If the 
taxpayer does not rebut this presumption by clear and convincing 
evidence, then BK will be a conduit entity.
    Example 10. Reduction of tax. (i) On February 1, 1995, FP issues 
debt to the public that would satisfy the requirements of section 
871(h)(2)(A) (relating to obligations that are not in registered form) 
if issued by a U.S. person. FP lends the proceeds of the debt offering 
to DS in exchange for a note.
    (ii) The debt issued by FP and the DS note are financing 
transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of this 
section and together constitute a financing arrangement within the 
meaning of paragraph (a)(2)(i) of this section. The holders of the FP 
debt are the financing entities, FP is the intermediate entity and DS is 
the financed entity. Because interest payments on the debt issued by FP 
would not have been subject to withholding tax if the debt had been 
issued by DS, there is no reduction in tax under paragraph (a)(4)(i)(A) 
of this section. Accordingly, FP is not a conduit entity.
    Example 11. Reduction of tax. (i) On January 1, 1995, FP licenses to 
FS the rights to use a patent in the United States to manufacture 
product A. FS agrees to pay FP a fixed amount in royalties each year 
under the license. On January 1, 1996, FS sublicenses to DS the rights 
to use the patent in the United States. Under the sublicense, DS agrees 
to pay FS royalties based upon the units of product A manufactured by DS 
each year. Although the formula for computing the amount of royalties 
paid by DS to FS differs from the formula for computing the amount of 
royalties paid by FS to FP, each represents an arm's length rate.
    (ii) Although the royalties paid by DS to FS are exempt from U.S. 
withholding tax, the royalty payments between FS and FP are income from 
U.S. sources under section 861(a)(4) subject to the 30 percent gross tax 
imposed by Sec.  1.881-2(b) and subject to withholding under Sec.  
1.1441-2(a). Because the rate of tax imposed on royalties paid by FS to 
FP is the same as the rate that would have been imposed on royalties 
paid by DS to FP, the participation of FS in the FP-FS-DS financing 
arrangement does not reduce the tax imposed by section 881 within the 
meaning of paragraph (a)(4)(i)(A) of this section. Accordingly, FP is 
not a conduit entity.
    Example 12. A principal purpose. (i) On January 1, 1995, FS lends 
$10,000,000 to DS in exchange for a 10-year note that pays interest 
annually at a rate of 8 percent per annum. As was intended at the time 
of the loan from FS to DS, on July 1, 1995, FP makes an interest-free 
demand loan of $10,000,000 to FS. A principal purpose for FS' 
participation in the FP-FS-DS financing arrangement is that FS generally 
coordinates the financing for all of FP's subsidiaries (although FS does 
not engage in significant financing activities with respect to such 
financing transactions). However, another principal purpose for FS' 
participation is to allow the parties to benefit from the lower 
withholding tax rate provided under the income tax treaty between 
country T and the United States.

[[Page 447]]

    (ii) The financing arrangement satisfies the tax avoidance purpose 
requirement of paragraph (a)(4)(i)(B) of this section because FS 
participated in the financing arrangement pursuant to a plan one of the 
principal purposes of which is to allow the parties to benefit from the 
country T-U.S. treaty.
    Example 13. A principal purpose. (i) DX is a U.S. corporation that 
intends to purchase property to use in its manufacturing business. FX is 
a partnership organized in country N that is owned in equal parts by LC1 
and LC2, leasing companies that are unrelated to DX. BK, a bank 
organized in country N and unrelated to DX, LC1 and LC2, lends 
$100,000,000 to FX to enable FX to purchase the property. On the same 
day, FX purchases the property and engages in a transaction with DX 
which is treated as a lease of the property for country N tax purposes 
but a loan for U.S. tax purposes. Accordingly, DX is treated as the 
owner of the property for U.S. tax purposes. The parties comply with the 
requirements of section 881(c) with respect to the debt obligation of DX 
to FX. FX and DX structured these transactions in this manner so that 
LC1 and LC2 would be entitled to accelerated depreciation deductions 
with respect to the property in country N and DX would be entitled to 
accelerated depreciation deductions in the United States. None of the 
parties would have participated in the transaction if the payments made 
by DX were subject to U.S. withholding tax.
    (ii) The loan from BK to FX and from FX to DX are financing 
transactions and, together constitute a financing arrangement. The 
participation of FX in the financing arrangement reduces the tax imposed 
by section 881 because payments made to FX, but not BK, qualify for the 
portfolio interest exemption of section 881(c) because BK is a bank 
making an extension of credit in the ordinary course of its trade or 
business within the meaning of section 881(c)(3)(A). Moreover, because 
DX borrowed the money from FX instead of borrowing the money directly 
from BK to avoid the tax imposed by section 881, one of the principal 
purposes of the participation of FX was to avoid that tax (even though 
another principal purpose of the participation of FX was to allow LC1 
and LC2 to take advantage of accelerated depreciation deductions in 
country N). Assuming that FX would not have participated in the 
financing arrangement on substantially the same terms but for the fact 
that BK loaned it $100,000,000, FX is a conduit entity and the financing 
arrangement is a conduit financing arrangement.
    Example 14. Significant reduction of tax. (i) FS owns all of the 
stock of FS1, which also is a resident of country T. FS1 owns all of the 
stock of DS. On January 1, 1995, FP contributes $10,000,000 to the 
capital of FS in return for perpetual preferred stock. On July 1, 1995, 
FS lends $10,000,000 to FS1. On January 1, 1996, FS1 lends $10,000,000 
to DS. Under the terms of the country T-U.S. income tax treaty, a 
country T resident is not entitled to the reduced withholding rate on 
interest income provided by the treaty if the resident is entitled to 
specified tax benefits under country T law. Although FS1 may deduct 
interest paid on the loan from FS, these deductions are not pursuant to 
any special tax benefits provided by country T law. However, FS 
qualifies for one of the enumerated tax benefits pursuant to which it 
may deduct dividends paid with respect to the stock held by FP. 
Therefore, if FS had made a loan directly to DS, FS would not have been 
entitled to the benefits of the country T-U.S. tax treaty with respect 
to payments it received from DS, and such payments would have been 
subject to tax under section 881 at a 30 percent rate.
    (ii) The FS-FS1 loan and the FS1-DS loan are financing transactions 
within the meaning of paragraph (a)(2)(ii)(A)(1) of this section and 
together constitute a financing arrangement within the meaning of 
paragraph (a)(2)(i) of this section. Pursuant to paragraph (b)(2)(i) of 
this section, the significant reduction in tax resulting from the 
participation of FS1 in the financing arrangement is evidence that the 
participation of FS1 in the financing arrangement is pursuant to a tax 
avoidance plan. However, other facts relevant to the presence of such a 
plan must also be taken into account.
    Example 15. Significant reduction of tax. (i) FP owns 90 percent of 
the voting stock of FX, an unlimited liability company organized in 
country T. The other 10 percent of the common stock of FX is owned by 
FP1, a subsidiary of FP that is organized in country N. Although FX is a 
partnership for U.S. tax purposes, FX is entitled to the benefits of the 
U.S.-country T income tax treaty because FX is subject to tax in country 
T as a resident corporation. On January 1, 1996, FP contributes 
$10,000,000 to FX in exchange for an instrument denominated as preferred 
stock that pays a dividend of 7 percent and that must be redeemed by FX 
in seven years. For U.S. tax purposes, the preferred stock is a 
partnership interest. On July 1, 1996, FX makes a loan of $10,000,000 to 
DS in exchange for a 7-year note paying interest at 6 percent.
    (ii) Because FX is required to redeem the partnership interest at a 
specified time, the partnership interest constitutes a financing 
transaction within the meaning of paragraph (a)(2)(ii)(A)(2) of this 
section. Moreover, because the FX-DS note is a financing transaction 
within the meaning of paragraph (a)(2)(ii)(A)(1) of this section, 
together the transactions constitute a financing arrangement within the 
meaning of (a)(2)(i) of this section. Payments of interest made directly 
by DS to FP and FP1 would not be eligible for the portfolio interest 
exemption and

[[Page 448]]

would not be entitled to a reduction in withholding tax pursuant to a 
tax treaty. Therefore, there is a significant reduction in tax resulting 
from the participation of FX in the financing arrangement, which is 
evidence that the participation of FX in the financing arrangement is 
pursuant to a tax avoidance plan. However, other facts relevant to the 
existence of such a plan must also be taken into account.
    Example 16. Significant reduction of tax. (i) FP owns a 10 percent 
interest in the profits and capital of FX, a partnership organized in 
country N. The other 90 percent interest in FX is owned by G, an 
unrelated corporation that is organized in country T. FX is not engaged 
in business in the United States. On January 1, 1996, FP contributes 
$10,000,000 to FX in exchange for an instrument documented as perpetual 
subordinated debt that provides for quarterly interest payments at 9 
percent per annum. Under the terms of the instrument, payments on the 
perpetual subordinated debt do not otherwise affect the allocation of 
income between the partners. FP has the right to require the liquidation 
of FX if FX fails to make an interest payment. For U.S. tax purposes, 
the perpetual subordinated debt is treated as a partnership interest in 
FX and the payments on the perpetual subordinated debt constitute 
guaranteed payments within the meaning of section 707(c). On July 1, 
1996, FX makes a loan of $10,000,000 to DS in exchange for a 7-year note 
paying interest at 8 percent per annum.
    (ii) Because FP has the effective right to force payment of the 
``interest'' on the perpetual subordinated debt, the instrument 
constitutes a financing transaction within the meaning of paragraph 
(a)(2)(ii)(A)(2) of this section. Moreover, because the note between FX 
and DS is a financing transaction within the meaning of paragraph 
(a)(2)(ii)(A)(1) of this section, together the transactions are a 
financing arrangement within the meaning of (a)(2)(i) of this section. 
Without regard to this section, 90 percent of each interest payment 
received by FX would be treated as exempt from U.S. withholding tax 
because it is beneficially owned by G, while 10 percent would be subject 
to a 30 percent withholding tax because beneficially owned by FP. If FP 
held directly the note issued by DS, 100 percent of the interest 
payments on the note would have been subject to the 30 percent 
withholding tax. The significant reduction in the tax imposed by section 
881 resulting from the participation of FX in the financing arrangement 
is evidence that the participation of FX in the financing arrangement is 
pursuant to a tax avoidance plan. However, other facts relevant to the 
presence of such a plan must also be taken into account.
    Example 17. Time period between transactions. (i) On January 1, 
1995, FP lends $10,000,000 to FS in exchange for a 10-year note that 
pays no interest annually. When the note matures, FS is obligated to pay 
$24,000,000 to FP. On January 1, 1996, FS lends $10,000,000 to DS in 
exchange for a 10-year note that pays interest annually at a rate of 10 
percent per annum.
    (ii) The FS note held by FP and the DS note held by FS are financing 
transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of this 
section and together constitute a financing arrangement within the 
meaning of (a)(2)(i) of this section. Pursuant to paragraph (b)(2)(iii) 
of this section, the short period of time (twelve months) between the 
loan by FP to FS and the loan by FS to DS is evidence that the 
participation of FS in the financing arrangement is pursuant to a tax 
avoidance plan. However, other facts relevant to the presence of such a 
plan must also be taken into account.
    Example 18. Financing transactions in the ordinary course of 
business. (i) FP is a holding company. FS is actively engaged in country 
T in the business of manufacturing and selling product A. DS 
manufactures product B, a principal component in which is product A. FS' 
business activity is substantial. On January 1, 1995, FP lends 
$100,000,000 to FS to finance FS' business operations. On January 1, 
1996, FS ships $30,000,000 of product A to DS. In return, FS creates an 
interest-bearing account receivable on its books. FS' shipment is in the 
ordinary course of the active conduct of its trade or business (which is 
complementary to DS' trade or business.)
    (ii) The loan from FP to FS and the accounts receivable opened by FS 
for a payment owed by DS are financing transactions within the meaning 
of paragraph (a)(2)(ii)(A)(1) of this section and together constitute a 
financing arrangement within the meaning of paragraph (a)(2)(i) of this 
section. Pursuant to paragraph (b)(2)(iv) of this section, the fact that 
DS' liability to FS is created in the ordinary course of the active 
conduct of DS' trade or business that is complementary to a business 
actively engaged in by DS is evidence that the participation of FS in 
the financing arrangement is not pursuant to a tax avoidance plan. 
However, other facts relevant to the presence of such a plan must also 
be taken into account.
    Example 19. Tax avoidance plan--other factors. (i) On February 1, 
1995, FP issues debt in Country N that is in registered form within the 
meaning of section 881(c)(3)(A). The FP debt would satisfy the 
requirements of section 881(c) if the debt were issued by a U.S. person 
and the withholding agent received the certification required by section 
871(h)(2)(B)(ii). The purchasers of the debt are financial institutions 
and there is no reason to believe that they would not furnish Forms W-8. 
On March 1, 1995, FP lends a portion of the proceeds of the offering to 
DS.
    (ii) The FP debt and the loan to DS are financing transactions 
within the meaning of

[[Page 449]]

paragraph (a)(2)(ii)(A)(1) of this section and together constitute a 
financing arrangement within the meaning of paragraph (a)(2)(i) of this 
section. The owners of the FP debt are the financing entities, FP is the 
intermediate entity and DS is the financed entity. Interest payments on 
the debt issued by FP would be subject to withholding tax if the debt 
were issued by DS, unless DS received all necessary Forms W-8. 
Therefore, the participation of FP in the financing arrangement 
potentially reduces the tax imposed by section 881(a). However, because 
it is reasonable to assume that the purchasers of the FP debt would have 
provided certifications in order to avoid the withholding tax imposed by 
section 881, there is not a tax avoidance plan. Accordingly, FP is not a 
conduit entity.
    Example 20. Tax avoidance plan--other factors. (i) Over a period of 
years, FP has maintained a deposit with BK, a bank organized in the 
United States, that is unrelated to FP and its subsidiaries. FP often 
sells goods and purchases raw materials in the United States. FP opened 
the bank account with BK in order to facilitate this business and the 
amounts it maintains in the account are reasonably related to its 
dollar-denominated working capital needs. On January 1, 1995, BK lends 
$5,000,000 to DS. After the loan is made, the balance in FP's bank 
account remains within a range appropriate to meet FP's working capital 
needs.
    (ii) FP's deposit with BK and BK's loan to DS are financing 
transactions within the meaning of paragraph (a)(2)(ii)(A)(1) of this 
section and together constitute a financing arrangement within the 
meaning of paragraph (a)(2)(i) of this section. Pursuant to section 
881(i), interest paid by BK to FP with respect to the bank deposit is 
exempt from withholding tax. Interest paid directly by DS to FP would 
not be exempt from withholding tax under section 881(i) and therefore 
would be subject to a 30% withholding tax. Accordingly, there is a 
significant reduction in the tax imposed by section 881, which is 
evidence of the existence of a tax avoidance plan. See paragraph 
(b)(2)(i) of this section. However, the director of field operations 
also will consider the fact that FP historically has maintained an 
account with BK to meet its working capital needs and that, prior to and 
after BK's loan to DS, the balance within the account remains within a 
range appropriate to meet those business needs as evidence that the 
participation of BK in the FP-BK-DS financing arrangement is not 
pursuant to a tax avoidance plan. In determining the presence or absence 
of a tax avoidance plan, all relevant facts will be taken into account.
    Example 21. Tax avoidance plan--other factors. (i) Assume the same 
facts as in Example 20, except that on January 1, 2000, FP's deposit 
with BK substantially exceeds FP's expected working capital needs and on 
January 2, 2000, BK lends additional funds to DS. Assume also that BK's 
loan to DS provides BK with a right of offset against FP's deposit. 
Finally, assume that FP would have lent the funds to DS directly but for 
the imposition of the withholding tax on payments made directly to FP by 
DS.
    (ii) As in Example 19, the transactions in paragraph (i) of this 
Example 21 are a financing arrangement within the meaning of paragraph 
(a)(2)(i) and the participation of the BK reduces the section 881 tax. 
In this case, the presence of funds substantially in excess of FP's 
working capital needs and the fact that FP would have been willing to 
lend funds directly to DS if not for the withholding tax are evidence 
that the participation of BK in the FP-BK-FS financing arrangement is 
pursuant to a tax avoidance plan. However, other facts relevant to the 
presence of such a plan must also be taken into account. Even if the 
director of field operations determines that the participation of BK in 
the financing arrangement is pursuant to a tax avoidance plan, BK may 
not be treated as a conduit entity unless BK would not have participated 
in the financing arrangement on substantially the same terms in the 
absence of FP's deposit with BK. BK's right of offset against FP's 
deposit (a form of guarantee of BK's loan to DS) creates a presumption 
that BK would not have made the loan to DS on substantially the same 
terms in the absence of FP's deposit with BK. If the taxpayer overcomes 
the presumption by clear and convincing evidence, BK will not be a 
conduit entity.
    Example 22. Significant financing activities. (i) FS is responsible 
for coordinating the financing of all of the subsidiaries of FP, which 
are engaged in substantial trades or businesses and are located in 
country T, country N, and the United States. FS maintains a centralized 
cash management accounting system for FP and its subsidiaries in which 
it records all intercompany payables and receivables; these payables and 
receivables ultimately are reduced to a single balance either due from 
or owing to FS and each of FP's subsidiaries. FS is responsible for 
disbursing or receiving any cash payments required by transactions 
between its affiliates and unrelated parties. FS must borrow any cash 
necessary to meet those external obligations and invests any excess cash 
for the benefit of the FP group. FS enters into interest rate and 
foreign exchange contracts as necessary to manage the risks arising from 
mismatches in incoming and outgoing cash flows. The activities of FS are 
intended (and reasonably can be expected) to reduce transaction costs 
and overhead and other fixed costs. FS has 50 employees, including 
clerical and other back office personnel, located in country T. At the 
request of DS, on January 1, 1995, FS pays a supplier $1,000,000 for 
materials delivered to DS and

[[Page 450]]

charges DS an open account receivable for this amount. On February 3, 
1995, FS reverses the account receivable from DS to FS when DS delivers 
to FP goods with a value of $1,000,000.
    (ii) The accounts payable from DS to FS and from FS to other 
subsidiaries of FP constitute financing transactions within the meaning 
of paragraph (a)(2)(ii)(A)(1) of this section, and the transactions 
together constitute a financing arrangement within the meaning of 
paragraph (a)(2)(i) of this section. FS's activities constitute 
significant financing activities with respect to the financing 
transactions even though FS did not actively and materially participate 
in arranging the financing transactions because the financing 
transactions consisted of trade receivables and trade payables that were 
ordinary and necessary to carry on the trades or businesses of DS and 
the other subsidiaries of FP. Accordingly, pursuant to paragraph 
(b)(3)(i) of this section, FS' participation in the financing 
arrangement is presumed not to be pursuant to a tax avoidance plan.
    Example 23. Significant financing activities--active risk 
management. (i) The facts are the same as in Example 22, except that, in 
addition to its short-term funding needs, DS needs long-term financing 
to fund an acquisition of another U.S. company; the acquisition is 
scheduled to close on January 15, 1995. FS has a revolving credit 
agreement with a syndicate of banks located in Country N. On January 14, 
1995, FS borrows [yen]10 billion for 10 years under the revolving credit 
agreement, paying yen LIBOR plus 50 basis points on a quarterly basis. 
FS enters into a currency swap with BK, an unrelated bank that is not a 
member of the syndicate, under which FS will pay BK [yen]10 billion and 
will receive $100 million on January 15, 1995; these payments will be 
reversed on January 15, 2004. FS will pay BK U.S. dollar LIBOR plus 50 
basis points on a notional principal amount of $100 million semi-
annually and will receive yen LIBOR plus 50 basis points on a notional 
principal amount of [yen]10 billion quarterly. Upon the closing of the 
acquisition on January 15, 1995, DS borrows $100 million from FS for 10 
years, paying U.S. dollar LIBOR plus 50 basis points semiannually.
    (ii) Although FS performs significant financing activities with 
respect to certain financing transactions to which it is a party, FS 
does not perform significant financing activities with respect to the 
financing transactions between FS and the syndicate of banks and between 
FS and DS because FS has eliminated all material market risks arising 
from those financing transactions through its currency swap with BK. 
Accordingly, the financing arrangement does not benefit from the 
presumption of paragraph (b)(3)(i) of this section and the director of 
field operations must determine whether the participation of FS in the 
financing arrangement is pursuant to a tax avoidance plan on the basis 
of all the facts and circumstances. However, if additional facts 
indicated that FS reviews its currency swaps daily to determine whether 
they are the most cost efficient way of managing their currency risk 
and, as a result, frequently terminates swaps in favor of entering into 
more cost efficient hedging arrangements with unrelated parties, FS 
would be considered to perform significant financing activities and FS' 
participation in the financing arrangements would not be pursuant to a 
tax avoidance plan.
    Example 24. Significant financing activities--presumption rebutted. 
(i) The facts are the same as in Example 22, except that, on January 1, 
1995, FP lends to FS DM 15,000,000 (worth $10,000,000) in exchange for a 
10 year note that pays interest annually at a rate of 5 percent per 
annum. Also, on March 15, 1995, FS lends $10,000,000 to DS in exchange 
for a 10-year note that pays interest annually at a rate of 8 percent 
per annum. FS would not have had sufficient funds to make the loan to DS 
without the loan from FP. FS does not enter into any long-term hedging 
transaction with respect to these financing transactions, but manages 
the interest rate and currency risk arising from the transactions on a 
daily, weekly or quarterly basis by entering into forward currency 
contracts.
    (ii) Because FS performs significant financing activities with 
respect to the financing transactions between FS, DS and FP, the 
participation of FS in the financing arrangement is presumed not to be 
pursuant to a tax avoidance plan. The director of field operations may 
rebut this presumption by establishing that the participation of FS is 
pursuant to a tax avoidance plan, based on all the facts and 
circumstances. The mere fact that FS is a resident of country T is not 
sufficient to establish the existence of a tax avoidance plan. However, 
the existence of a plan can be inferred from other factors in addition 
to the fact that FS is a resident of country T. For example, the loans 
are made within a short time period and FS would not have been able to 
make the loan to DS without the loan from FP.
    Example 25. Determination of amount of tax liability. (i) On January 
1, 1996, FP makes two three-year installment loans of $250,000 each to 
FS that pay interest at a rate of 9 percent per annum. The loans are 
self-amortizing with payments on each loan of $7,950 per month. On the 
same date, FS lends $1,000,000 to DS in exchange for a two-year note 
that pays interest semi-annually at a rate of 10 percent per annum, 
beginning on June 30, 1996. The FS-DS loan is not self-amortizing. 
Assume that for the period of January 1, 1996 through June 30, 1996, the 
average principal amount of the financing transactions between FP and FS 
that comprise the financing arrangement is $469,319. Further, assume 
that for the period of July 1, 1996 through

[[Page 451]]

December 31, 1996, the average principal amount of the financing 
transactions between FP and FS is $393,632. The average principal amount 
of the financing transaction between FS and DS for the same periods is 
$1,000,000. The director of field operations determines that the 
financing transactions between FP and FS, and FS and DS, are a conduit 
financing arrangement.
    (ii) Pursuant to paragraph (d)(1)(i) of this section, the portion of 
the $50,000 interest payment made by DS to FS on June 30, 1996, that is 
recharacterized as a payment to FP is $23,450 computed as follows: 
($50,000 x $469,319/$1,000,000) = $23,450. The portion of the interest 
payment made on December 31, 1996 that is recharacterized as a payment 
to FP is $19,650, computed as follows: ($50,000 x $393,632/$1,000,000) = 
$19,650. Furthermore, under Sec.  1.1441-3(g), DS is liable for 
withholding tax at a 30 percent rate on the portion of the $50,000 
payment to FS that is recharacterized as a payment to FP, i.e., $7,035 
with respect to the June 30, 1996 payment and $5,895 with respect to the 
December 31, 1996 payment.
    Example 26. Determination of principal amount. (i) FP lends DM 
5,000,000 to FS in exchange for a ten year note that pays interest semi-
annually at a rate of 8 percent per annum. Six months later, pursuant to 
a tax avoidance plan, FS lends DM 10,000,000 to DS in exchange for a 10 
year note that pays interest semi-annually at a rate of 10 percent per 
annum. At the time FP make its loan to FS, the exchange rate is DM 1.5/
$1. At the time FS makes its loan to DS the exchange rate is DM 1.4/$1.
    (ii) FP's loan to FS and FS' loan to DS are financing transactions 
and together constitute a financing arrangement. Furthermore, because 
the participation of FS reduces the tax imposed under section 881 and 
FS' participation is pursuant to a tax avoidance plan, the financing 
arrangement is a conduit financing arrangement.
    (iii) Pursuant to paragraph (d)(1)(i) of this section, the amount 
subject to recharacterization is a fraction the numerator of which is 
the lowest aggregate principal amount advanced and the denominator of 
which is the principal amount advanced from FS to DS. Because the 
property advanced in these financing transactions is the same type of 
fungible property, under paragraph (d)(1)(ii)(A) of this section, both 
are valued on the date of the last financing transaction. Accordingly, 
the portion of the payments of interest that is recharacterized is ((DM 
5,000,000 x DM 1.4/$1)/(DM 10,000,000 x DM 1.4/$1) or 0.5.

    (f) Effective/applicability date. This section is effective for 
payments made by financed entities on or after September 11, 1995. This 
section shall not apply to interest payments covered by section 
127(g)(3) of the Tax Reform Act of 1984, and to interest payments with 
respect to other debt obligations issued prior to October 15, 1984 
(whether or not such debt was issued by a Netherlands Antilles 
corporation). Paragraph (a)(2)(i)(C) and Example 3 of paragraph (e) of 
this section apply to payments made on or after December 9, 2011.

[T.D. 8611, 60 FR 41005, Aug. 11, 1995; 60 FR 55312, Oct. 31, 1995; 63 
FR 67578, Dec. 8, 1998; T.D. 9562, 76 FR 76896, Dec. 9, 2011; 77 FR 
22480, Apr. 16, 2012]



Sec.  1.881-4  Recordkeeping requirements concerning 
conduit financing arrangements.

    (a) Scope. This section provides rules for the maintenance of 
records concerning certain financing arrangements to which the 
provisions of Sec.  1.881-3 apply.
    (b) Recordkeeping requirements--(1) In general. Any person subject 
to the general recordkeeping requirements of section 6001 must keep the 
permanent books of account or records, as required by section 6001, that 
may be relevant to determining whether that person is a party to a 
financing arrangement and whether that financing arrangement is a 
conduit financing arrangement.
    (2) Application of Sections 6038 and 6038A. A financed entity that 
is a reporting corporation within the meaning of section 6038A(a) and 
the regulations under that section, and any other person that is subject 
to the recordkeeping requirements of Sec.  1.6038A-3, must comply with 
those recordkeeping requirements with respect to records that may be 
relevant to determining whether the financed entity is a party to a 
financing arrangement and whether that financing arrangement is a 
conduit financing arrangement. Such records, including records that a 
person is required to maintain pursuant to paragraph (c) of this 
section, shall be considered records that are required to be maintained 
pursuant to section 6038 or 6038A. Accordingly, the provisions of 
sections 6038 and 6038A (including, without limitation, the penalty 
provisions thereof), and the regulations under those sections, shall 
apply to any records required to be maintained pursuant to this section.

[[Page 452]]

    (c) Records to be maintained--(1) In general. An entity described in 
paragraph (b) of this section shall be required to retain any records 
containing the following information concerning each financing 
transaction that the entity knows or has reason to know comprises the 
financing arrangement--
    (i) The nature (e.g., loan, stock, lease, license) of each financing 
transaction;
    (ii) The name, address, taxpayer identification number (if any) and 
country of residence of--
    (A) Each person that advanced money or other property, or granted 
rights to use property;
    (B) Each person that was the recipient of the advance or rights; and
    (C) Each person to whom a payment was made pursuant to the financing 
transaction (to the extent that person is a different person than the 
person who made the advance or granted the rights);
    (iii) The date and amount of--
    (A) Each advance of money or other property or grant of rights; and
    (B) Each payment made in return for the advance or grant of rights;
    (iv) The terms of any guarantee provided in conjunction with a 
financing transaction, including the name of the guarantor; and
    (v) In cases where one or both of the parties to a financing 
transaction are related to each other or another entity in the financing 
arrangement, the manner in which these persons are related.
    (2) Additional documents. An entity described in paragraph (b) of 
this section must also retain all records relating to the circumstances 
surrounding its participation in the financing transactions and 
financing arrangements. Such documents may include, but are not limited 
to--
    (i) Minutes of board of directors meetings;
    (ii) Board resolutions or other authorizations for the financing 
transactions;
    (iii) Private letter rulings;
    (iv) Financial reports (audited or unaudited);
    (v) Notes to financial statements;
    (vi) Bank statements;
    (vii) Copies of wire transfers;
    (viii) Offering documents;
    (ix) Materials from investment advisors, bankers and tax advisors; 
and
    (x) Evidences of indebtedness.
    (3) Effect of record maintenance requirement. Record maintenance in 
accordance with paragraph (b) of this section generally does not require 
the original creation of records that are ordinarily not created by 
affected entities. If, however, a document that is actually created is 
described in this paragraph (c), it is to be retained even if the 
document is not of a type ordinarily created by the affected entity.
    (d) Effective date. This section is effective September 11, 1995. 
This section shall not apply to interest payments covered by section 
127(g)(3) of the Tax Reform Act of 1984, and to interest payments with 
respect to other debt obligations issued prior to October 15, 1984 
(whether or not such debt was issued by a Netherlands Antilles 
corporation).

[T.D. 8611, 60 FR 41014, Aug. 11, 1995]



Sec.  1.881-5  Exception for certain possessions corporations.

    (a) Scope. Section 881(b) and this section provide special rules for 
the application of sections 881 and 884 to certain corporations created 
or organized in possessions of the United States. Paragraph (g) of this 
section provides special rules for the application of sections 881 and 
884 to corporations created or organized in the United States for 
purposes of determining tax liability incurred to certain possessions 
that administer 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. See 
Sec.  1.884-0(b) for special rules relating to the application of 
section 884 with respect to possessions of the United States.
    (b) Operative rules. (1) Corporations described in paragraphs (c) 
and (d) of this section are not treated as foreign corporations for 
purposes of section 881. Accordingly, they are exempt from the tax 
imposed by section 881(a).
    (2) For corporations described in paragraph (e) of this section, the 
rate of tax imposed by section 881(a) on U.S. source dividends received 
is 10 percent (rather than the generally applicable 30 percent).

[[Page 453]]

    (c) U.S. Virgin Islands and section 931 possessions. A corporation 
created or organized in, or under the law of, the U.S. Virgin Islands or 
a section 931 possession is described in this paragraph (c) for a 
taxable year when the following conditions are satisfied--
    (1) At all times during such taxable year, less than 25 percent in 
value of the stock of such corporation is beneficially owned (directly 
or indirectly) by foreign persons;
    (2) At least 65 percent of the gross income of such corporation is 
shown to the satisfaction of the Commissioner upon examination to be 
effectively connected with the conduct of a trade or business in such a 
possession or the United States for the 3-year period ending with the 
close of the taxable year of such corporation (or for such part of such 
period as the corporation or any predecessor has been in existence); and
    (3) No substantial part of the income of such corporation for the 
taxable year is used (directly or indirectly) to satisfy obligations to 
persons who are not bona fide residents of such a possession or the 
United States.
    (d) Section 935 possessions. A corporation created or organized in, 
or under the law of, a section 935 possession is described in this 
paragraph (d) for a taxable year when the following conditions are 
satisfied--
    (1) At all times during such taxable year, less than 25 percent in 
value of the stock of such corporation is owned (directly or indirectly) 
by foreign persons; and
    (2) At least 20 percent of the gross income of such corporation is 
shown to the satisfaction of the Commissioner upon examination to have 
been derived from sources within such possession for the 3-year period 
ending with the close of the preceding taxable year of such corporation 
(or for such part of such period as the corporation has been in 
existence).
    (e) Puerto Rico. A corporation created or organized in, or under the 
law of, Puerto Rico is described in this paragraph (e) for a taxable 
year when the conditions of paragraphs (c)(1) through (c)(3) of this 
section are satisfied (using the language ``Puerto Rico'' instead of 
``such a possession'').
    (f) Definitions and other rules. For purposes of this section--
    (1) ``Section 931 possession'' is defined in Sec.  1.931-1(c)(1);and
    (2) ``Section 935 possession'' is defined in Sec.  1.935-1(a)(3)(i).
    (3) Foreign person means any person other than--
    (i) A United States person (as defined in section 7701(a)(30) and 
the regulations under that section); or
    (ii) A person who would be a United States person if references to 
the United States in section 7701 included references to a possession of 
the United States.
    (4) Bona fide resident--
    (i) With respect to a particular possession, means--
    (A) An individual who is a bona fide resident of the possession as 
defined in Sec.  1.937-1; or
    (B) A business entity organized under the laws of the possession and 
taxable as a corporation in the possession; and
    (ii) With respect to the United States, means--
    (A) An individual who is a citizen or resident of the United States 
(as defined under section 7701(b)(1)(A)); or
    (B) A business entity organized under the laws of the United States 
or any State that is classified as a corporation for Federal tax 
purposes under Sec.  301.7701-2(b) of this chapter.
    (5) Source. The rules of Sec.  1.937-2 will apply for determining 
whether income is from sources within a possession.
    (6) Effectively connected income. The rules of Sec.  1.937-3 (other 
than paragraph (c) of that section) will apply for determining whether 
income is effectively connected with the conduct of a trade or business 
in a possession.
    (7) Indirect ownership. 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).
    (g) Mirror code jurisdictions. For purposes of applying mirrored 
section 881 to determine tax liability incurred to a section 935 
possession or the U.S. Virgin Islands--
    (1) The rules of paragraphs (b) through (d) of this section will not 
apply; and

[[Page 454]]

    (2) A corporation created or organized in, or under the law of, such 
possession or the United States will not be considered a foreign 
corporation.
    (h) Example. The principles of this section are illustrated by the 
following example:

    Example. X is a corporation organized under the law of the U.S. 
Virgin Islands with a branch located in State F. At least 65 percent of 
the gross income of X is effectively connected with the conduct of a 
trade or business in the U.S. Virgin Islands and no substantial part of 
the income of X for the taxable year is used to satisfy obligations to 
persons who are not bona fide residents of the United States or the U.S. 
Virgin Islands. Seventy-four percent of the stock of X is owned by 
unrelated individuals who are residents of the United States or the U.S. 
Virgin Islands. Y, a corporation organized under the law of State D, and 
Z, a partnership organized under the law of State F, each own 13 percent 
of the stock of X. A, an unrelated foreign individual, owns 100 percent 
of the stock of corporation Y. B and C, unrelated foreign individuals, 
each own a 50 percent interest in partnership Z. Thus, the condition of 
paragraph (c)(1) of this section is not satisfied, because 26 percent of 
X is owned indirectly by foreign persons (A, B, and C). Accordingly, X 
is treated as a foreign corporation for purposes of section 881.

    (i) Effective/applicability dates. Except as otherwise provided in 
this paragraph (i), this section applies to payments made in taxable 
years ending after April 9, 2008. If, on or after April 9, 2008, there 
takes effect an increase in the Commonwealth of Puerto Rico's 
withholding tax generally applicable to dividends paid to United States 
corporations not engaged in a trade or business in the Commonwealth to a 
rate greater than 10 percent, the rules of paragraphs (b)(2) and (e) of 
this section will not apply to dividends received on or after the 
effective date of the increase. Paragraph (f)(4) of this section applies 
to payments made after January 31, 2006. Taxpayers may choose to apply 
paragraph (f)(4) of this section to payments made after October 22, 
2004.

[T.D. 9248, 71 FR 5001, Jan. 31, 2006, as amended by T.D. 9391, 73 FR 
19359, Apr. 9, 2008; 73 FR 27728, May 14, 2008]



Sec.  1.882-0  Table of contents.

    This section lists captions contained in Sec. Sec.  1.882-1, 1.882-
2, 1.882-3, 1.882-4 and 1.882-5.

Sec.  1.882-1 Taxation of foreign corporations engaged in U.S. business 
   or of foreign corporations treated as having effectively connected 
                                 income.

    (a) Segregation of income.
    (b) Imposition of tax.
    (1) Income not effectively connected with the conduct of a trade or 
business in the United States.
    (2) Income effectively connected with the conduct of a trade or 
business in the United States.
    (i) In general.
    (ii) Determination of taxable income.
    (iii) Cross references.
    (c) Change in trade or business status.
    (d) Credits against tax.
    (e) Payment of estimated tax.
    (f) Effective date.

   Sec.  1.882-2 Income of foreign corporation treated as effectively 
                      connected with U.S. business.

    (a) Election as to real property income.
    (b) Interest on U.S. obligations received by banks organized in 
possessions.
    (c) Treatment of income.
    (d) Effective date.

          Sec.  1.882-3 Gross income of a foreign corporation.

    (a) In general.
    (1) Inclusions.
    (2) Exchange transactions.
    (3) Exclusions.
    (b) Foreign corporations not engaged in U.S. business.
    (c) Foreign corporations engaged in U.S. business.
    (d) Effective date.

      Sec.  1.882-4 Allowance of deductions and credits to foreign 
                              corporations.

    (a) Foreign corporations.
    (1) In general.
    (2) Return necessary.
    (3) Filing deadline for return.
    (4) Return by Internal Revenue Service.
    (b) Allowed deductions and credits.
    (1) In general.
    (2) Verification.

           Sec.  1.882-5 Determination of interest deduction.

    (a)(1) Overview.
    (i) In general.
    (ii) Direct allocations.
    (A) In general.
    (B) Partnership interests.
    (2) Coordination with tax treaties.
    (3) Limitation on interest expense.
    (4) Translation convention for foreign currency.

[[Page 455]]

    (5) Coordination with other sections.
    (6) Special rule for foreign governments.
    (7) Elections under Sec.  1.882-5.
    (i) In general.
    (ii) Failure to make the proper election.
    (iii) Step 2 special election for banks.
    (8) Examples.
    (b) Step 1: Determination of total value of U.S. assets for the 
taxable year.
    (1) Classification of an asset as a U.S. asset.
    (i) General rule.
    (ii) Items excluded from the definition of U.S. asset.
    (iii) Items included in the definition of U.S. asset.
    (iv) Interbranch transactions.
    (v) Assets acquired to increase U.S. assets artificially.
    (2) Determination of the value of a U.S. asset.
    (i) General rule.
    (ii) Fair-market value election.
    (A) In general.
    (B) Adjustment to partnership basis.
    (iii) Reduction of total value of U.S. assets by amount of bad debt 
reserves under section 585.
    (A) In general.
    (B) Example.
    (3) Computation of total value of U.S. assets.
    (i) General rule.
    (ii) Adjustment to basis of financial instruments.
    (c) Step 2: Determination of total amount of U.S.-connected 
liabilities for the taxable year.
    (1) General rule.
    (2) Computation of the actual ratio.
    (i) In general.
    (ii) Classification of items.
    (iii) Determination of amount of worldwide liabilities.
    (iv) Determination of value of worldwide assets.
    (v) Hedging transactions.
    (vi) Treatment of partnership interests and liabilities.
    (vii) Computation of actual ratio of insurance companies.
    (viii) Interbranch transactions.
    (ix) Amounts must be expressed in a single currency.
    (3) Adjustments.
    (4) Elective fixed ratio method of determining U.S. liabilities.
    (5) Examples.
    (d) Step 3: Determination of amount of interest expense allocable to 
ECI under the adjusted U.S. booked liabilities method.
    (1) General rule.
    (2) U.S. booked liabilities.
    (i) In general.
    (ii) Properly reflected on the books of the U.S. trade or business 
of a foreign corporation that is not a bank.
    (A) In general.
    (B) Identified liabilities not properly reflected.
    (iii) Properly reflected on the books of the U.S. trade or business 
of a foreign corporation that is a bank.
    (A) In general.
    (B) Inadvertent error.
    (iv) Liabilities of insurance companies.
    (v) Liabilities used to increase artificially interest expense on 
U.S. booked liabilities.
    (vi) Hedging transactions.
    (vii) Amount of U.S. booked liabilities of a partner.
    (viii) Interbranch transactions.
    (3) Average total amount of U.S. booked liabilities.
    (4) Interest expense where U.S. booked liabilities equal or exceed 
U.S. liabilities.
    (i) In general.
    (ii) Scaling ratio.
    (iii) Special rules for insurance companies.
    (5) U.S.-connected interest rate where U.S. booked liabilities are 
less than U.S.-connected liabilities.
    (i) In general.
    (ii) Interest rate on excess U.S.-connected liabilities.
    (A) General rule.
    (B) Annual published rate election.
    (6) Examples.
    (e) Separate currency pools method.
    (1) General rule.
    (i) Determine the value of U.S. assets in each currency pool.
    (ii) Determine the U.S.-connected liabilities in each currency pool.
    (iii) Determine the interest expense attributable to each currency 
pool.
    (2) Prescribed interest rate.
    (3) Hedging transactions.
    (4) Election not available if excessive hyperinflationary assets.
    (5) Examples.
    (f) Effective date.
    (1) General rule.
    (2) Special rules for financial products.

[T.D. 8658, 61 FR 9329, Mar. 8, 1996; 61 FR 15891, Apr. 10, 1996, as 
amended by T.D. 9281, 71 FR 47448, Aug. 17, 2006; T.D. 9465, 74 FR 
49317, Sept. 28, 2009]



Sec.  1.882-1  Taxation of foreign corporations engaged in U.S. business 
or of foreign corporations treated as having effectively connected income.

    (a) Segregation of income. This section applies for purposes of 
determining the tax of a foreign corporation which at any time during 
the taxable year is engaged in trade or business in the United States. 
It also applies for purposes of determining the tax of a foreign 
corporation which at no time during the taxable year is engaged in trade

[[Page 456]]

or business in the United States but has for the taxable year real 
property income or interest on obligations of the United States which, 
by reason of section 882 (d) or (e) and Sec.  1.882-2, is treated as 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that corporation. A foreign 
corporation to which this section applies must segregate its gross 
income for the taxable year into two categories, namely, the income 
which is effectively connected for the taxable year with the conduct of 
a trade or business in the United States by that corporation and the 
income which is not effectively connected for the taxable year with the 
conduct of a trade or business in the United States by that corporation. 
A separate tax shall then be determined upon each such category of 
income, as provided in paragraph (b) of this section. The determination 
of whether income or gain is or is not effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by the foreign corporation shall be made in accordance with 
section 864(c) and Sec. Sec.  1.864-3 through 1.864-7. For purposes of 
this section income which is effectively connected for the taxable year 
with the conduct of a trade or business in the United States includes 
all income which is treated under section 882 (d) or (e) and Sec.  
1.882-2 as income which is effectively connected for the taxable year 
with the conduct of a trade or business in the United States by the 
foreign corporation.
    (b) Imposition of tax--(1) Income not effectively connected with the 
conduct of a trade or business in the United States. If a foreign 
corporation to which this section applies derives during the taxable 
year from sources within the United States income or gains described in 
section 881(a) and paragraph (b) or (c) of Sec.  1.881-2 which are not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that corporation, such income or 
gains shall be subject to a flat tax of 30 percent of the aggregate 
amount of such items. This tax shall be determined in the manner, and 
subject to the same conditions, set forth in Sec.  1.881-2 as though the 
income or gains were derived by a foreign corporation not engaged in 
trade or business in the United States during the taxable year, except 
that in applying paragraph (c) of such section there shall not be taken 
into account any gains which are taken into account in determining the 
tax under section 882(a)(1) and subparagraph (2) of this paragraph.
    (2) Income effectively connected with the conduct of a trade or 
business in the United States--(i) In general. If a foreign corporation 
to which this section applies derives income or gains which are 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that corporation, the taxable income 
or gains shall, except as provided in Sec.  1.871-12, be taxed in 
accordance with section 11 or, in the alternative, section 1201(a). See 
sections 11(f) and 882(a)(1). Any income of the foreign corporation 
which is not effectively connected for the taxable year with the conduct 
of a trade or business in the United States by that corporation shall 
not be taken into account in determining either the rate or amount of 
such tax.
    (ii) Determination of taxable income. The taxable income for any 
taxable year for purposes of this subparagraph consists only of the 
foreign corporation's taxable income which is effectively connected for 
the taxable year with the conduct of a trade or business in the United 
States by that corporation; and, for this purpose, it is immaterial that 
the trade or business with which that income is effectively connected is 
not the same as the trade or business carried on in the United States by 
that corporation during the taxable year. See example 2 in Sec.  1.864-
4(b). In determining such taxable income all amounts constituting, or 
considered to be, gains or losses for the taxable year from the sale or 
exchange of capital assets shall be taken into account if such gains or 
losses are effectively connected for the taxable year with the conduct 
of a trade or business in the United States by that corporation.
    (iii) Cross references. For rules for determining the gross income 
and deductions for the taxable year, see section

[[Page 457]]

882 (b) and (c)(1) and the regulations thereunder.
    (c) Change in trade or business status. The principles of paragraph 
(c) of Sec.  1.871-8 shall apply to cases where there has been a change 
in the trade or business status of a foreign corporation.
    (d) Credits against tax. The credits allowed by section 32 (relating 
to tax withheld at source on foreign corporations), section 33 (relating 
to the foreign tax credit), section 38 (relating to investment in 
certain depreciable property), section 39 (relating to certain uses of 
gasoline and lubricating oil), section 40 (relating to expenses of work 
incentive programs), and section 6042 (relating to overpayments of a 
tax) shall be allowed against the tax determined in accordance with this 
section. However, the credits allowed by sections 33, 38, and 40 shall 
not be allowed against the flat tax of 30 percent imposed by section 
881(a) and paragraph (b)(1) of this section. For special rules 
applicable in determining the foreign tax credit, see section 906(b) and 
the regulations thereunder. For the disallowance of certain credits 
where a return is not filed for the taxable year see section 882(c)(2) 
and the regulations thereunder.
    (e) Payment of estimated tax. Every foreign corporation which for 
the taxable year is subject to tax under section 11 or 1201(a) and this 
section must make payment of its estimated tax in accordance with 
section 6154 and the regulations thereunder. In determining the amount 
of the estimated tax the foreign corporation must treat the tax imposed 
by section 881(a) and paragraph (b)(1) of this section as though it were 
a tax imposed by section 11.
    (f) Effective date. This section applies for taxable years beginning 
after December 31, 1966. For corresponding rules applicable to taxable 
years beginning before January 1, 1967, see 26 CFR 1.882-1 (Revised as 
of January 1, 1971).

[T.D. 7293, 38 FR 32797, Nov. 28, 1973]



Sec.  1.882-2  Income of foreign corporations treated as effectively 
connected with U.S. business.

    (a) Election as to real property income. A foreign corporation which 
during the taxable year derives any income from real property which is 
located in the United States, or derives income from any interest in any 
such real property, may elect, pursuant to section 882(d) and Sec.  
1.871-10, to treat all such income as income which is effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by that corporation. The election may be made 
whether or not the foreign corporation is engaged in trade or business 
in the United States during the taxable year for which the election is 
made or whether or not the corporation has income from real property 
which for the taxable year is effectively connected with the conduct of 
a trade or business in the United States, but it may be made only with 
respect to income from sources within the United States which, without 
regard to section 882(d) and Sec.  1.871-10, is not effectively 
connected for the taxable year with the conduct of a trade or business 
in the United States by that corporation. The income to which the 
election applies shall be determined as provided in paragraph (b) of 
Sec.  1.871-10 and shall be subject to tax in the manner, and subject to 
the same conditions, provided by section 882(a)(1) and paragraph (b)(2) 
of Sec.  1.882-1. Section 871(d) (2) and (3) and the provisions of Sec.  
1.871-10 thereunder shall apply in respect of an election under section 
882(d) in the same manner and to the same extent as they apply in 
respect of elections under section 871(d).
    (b) Interest on U.S. obligations received by banks organized in 
possessions. Interest received from sources within the United States 
during the taxable year on obligations of the United States by a foreign 
corporation created or organized in, or under the law of, a possession 
of the United States and carrying on the banking business in a 
possession of the United States during the taxable year shall be 
treated, pursuant to section 882(e) and this paragraph, as income which 
is effectively connected for the taxable year with the conduct of a 
trade or business in the United States by that corporation. This 
paragraph applies whether or not the foreign corporation is engaged in 
trade or business in the United States at any time during the taxable 
year but only with

[[Page 458]]

respect to income which, without regard to this paragraph, is not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that corporation. Any interest to 
which this paragraph applies shall be subject to tax in the manner, and 
subject to the same conditions, provided by section 882(a)(1) and 
paragraph (b)(2) of Sec.  1.882-1. To the extent that deductions are 
connected with interest to which this paragraph applies, they shall be 
treated for purposes of section 882(c)(1) and the regulations thereunder 
as connected with income which is effectively connected for the taxable 
year with the conduct of a trade or business in the United States by the 
foreign corporation. An election by the taxpayer is not required in 
respect of the income to which this paragraph applies. For purposes of 
this paragraph the term ``possession of the United States'' includes 
Guam, the Midway Islands, the Panama Canal Zone, the Commonwealth of 
Puerto Rico, American Samoa, the Virgin Islands, and Wake Island.
    (c) Treatment of income. Any income in respect of which an election 
described in paragraph (a) of this section is in effect, and any 
interest to which paragraph (b) of this section applies, shall be 
treated, for purposes of paragraph (b)(2) of Sec.  1.882-1 and paragraph 
(a) of Sec.  1.1441-4, as income which is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by the foreign corporation. A foreign corporation shall not be 
treated as being engaged in trade or business in the United States 
merely by reason of having such income for the taxable year.
    (d) Effective date. This section applies for taxable years beginning 
after December 31, 1966. There are no corresponding rules in this part 
for taxable years beginning before January 1, 1967.

[T.D. 7293, 38 FR 32798, Nov. 28, 1973]



Sec.  1.882-3  Gross income of a foreign corporation.

    (a) In general--(1) Inclusions. The gross income of a foreign 
corporation for any taxable year includes only (i) the gross income 
which is derived from sources within the United States and which is not 
effectively connected for the taxable year with the conduct of a trade 
or business in the United States by that corporation and (ii) the gross 
income, irrespective of whether such income is derived from sources 
within or without the United States, which is effectively connected for 
the taxable year with the conduct of a trade or business in the United 
States by that corporation. For the determination of the sources of 
income, see sections 861 through 863, and the regulations thereunder. 
For the determination of whether income from sources within or without 
the United States is effectively connected for the taxable year with the 
conduct of a trade or business in the United States, see sections 864(c) 
and 882 (d) and (e), Sec. Sec.  1.864-3 through 1.864-7, and Sec.  
1.882-2.
    (2) Exchange transactions. Even though a foreign corporation which 
effects certain transactions in the United States in stocks, securities, 
or commodities during the taxable year may not, by reason of section 
864(b)(2) and paragraph (c) or (d) of Sec.  1.864-2, be engaged in trade 
or business in the United States during the taxable year through the 
effecting of such transactions, nevertheless it shall be required to 
include in gross income for the taxable year the gains and profits from 
those transactions to the extent required by paragraph (c) of Sec.  
1.881-2 or by paragraph (a) of Sec.  1.882-1.
    (3) Exclusions. For exclusions from gross income of a foreign 
corporation, see Sec.  1.883-1.
    (b) Foreign corporations not engaged in U.S. business. In the case 
of a foreign corporation which at no time during the taxable year is 
engaged in trade or business in the United States the gross income shall 
include only (1) the gross income from sources within the United States 
which is described in section 881(a) and paragraphs (b) and (c) of Sec.  
1.881-2, and (2) the gross income from sources within the United States 
which, by reason of section 882 (d) or (e) and Sec.  1.882-2, is treated 
as effectively connected for the taxable year with the conduct of a 
trade or business in the United States by that corporation.
    (c) Foreign corporations engaged in U.S. business. In the case of a 
foreign corporation which is engaged in trade

[[Page 459]]

or business in the United States at any time during the taxable year, 
the gross income shall include (1) the gross income from sources within 
and without the United States which is effectively connected for the 
taxable year with the conduct of a trade or business in the United 
States by that corporation, (2) the gross income from sources within the 
United States which, by reason of section 882 (d) or (e) and Sec.  
1.882-2, is treated as effectively connected for the taxable year with 
the conduct of a trade or business in the United States by that 
corporation, and (3) the gross income from sources within the United 
States which is described in section 881(a) and paragraphs (b) and (c) 
of Sec.  1.881-2 and is not effectively connected for the taxable year 
with the conduct of a trade or business in the United States by that 
corporation.
    (d) Effective date. This section applies for taxable years beginning 
after December 31, 1966. For corresponding rules applicable to taxable 
years beginning before January 1, 1967, see 26 CFR 1.882-2 (Revised as 
of January 1, 1971).

[T.D. 7293, 38 FR 32799, Nov. 28, 1973]



Sec.  1.882-4  Allowance of deductions and credits to foreign corporations.

    (a) Foreign corporations--(1) In general. A foreign corporation that 
is engaged in, or receives income treated as effectively connected with, 
a trade or business within the United States is allowed the deductions 
which are properly allocated and apportioned to the foreign 
corporation's gross income which is effectively connected, or treated as 
effectively connected, with its conduct of a trade or business within 
the United States. The foreign corporation is entitled to credits which 
are attributable to that effectively connected income. No provision of 
this section (other than paragraph (b)(2)) shall be construed to deny 
the credits provided by sections 33, 34 and 852(b)(3)(D)(ii) or the 
deduction allowed by section 170.
    (2) Return necessary. A foreign corporation shall receive the 
benefit of the deductions and credits otherwise allowed to it with 
respect to the income tax, only if it timely files or causes to be filed 
with the Philadelphia Service Center, in the manner prescribed in 
subtitle F, a true and accurate return of its taxable income which is 
effectively connected, or treated as effectively connected, for the 
taxable year with the conduct of a trade or business in the United 
States by that corporation. The deductions and credits allowed such a 
corporation electing under a tax convention to be subject to tax on a 
net basis may be obtained by filing a return of income in the manner 
prescribed in the regulations (if any) under the tax convention or under 
any other guidance issued by the Commissioner.
    (3) Filing deadline for return. (i) As provided in paragraph (a)(2) 
of this section, for purposes of computing the foreign corporation's 
taxable income for any taxable year, otherwise allowable deductions 
(other than that allowed by section 170) and credits (other than those 
allowed by sections 33, 34 and 852(b)(3)(D)(ii)) will be allowed only if 
a return for that taxable year is filed by the foreign corporation on a 
timely basis. For taxable years of a foreign corporation ending after 
July 31, 1990, whether a return for the current taxable year has been 
filed on a timely basis is dependent upon whether the foreign 
corporation filed a return for the taxable year immediately preceding 
the current taxable year. If a return was filed for that immediately 
preceding taxable year, or if the current taxable year is the first 
taxable year of the foreign corporation for which a return is required 
to be filed, the required return for the current taxable year must be 
filed within 18 months of the due date as set forth in section 6072 and 
the regulations under that section, for filing the return for the 
current taxable year. If no return for the taxable year immediately 
preceding the current taxable year has been filed, the required return 
for the current taxable year (other than the first taxable year of the 
foreign corporation for which a return is required to be filed) must 
have been filed no later than the earlier of the date which is 18 months 
after the due date, as set forth in section 6072, for filing the return 
for the current taxable year or the date the Internal Revenue Service 
mails a notice to the foreign corporation advising the corporation that 
the

[[Page 460]]

current year tax return has not been filed and that no deductions (other 
than that allowed under section 170) or credits (other than those 
allowed under sections 33, 34 and 852(b)(3)(D)(ii)) may be claimed by 
the taxpayer.
    (ii) The filing deadlines set forth in paragraph (a)(3)(i) of this 
section may be waived if the foreign corporation establishes to the 
satisfaction of the Commissioner or his or her delegate that the 
corporation, based on the facts and circumstances, acted reasonably and 
in good faith in failing to file a U.S. income tax return (including a 
protective return (as described in paragraph (a)(3)(vi) of this 
section)). For this purpose, a foreign corporation shall not be 
considered to have acted reasonably and in good faith if it knew that it 
was required to file the return and chose not to do so. In addition, a 
foreign corporation shall not be granted a waiver unless it cooperates 
in the process of determining its income tax liability for the taxable 
year for which the return was not filed. The Commissioner or his or her 
delegate shall consider the following factors in determining whether the 
foreign corporation, based on the facts and circumstances, acted 
reasonably and in good faith in failing to file a U.S. income tax 
return--
    (A) Whether the corporation voluntarily identifies itself to the 
Internal Revenue Service as having failed to file a U.S. income tax 
return before the Internal Revenue Service discovers the failure to 
file;
    (B) Whether the corporation did not become aware of its ability to 
file a protective return (as described in paragraph (a)(3)(vi) of this 
section) by the deadline for filing a protective return;
    (C) Whether the corporation had not previously filed a U.S. income 
tax return;
    (D) Whether the corporation failed to file a U.S. income tax return 
because, after exercising reasonable diligence (taking into account its 
relevant experience and level of sophistication), the corporation was 
unaware of the necessity for filing the return;
    (E) Whether the corporation failed to file a U.S. income tax return 
because of intervening events beyond its control; and
    (F) Whether other mitigating or exacerbating factors existed.
    (iii) The following examples illustrate the provisions of this 
section. In all examples, FC is a foreign corporation and uses the 
calendar year as its taxable year. The examples are as follows:

    Example 1. Foreign corporation discloses own failure to file. In 
Year 1, FC became a limited partner with a passive investment in a U.S. 
limited partnership that was engaged in a U.S. trade or business. During 
Year 1 through Year 4, FC incurred losses with respect to its U.S. 
partnership interest. FC's foreign tax director incorrectly concluded 
that because it was a limited partner and had only losses from its 
partnership interest, FC was not required to file a U.S. income tax 
return. FC's management was aware neither of FC's obligation to file a 
U.S. income tax return for those years, nor of its ability to file a 
protective return for those years. FC had never filed a U.S. income tax 
return before. In Year 5, FC began realizing a profit rather than a loss 
with respect to its partnership interest and, for this reason, engaged a 
U.S. tax advisor to handle its responsibility to file U.S. income tax 
returns. In preparing FC's income tax return for Year 5, FC's U.S. tax 
advisor discovered that returns were not filed for Year 1 through Year 
4. Therefore, with respect to those years for which applicable filing 
deadlines in paragraph (a)(3)(i) of this section were not met, FC would 
be barred by paragraph (a)(2) of this section from claiming any 
deductions that otherwise would have given rise to net operating losses 
on returns for those years, and that would have been available as loss 
carryforwards in subsequent years. At FC's direction, its U.S. tax 
advisor promptly contacted the appropriate examining personnel and 
cooperated with the Internal Revenue Service in determining FC's income 
tax liability, for example, by preparing and filing the appropriate 
income tax returns for Year 1 through Year 4 and by making FC's books 
and records available to an Internal Revenue Service examiner. FC has 
met the standard described in paragraph (a)(3)(ii) of this section for 
waiver of any applicable filing deadlines in paragraph (a)(3)(i) of this 
section.
    Example 2. Foreign corporation refuses to cooperate. Same facts as 
in Example 1, except that while FC's U.S. tax advisor contacted the 
appropriate examining personnel and filed the appropriate income tax 
returns for Year 1 through Year 4, FC refused all requests by the 
Internal Revenue Service to provide supporting information (for example, 
books and records) with respect to those returns. Because FC did not 
cooperate in determining its U.S. tax liability for the taxable years 
for which an income tax return was

[[Page 461]]

not timely filed, FC is not granted a waiver as described in paragraph 
(a)(3)(ii) of this section of any applicable filing deadlines in 
paragraph (a)(3)(i) of this section.
    Example 3. Foreign corporation fails to file a protective return. 
Same facts as in Example 1, except that in Year 1 through Year 4, FC's 
tax director also consulted a U.S. tax advisor, who advised FC's tax 
director that it was uncertain whether U.S. income tax returns were 
necessary for those years and that FC could protect its right 
subsequently to claim the loss carryforwards by filing protective 
returns under paragraph (a)(3)(vi) of this section. FC did not file U.S. 
income tax returns or protective returns for those years. FC did not 
present evidence that intervening events beyond FC's control prevented 
it from filing an income tax return, and there were no other mitigating 
factors. FC has not met the standard described in paragraph (a)(3)(ii) 
of this section for waiver of any applicable filing deadlines in 
paragraph (a)(3)(i) of this section.
    Example 4. Foreign corporation with effectively connected income. In 
Year 1, FC, a technology company, opened an office in the United States 
to market and sell a software program that FC had developed outside the 
United States. FC had minimal business or tax experience 
internationally, and no such experience in the United States. Through 
FC's direct efforts, U.S. sales of the software produced income 
effectively connected with a U.S. trade or business. FC, however, did 
not file U.S. income tax returns for Year 1 or Year 2. FC's management 
was aware neither of FC's obligation to file a U.S. income tax return 
for those years, nor of its ability to file a protective return for 
those years. FC had never filed a U.S. income tax return before. In 
January of Year 4, FC engaged U.S. counsel in connection with licensing 
software to an unrelated U.S. company. U.S. counsel reviewed FC's U.S. 
activities and advised FC that it should have filed U.S. income tax 
returns for Year 1 and Year 2. FC immediately engaged a U.S. tax advisor 
who, at FC's direction, promptly contacted the appropriate examining 
personnel and cooperated with the Internal Revenue Service in 
determining FC's income tax liability, for example, by preparing and 
filing the appropriate income tax returns for Year 1 and Year 2 and by 
making FC's books and records available to an Internal Revenue Service 
examiner. FC has met the standard described in paragraph (a)(3)(ii) of 
this section for waiver of any applicable filing deadlines in paragraph 
(a)(3)(i) of this section.
    Example 5. IRS discovers foreign corporation's failure to file. In 
Year 1, FC, a technology company, opened an office in the United States 
to market and sell a software program that FC had developed outside the 
United States. Through FC's direct efforts, U.S. sales of the software 
produced income effectively connected with a U.S. trade or business. FC 
had extensive experience conducting similar business activities in other 
countries, including making the appropriate tax filings. However, FC's 
management was aware neither of FC's obligation to file a U.S. income 
tax return for those years, nor of its ability to file a protective 
return for those years. FC had never filed a U.S. income tax return 
before. Despite FC's extensive experience conducting similar business 
activities in other countries, it made no effort to seek advice in 
connection with its U.S. tax obligations. FC failed to file either U.S. 
income tax returns or protective returns for Year 1 and Year 2. In 
January of Year 4, an Internal Revenue Service examiner asked FC for an 
explanation of FC's failure to file U.S. income tax returns. FC 
immediately engaged a U.S. tax advisor, and cooperated with the Internal 
Revenue Service in determining FC's income tax liability, for example, 
by preparing and filing the appropriate income tax returns for Year 1 
and Year 2 and by making FC's books and records available to the 
examiner. FC did not present evidence that intervening events beyond its 
control prevented it from filing a return, and there were no other 
mitigating factors. FC has not met the standard described in paragraph 
(a)(3)(ii) of this section for waiver of any applicable filing deadlines 
in paragraph (a)(3)(i) of this section.
    Example 6. Foreign corporation with prior filing history. FC began a 
U.S. trade or business in Year 1. FC's tax advisor filed the appropriate 
U.S. income tax returns for Year 1 through Year 6, reporting income 
effectively connected with FC's U.S. trade or business. In Year 7, FC 
replaced its tax advisor with a tax advisor unfamiliar with U.S. tax 
law. FC did not file a U.S. income tax return for any year from Year 7 
through Year 10, although it had effectively connected income for those 
years. FC's management was aware of FC's ability to file a protective 
return for those years. In Year 11, an Internal Revenue Service examiner 
contacted FC and asked its chief financial officer for an explanation of 
FC's failure to file U.S. income tax returns after Year 6. FC 
immediately engaged a U.S. tax advisor and cooperated with the Internal 
Revenue Service in determining FC's income tax liability, for example, 
by preparing and filing the appropriate income tax returns for Year 7 
through Year 10 and by making FC's books and records available to the 
examiner. FC did not present evidence that intervening events beyond its 
control prevented it from filing a return, and there were no other 
mitigating factors. FC has not met the standard described in paragraph 
(a)(3)(ii) of this section for waiver of any applicable filing deadlines 
in paragraph (a)(3)(i) of this section.

    (iv) Paragraphs (a)(3)(ii) and (iii) of this section are applicable 
to open

[[Page 462]]

years for which a request for a waiver is filed on or after January 29, 
2002.
    (v) A foreign corporation which has a permanent establishment, as 
defined in an income tax treaty between the United States and the 
foreign corporation's country of residence, in the United States is 
subject to the filing deadlines set forth in paragraph (a)(3)(i) of this 
section.
    (vi) If a foreign corporation conducts limited activities in the 
United States in a taxable year which the foreign corporation determines 
does not give rise to gross income which is effectively connected with 
the conduct of a trade or business within the United States as defined 
in sections 882(b) and 864 (b) and (c) and the regulations under those 
sections, the foreign corporation may nonetheless file a return for that 
taxable year on a timely basis under paragraph (a)(3)(i) of this section 
and thereby protect the right to receive the benefit of the deductions 
and credits attributable to that gross income if it is later determined, 
after the return was filed, that the original determination was 
incorrect. On that timely filed return, the foreign corporation is not 
required to report any gross income as effectively connected with a 
United States trade or business or any deductions or credits but should 
attach a statement indicating that the return is being filed for the 
reason set forth in this paragraph (a)(3). If the foreign corporation 
determines that part of the activities which it conducts in the United 
States in a taxable year gives rise to gross income which is effectively 
connected with the conduct of a trade or business and part does not, the 
foreign corporation must timely file a return for that taxable year to 
report the gross income determined to be effectively connected, or 
treated as effectively connected, with the conduct of the trade or 
business within the United States and the deductions and credits 
attributable to the gross income. In addition, the foreign corporation 
should attach to that return the statement described in this paragraph 
(b)(3) with regard to the other activities. The foreign corporation may 
follow the same procedure if it determines initially that it has no 
United States tax liability under the provisions of an applicable income 
tax treaty. In the event the foreign corporation relies on the 
provisions of an income tax treaty to reduce or eliminate the income 
subject to taxation, or to reduce the rate of tax, disclosure may be 
required pursuant to section 6114.
    (vii) In order to be eligible for any deductions and credits for 
purposes of computing the accumulated earnings tax of section 531, a 
foreign corporation must file a true and accurate return; on a timely 
basis, in the manner as set forth in paragraph (a) (2) and (3) of this 
section.
    (4) Return by Internal Revenue Service. If a foreign corporation has 
various sources of income within the United States and a return of 
income has not been filed, in the manner prescribed by subtitle F, 
including the filing deadlines set forth in paragraph (a)(3) of this 
section, the Internal Revenue Service shall:
    (i) Cause a return of income to be made,
    (ii) Include on the return the income described in Sec.  1.882-1 of 
that corporation from all sources concerning which it has information, 
and
    (iii) Assess the tax and collect it from one or more of those 
sources of income within the United States, without allowance for any 
deductions (other than that allowed by section 170) or credits (other 
than those allowed by sections 33, 34 and 852(b)(3)(D)(ii)).
    If the income of the corporation is not effectively connected with, 
or if the corporation did not receive income that is treated as being 
effectively connected with, the conduct of a United States trade or 
business, the tax will be assessed under Sec.  1.882-1(b)(1) on a gross 
basis, without allowance for any deduction (other than that allowed by 
section 170) or credit (other than the credits allowed by sections 33, 
34 and 852(b)(3)(D)(ii)). If the income is effectively connected, or 
treated as effectively connected, with the conduct of a United States 
trade on business, tax will be assessed in accordance with either 
section 11, 55 or 1201(a) without allowance for any deduction (other 
than that allowed by section 170) or credit (other than the credits 
allowed by sections 33, 34 and 852(b)(3)(D)(ii)).

[[Page 463]]

    (b) Allowed deductions and credits--(1) In general. Except for the 
deduction allowed under section 170 for charitable contributions and 
gifts (see section 882(c)(1)(B)), deductions are allowed to a foreign 
corporation only to the extent they are connected with gross income 
which is effectively connected, or treated as effectively connected, 
with the conduct of a trade or business in the United States. Deductible 
expenses (other than interest expense) are properly allocated and 
apportioned to effectively connected gross income in accordance with the 
rules of Sec.  1.861-8. For the method of determining the interest 
deduction allowed to a foreign corporation, see Sec.  1.882-5. Other 
than the credits allowed by sections 33, 34 and 852(b)(3)(D)(ii), the 
foreign corporation is entitled to credits only if they are attributable 
to effectively connected income. See paragraph (a)(2) of this section 
for the requirement that a return be filed. Except as provided by 
section 906, a foreign corporation shall not be allowed the credit 
against the tax for taxes of foreign countries and possessions of the 
United States allowed by section 901.
    (2) Verification. At the request of the Internal Revenue Service, a 
foreign corporation claiming deductions from gross income which is 
effectively connected, or treated as effectively connected, with the 
conduct of a trade or business in the United States or credits which are 
attributable to that income must furnish at the place designated 
pursuant to Sec.  301.7605-1(a) information sufficient to establish that 
the corporation is entitled to the deductions and credits in the amounts 
claimed. All information must be furnished in a form suitable to permit 
verification of claimed deductions and credits. The Internal Revenue 
Service may require, as appropriate, that an English translation be 
provided with any information in a foreign language. If a foreign 
corporation fails to furnish sufficient information, the Internal 
Revenue Service may in its discretion disallow any claimed deductions 
and credits in full or in part. For additional filing requirements and 
for penalties for failure to provide information, see also section 
6038A.

[T.D. 8322, 55 FR 50830, Dec. 11, 1990, as amended by T.D. 8981, 67 FR 
4175, Jan. 29, 2002; T.D. 9043, 68 FR 11314, Mar. 10, 2003]



Sec.  1.882-5  Determination of interest deduction.

    (a)(1) Overview--(i) In general. The amount of interest expense of a 
foreign corporation that is allocable under section 882(c) to income 
which is (or is treated as) effectively connected with the conduct of a 
trade or business within the United States (ECI) is the sum of the 
interest allocable by the foreign corporation under the three-step 
process set forth in paragraphs (b), (c), and (d) of this section and 
the specially allocated interest expense determined under paragraph 
(a)(1)(ii) of this section. The provisions of this section provide the 
exclusive rules for allocating interest expense to the ECI of a foreign 
corporation under section 882(c). Under the three-step process, the 
total value of the U.S. assets of a foreign corporation is first 
determined under paragraph (b) of this section (Step 1). Next, the 
amount of U.S.-connected liabilities is determined under paragraph (c) 
of this section (Step 2). Finally, the amount of interest paid or 
accrued on U.S.-booked liabilities, as determined under paragraph (d)(2) 
of this section, is adjusted for interest expense attributable to the 
difference between U.S.-connected liabilities and U.S.-booked 
liabilities (Step 3). Alternatively, a foreign corporation may elect to 
determine its interest rate on U.S.-connected liabilities by reference 
to its U.S. assets, using the separate currency pools method described 
in paragraph (e) of this section.
    (ii) Direct allocations--(A) In general. A foreign corporation that 
has a U.S. asset and indebtedness that meet the requirements of Sec.  
1.861-10T (b) or (c), as limited by Sec.  1.861-10T(d)(1), shall 
directly allocate interest expense from such indebtedness to income from 
such asset in the manner and to the extent provided in Sec.  1.861-10T. 
For purposes of paragraph (b)(1) or (c)(2) of this section, a foreign 
corporation that allocates its interest expense under the direct 
allocation rule of this paragraph (a)(1)(ii)(A) shall reduce the basis 
of

[[Page 464]]

the asset that meets the requirements of Sec.  1.861-10T (b) or (c) by 
the principal amount of the indebtedness that meets the requirements of 
Sec.  1.861- 10T (b) or (c). The foreign corporation shall also 
disregard any indebtedness that meets the requirements of Sec.  1.861-
10T (b) or (c) in determining the amount of the foreign corporation's 
liabilities under paragraphs (c)(2) and (d)(2) of this section and shall 
not take into account any interest expense paid or accrued with respect 
to such a liability for purposes of paragraph (d) or (e) of this 
section.
    (B) Partnership interest. A foreign corporation that is a partner in 
a partnership that has a U.S. asset and indebtedness that meet the 
requirements of Sec.  1.861-10T (b) or (c), as limited by Sec.  1.861-
10T(d)(1), shall directly allocate its distributive share of interest 
expense from that indebtedness to its distributive share of income from 
that asset in the manner and to the extent provided in Sec.  1.861-10T. 
A foreign corporation that allocates its distributive share of interest 
expense under the direct allocation rule of this paragraph (a)(1)(ii)(B) 
shall disregard any partnership indebtedness that meets the requirements 
of Sec.  1.861-10T (b) or (c) in determining the amount of its 
distributive share of partnership liabilities for purposes of paragraphs 
(b)(1), (c)(2)(vi), and (d)(2)(vii) or (e)(1)(ii) of this section, and 
shall not take into account any partnership interest expense paid or 
accrued with respect to such a liability for purposes of paragraph (d) 
or (e) of this section. For purposes of paragraph (b)(1) of this 
section, a foreign corporation that directly allocates its distributive 
share of interest expense under this paragraph (a)(1)(ii)(B) shall--
    (1) Reduce the partnership's basis in such asset by the amount of 
such indebtedness in allocating its basis in the partnership under Sec.  
1.884-1(d)(3)(ii); or
    (2) Reduce the partnership's income from such asset by the 
partnership's interest expense from such indebtedness under Sec.  1.884-
1(d)(3)(iii).
    (2) Coordination with tax treaties. Except as expressly provided by 
or pursuant to a U.S. income tax treaty or accompanying documents (such 
as an exchange of notes), the provisions of this section provide the 
exclusive rules for determining the interest expense attributable to the 
business profits of a permanent establishment under a U.S. income tax 
treaty.
    (3) Limitation on interest expense. In no event may the amount of 
interest expense computed under this section exceed the amount of 
interest on indebtedness paid or accrued by the taxpayer within the 
taxable year (translated into U.S. dollars at the weighted average 
exchange rate for each currency prescribed by Sec.  1.989(b)-1 for the 
taxable year).
    (4) Translation convention for foreign currency. For each 
computation required by this section, the taxpayer shall translate 
values and amounts into the relevant currency at a spot rate or a 
weighted average exchange rate consistent with the method such taxpayer 
uses for financial reporting purposes, provided such method is applied 
consistently from year to year. Interest expense paid or accrued, 
however, shall be translated under the rules of Sec.  1.988-2. The 
director of field operations or the Assistant Commissioner 
(International) may require that any or all computations required by 
this section be made in U.S. dollars if the functional currency of the 
taxpayer's home office is a hyperinflationary currency, as defined in 
Sec.  1.985-1, and the computation in U.S. dollars is necessary to 
prevent distortions.
    (5) Coordination with other sections. Any provision that disallows, 
defers, or capitalizes interest expense applies after determining the 
amount of interest expense allocated to ECI under this section. For 
example, in determining the amount of interest expense that is 
disallowed as a deduction under section 265 or 163(j), deferred under 
section 163(e)(3) or 267(a)(3), or capitalized under section 263A with 
respect to a United States trade or business, a taxpayer takes into 
account only the amount of interest expense allocable to ECI under this 
section.
    (6) Special rule for foreign governments. The amount of interest 
expense of a foreign government, as defined in Sec.  1.892-2T(a), that 
is allocable to ECI is the total amount of interest paid or accrued 
within the taxable year by the

[[Page 465]]

United States trade or business on U.S. booked liabilities (as defined 
in paragraph (d)(2) of this section). Interest expense of a foreign 
government, however, is not allocable to ECI to the extent that it is 
incurred with respect to U.S. booked liabilities that exceed 80 percent 
of the total value of U.S. assets for the taxable year (determined under 
paragraph (b) of this section). This paragraph (a)(6) does not apply to 
controlled commercial entities within the meaning of Sec.  1.892-5T.
    (7) Elections under Sec.  1.882-5--(i) In general. A corporation 
must make each election provided in this section on the corporation's 
original timely filed Federal income tax return for the first taxable 
year it is subject to the rules of this section. An amended return does 
not qualify for this purpose, nor shall the provisions of Sec.  
301.9100-1 of this chapter and any guidance promulgated thereunder 
apply. Except as provided elsewhere in this section, each election under 
this section, whether an election for the first taxable year or a 
subsequent change of election, shall be made by indicating the method 
used on Schedule I (Form 1120-F) attached to the corporation's timely 
filed return. An elected method (other than the fair market value method 
under paragraph (b)(2)(ii) of this section, or the annual 30-day London 
Interbank Offered Rate (LIBOR) election in paragraph (d)(5)(ii) of this 
section) must be used for a minimum period of five years before the 
taxpayer may elect a different method. To change an election before the 
end of the requisite five-year period, a taxpayer must obtain the 
consent of the Commissioner or his delegate. The Commissioner or his 
delegate will generally consent to a taxpayer's request to change its 
election only in rare and unusual circumstances. After the five-year 
minimum period, an elected method may be changed for any subsequent year 
on the foreign corporation's original timely filed tax return for the 
first year to which the changed election applies.
    (ii) Failure to make the proper election. If a taxpayer, for any 
reason, fails to make an election provided in this section in a timely 
fashion, the Director of Field Operations may make any or all of the 
elections provided in this section on behalf of the taxpayer, and such 
elections shall be binding as if made by the taxpayer.
    (iii) Step 2 special election for banks. For the first taxable year 
for which an original income tax return is due (including extensions) 
after August 17, 2006, in which a taxpayer that is a bank as described 
in paragraph (c)(4) of this section is subject to the requirements of 
this section, a taxpayer may make a new election to use the fixed ratio 
on an original timely filed return. A new fixed ratio election may be 
made in any subsequent year subject to the timely filing and five-year 
minimum period requirements of paragraph (a)(7)(i) of this section. A 
new fixed ratio election under this paragraph (a)(7)(iii) is subject to 
the adjusted basis or fair market value conforming election requirements 
of paragraph (b)(2)(ii)(A)(2) of this section and may not be made if a 
taxpayer elects or maintains a fair market value election for purposes 
of paragraph (b) of this section. Taxpayers that already use the fixed 
ratio method under an existing election may continue to use the new 
fixed ratio at the higher percentage without having to make a new five-
year election in the first year that the higher percentage is effective.
    (8) Examples. The following examples illustrate the application of 
paragraph (a) of this section:

    Example 1. Direct allocations. (i) Facts: FC is a foreign 
corporation that conducts business through a branch, B, in the United 
States. Among B's U.S. assets is an interest in a partnership, P, that 
is engaged in airplane leasing solely in the U.S. FC contributes 200 x 
to P in exchange for its partnership interest. P incurs qualified 
nonrecourse indebtedness within the meaning of Sec.  1.861-10T to 
purchase an airplane. FC's share of the liability of P, as determined 
under section 752, is 800 x .
    (ii) Analysis: Pursuant to paragraph (a)(1)(ii)(B) of this section, 
FC is permitted to directly allocate its distributive share of the 
interest incurred with respect to the qualified nonrecourse indebtedness 
to FC's distributive share of the rental income generated by the 
airplane. A liability the interest on which is allocated directly to the 
income from a particular asset under paragraph (a)(1)(ii)(B) of this 
section is disregarded for purposes of paragraphs (b)(1), (c)(2)(vi), 
and (d)(2)(vii) or (e)(1)(ii) of this

[[Page 466]]

section. Consequently, for purposes of determining the value of FC's 
assets under paragraphs (b)(1) and (c)(2)(vi) of this section, FC's 
basis in P is reduced by the 800 x liability as determined under section 
752, but is not increased by the 800 x liability that is directly 
allocated under paragraph (a)(1)(ii)(B) of this section. Similarly, 
pursuant to paragraph (a)(1)(ii)(B) of this section, the 800 x liability 
is disregarded for purposes of determining FC's liabilities under 
paragraphs (c)(2)(vi) and (d)(2)(vii) of this section.
    Example 2. Limitation on interest expense. (i) FC is a foreign 
corporation that conducts a real estate business in the United States. 
In its 1997 tax year, FC has no outstanding indebtedness, and therefore 
incurs no interest expense. FC elects to use the 50% fixed ratio under 
paragraph (c)(4) of this section.
    (ii) Under paragraph (a)(3) of this section, FC is not allowed to 
deduct any interest expense that exceeds the amount of interest on 
indebtedness paid or accrued in that taxable year. Since FC incurred no 
interest expense in taxable year 1997, FC will not be entitled to any 
interest deduction for that year under Sec.  1.882-5, notwithstanding 
the fact that FC has elected to use the 50% fixed ratio.
    Example 3. Coordination with other sections. (i) FC is a foreign 
corporation that is a bank under section 585(a)(2) and a financial 
institution under section 265(b)(5). FC is a calendar year taxpayer, and 
operates a U.S. branch, B. Throughout its taxable year 1997, B holds 
only two assets that are U.S. assets within the meaning of paragraph 
(b)(1) of this section. FC does not make a fair-market value election 
under paragraph (b)(2)(ii) of this section, and, therefore, values its 
U.S. assets according to their bases under paragraph (b)(2)(i) of this 
section. The first asset is a taxable security with an adjusted basis of 
$100. The second asset is an obligation the interest on which is exempt 
from federal taxation under section 103, with an adjusted basis of $50. 
The tax-exempt obligation is not a qualified tax-exempt obligation as 
defined by section 265(b)(3)(B).
    (ii) FC calculates its interest expense under Sec.  1.882-5 to be 
$12. Under paragraph (a)(5) of this section, however, a portion of the 
interest expense that is allocated to FC's effectively connected income 
under Sec.  1.882-5 is disallowed in accordance with the provisions of 
section 265(b). Using the methodology prescribed under section 265, the 
amount of disallowed interest expense is $4, calculated as follows:
[GRAPHIC] [TIFF OMITTED] TR08MR96.000

    (iii) Therefore, FC deducts a total of $8 ($12-$4) of interest 
expense attributable to its effectively connected income in 1997.
    Example 4. Treaty exempt asset. (i) FC is a foreign corporation, 
resident in Country X, that is actively engaged in the banking business 
in the United States through a permanent establishment, B. The income 
tax treaty in effect between Country X and the United States provides 
that FC is not taxable on foreign source income earned by its U.S. 
permanent establishment. In its 1997 tax year, B earns $90 of U.S. 
source income from U.S. assets with an adjusted tax basis of $900, and 
$12 of foreign source interest income from U.S. assets with an adjusted 
tax basis of $100. FC's U.S. interest expense deduction, computed in 
accordance with Sec.  1.882-5, is $500.
    (ii) Under paragraph (a)(5) of this section, FC is required to apply 
any provision that disallows, defers, or capitalizes interest expense 
after determining the interest expense allocated to ECI under Sec.  
1.882-5. Section 265(a)(2) disallows interest expense that is allocable 
to one or more classes of income that are wholly exempt from taxation 
under subtitle A of the Internal Revenue Code. Section 1.265-1(b) 
provides that income wholly exempt from taxes includes both income 
excluded from tax under any provision of subtitle A and income wholly 
exempt from taxes under any other law. Section 894 specifies that the 
provisions of subtitle A are applied with due regard to any relevant 
treaty obligation of the United States. Because the treaty between the 
United States and Country X exempts foreign source income earned by B 
from U.S. tax, FC has assets that produce income wholly exempt from 
taxes under subtitle A, and must therefore allocate a portion of its 
Sec.  1.882-5 interest expense to its exempt income. Using the 
methodology prescribed under section 265, the amount of disallowed 
interest expense is $50, calculated as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.029

    (iii) Therefore, FC deducts a total of $450 ($500-$50) of interest 
expense attributable to its effectively connected income in 1997.

    (b) Step 1: Determination of total value of U.S. assets for the 
taxable year--(1) Classification of an asset as a U.S. asset--

[[Page 467]]

(i) General rule. Except as otherwise provided in this paragraph (b)(1), 
an asset is a U.S. asset for purposes of this section to the extent that 
it is a U.S. asset under Sec.  1.884-1(d). For purposes of this section, 
the term determination date, as used in Sec.  1.884-1(d), means each day 
for which the total value of U.S. assets is computed under paragraph 
(b)(3) of this section.
    (ii) Items excluded from the definition of U.S. asset. For purposes 
of this section, the term U.S. asset excludes an asset to the extent it 
produces income or gain described in sections 883 (a)(3) and (b).
    (iii) Items included in the definition of U.S. asset. For purposes 
of this section, the term U.S. asset includes--
    (A) U.S. real property held in a wholly-owned domestic subsidiary of 
a foreign corporation that qualifies as a bank under section 
585(a)(2)(B) (without regard to the second sentence thereof), provided 
that the real property would qualify as used in the foreign 
corporation's trade or business within the meaning of Sec.  1.864-4(c) 
(2) or (3) if held directly by the foreign corporation and either was 
initially acquired through foreclosure or similar proceedings or is U.S. 
real property occupied by the foreign corporation (the value of which 
shall be adjusted by the amount of any indebtedness that is reflected in 
the value of the property);
    (B) An asset that produces income treated as ECI under section 
921(d) or 926(b) (relating to certain income of a FSC and certain 
dividends paid by a FSC to a foreign corporation);
    (C) An asset that produces income treated as ECI under section 
953(c)(3)(C) (relating to certain income of a captive insurance company 
that a corporation elects to treat as ECI) that is not otherwise ECI; 
and
    (D) An asset that produces income treated as ECI under section 
882(e) (relating to certain interest income of possessions banks).
    (iv) Interbranch transactions. A transaction of any type between 
separate offices or branches of the same taxpayer does not create a U.S. 
asset.
    (v) Assets acquired to increase U.S. assets artificially. An asset 
shall not be treated as a U.S. asset if one of the principal purposes 
for acquiring or using that asset is to increase artificially the U.S. 
assets of a foreign corporation on the determination date. Whether an 
asset is acquired or used for such purpose will depend upon all the 
facts and circumstances of each case. Factors to be considered in 
determining whether one of the principal purposes in acquiring or using 
an asset is to increase artificially the U.S. assets of a foreign 
corporation include the length of time during which the asset was used 
in a U.S. trade or business, whether the asset was acquired from a 
related person, and whether the aggregate value of the U.S. assets of 
the foreign corporation increased temporarily on or around the 
determination date. A purpose may be a principal purpose even though it 
is outweighed by other purposes (taken together or separately).
    (2) Determination of the value of a U.S. asset--(i) General rule. 
The value of a U.S. asset is the adjusted basis of the asset for 
determining gain or loss from the sale or other disposition of that 
item, further adjusted as provided in paragraph (b)(2)(iii) of this 
section.
    (ii) Fair-market value election--
    (A) In general--(1) Fair market value conformity requirement. A 
taxpayer may elect to value all of its U.S. assets on the basis of fair 
market value, subject to the requirements of Sec.  1.861-9T(g)(1)(iii), 
and provided the taxpayer is eligible and uses the actual ratio method 
under paragraph (c)(2) of this section and the methodology prescribed in 
Sec.  1.861-9T(h). Once elected, the fair market value must be used by 
the taxpayer for both Step 1 and Step 2 described in paragraphs (b) and 
(c) of this section, and must be used in all subsequent taxable years 
unless the Commissioner or his delegate consents to a change.
    (2) Conforming election requirement. Taxpayers that as of the 
effective date of this paragraph (b)(2)(ii)(A)(2) have elected and 
currently use both the fair market value method for purposes of 
paragraph (b) of this section and a fixed ratio for purposes of 
paragraph (c)(4) of this section must conform either the adjusted basis 
or fair market value methods in Step 1 and Step 2 of the allocation 
formula by making an adjusted basis election for paragraph

[[Page 468]]

(b) of this section purposes while continuing the fixed ratio for Step 
2, or by making an actual ratio election under paragraph (c)(2) of this 
section while remaining on the fair market value method under paragraph 
(b) of this section. Taxpayers who elect to conform Step 1 and Step 2 of 
the formula to the adjusted basis method must remain on both methods for 
the minimum five-year period in accordance with the provisions of 
paragraph (a)(7) of this section. Taxpayers that elect to conform Step 1 
and Step 2 of the formula to the fair market value method must remain on 
the actual ratio method until the consent of the Commissioner or his 
delegate is obtained to switch to the adjusted basis method. If consent 
to use the adjusted basis method in Step 1 is granted in a later year, 
the taxpayer must remain on the actual ratio method for the minimum 
five-year period unless consent to use the fixed ratio is independently 
obtained under the requirements of paragraph (a)(7) of this section. For 
the first taxable year for which an original income tax return is due 
(including extensions) after August 17, 2006, taxpayers that are 
required to make a conforming election under this paragraph 
(b)(2)(ii)(A)(2), may do so on an original timely filed return. If a 
conforming election is not made within the timeframe provided in this 
paragraph, the Director of Field Operations or his delegate may make the 
conforming elections in accordance with the provisions of paragraph 
(a)(7)(ii) of this section.
    (B) Adjustment to partnership basis. If a partner makes a fair 
market value election under paragraph (b)(2)(ii) of this section, the 
value of the partner's interest in a partnership that is treated as an 
asset shall be the fair market value of his partnership interest, 
increased by the fair market value of the partner's share of the 
liabilities determined under paragraph (c)(2)(vi) of this section. See 
Sec.  1.884-1(d)(3).
    (iii) Reduction of total value of U.S. assets by amount of bad debt 
reserves under section 585--(A) In general. The total value of loans 
that qualify as U.S. assets shall be reduced by the amount of any 
reserve for bad debts additions to which are allowed as deductions under 
section 585.
    (B) Example. The following example illustrates the provisions of 
paragraph (b)(2)(iii)(A) of this section:

    Example. Foreign banks; bad debt reserves. FC is a foreign 
corporation that qualifies as a bank under section 585(a)(2)(B) (without 
regard to the second sentence thereof), but is not a large bank as 
defined in section 585(c)(2). FC conducts business through a branch, B, 
in the United States. Among B's U.S. assets are a portfolio of loans 
with an adjusted basis of $500. FC accounts for its bad debts for U.S. 
federal income tax purposes under the reserve method, and B maintains a 
deductible reserve for bad debts of $50. Under paragraph (b)(2)(iii) of 
this section, the total value of FC's portfolio of loans is $450 ($500-
$50).

    (3) Computation of total value of U.S. assets--(i) General rule. The 
total value of U.S. assets for the taxable year is the average of the 
sums of the values (determined under paragraph (b)(2) of this section) 
of U.S. assets. For each U.S. asset, value shall be computed at the most 
frequent regular intervals for which data are reasonably available. In 
no event shall the value of any U.S. asset be computed less frequently 
than monthly (beginning of taxable year and monthly thereafter) by a 
large bank (as defined in section 585(c)(2)) or a dealer in securities 
(within the meaning of section 475) and semi-annually (beginning, middle 
and end of taxable year) by any other taxpayer.
    (ii) Adjustment to basis of financial instruments. For purposes of 
determining the total average value of U.S. assets in this paragraph 
(b)(3), the value of a security or contract that is marked to market 
pursuant to section 475 or section 1256 shall be determined as if each 
determination date is the most frequent regular interval for which data 
are reasonably available that reflects the taxpayer's consistent 
business practices for reflecting mark-to-market valuations on its books 
and records.
    (c) Step 2: Determination of total amount of U.S.-connected 
liabilities for the taxable year--(1) General rule. The amount of U.S.-
connected liabilities for the taxable year equals the total value of 
U.S. assets for the taxable year (as determined under paragraph (b)(3) 
of this section) multiplied by the actual ratio for the taxable year (as 
determined under paragraph (c)(2) of this

[[Page 469]]

section) or, if the taxpayer has made an election in accordance with 
paragraph (c)(4) of this section, by the fixed ratio.
    (2) Computation of the actual ratio--(i) In general. A taxpayer's 
actual ratio for the taxable year is the total amount of its worldwide 
liabilities for the taxable year divided by the total value of its 
worldwide assets for the taxable year. The total amount of worldwide 
liabilities and the total value of worldwide assets for the taxable year 
is the average of the sums of the amounts of the taxpayer's worldwide 
liabilities and the values of its worldwide assets (determined under 
paragraphs (c)(2) (iii) and (iv) of this section). In each case, the 
sums must be computed semi-annually (beginning, middle and end of 
taxable year) by a large bank (as defined in section 585(c)(2)) and 
annually (beginning and end of taxable year) by any other taxpayer.
    (ii) Classification of items. The classification of an item as a 
liability or an asset must be consistent from year to year and in 
accordance with U.S. tax principles.
    (iii) Determination of amount of worldwide liabilities. The amount 
of a liability must be determined consistently from year to year and 
must be substantially in accordance with U.S. tax principles. To be 
substantially in accordance with U.S. tax principles, the principles 
used to determine the amount of a liability must not differ from U.S. 
tax principles to a degree that will materially affect the value of 
taxpayer's worldwide liabilities or the taxpayer's actual ratio.
    (iv) Determination of value of worldwide assets. The value of an 
asset must be determined consistently from year to year and must be 
substantially in accordance with U.S. tax principles. To be 
substantially in accordance with U.S. tax principles, the principles 
used to determine the value of an asset must not differ from U.S. tax 
principles to a degree that will materially affect the value of the 
taxpayer's worldwide assets or the taxpayer's actual ratio. The value of 
an asset is the adjusted basis of that asset for determining the gain or 
loss from the sale or other disposition of that asset, adjusted in the 
same manner as the basis of U.S. assets are adjusted under paragraphs 
(b)(2) (ii) through (iv) of this section. The rules of paragraph (b)(3) 
of this section apply in determining the total value of applicable 
worldwide assets for the taxable year, except that the minimum number of 
determination dates are those stated in paragraph (c)(2)(i) of this 
section.
    (v) Hedging transactions. [Reserved]
    (vi) Treatment of partnership interests and liabilities. For 
purposes of computing the actual ratio, the value of a partner's 
interest in a partnership that will be treated as an asset is the 
partner's adjusted basis in its partnership interest, reduced by the 
partner's share of liabilities of the partnership as determined under 
section 752 and increased by the partner's share of liabilities 
determined under this paragraph (c)(2)(vi). If the partner has made a 
fair market value election under paragraph (b)(2)(ii) of this section, 
the value of its interest in the partnership shall be increased by the 
fair market value of the partner's share of the liabilities determined 
under this paragraph (c)(2)(vi). For purposes of this section a partner 
shares in any liability of a partnership in the same proportion that it 
shares, for income tax purposes, in the expense attributable to that 
liability for the taxable year. A partner's adjusted basis in a 
partnership interest cannot be less than zero.
    (vii) Computation of actual ratio of insurance companies. [Reserved]
    (viii) Interbranch transactions. A transaction of any type between 
separate offices or branches of the same taxpayer does not create an 
asset or a liability.
    (ix) Amounts must be expressed in a single currency. The actual 
ratio must be computed in either U.S. dollars or the functional currency 
of the home office of the taxpayer, and that currency must be used 
consistently from year to year. For example, a taxpayer that determines 
the actual ratio annually using British pounds converted at the spot 
rate for financial reporting purposes must translate the U.S. dollar 
values of assets and amounts of liabilities of the U.S. trade or 
business into pounds using the spot rate on the last day of its taxable 
year. The director of field operations or the Assistant Commissioner 
(International) may require

[[Page 470]]

that the actual ratio be computed in dollars if the functional currency 
of the taxpayer's home office is a hyperinflationary currency, as 
defined in Sec.  1.985-1, that materially distorts the actual ratio.
    (3) Adjustments. The director of field operations or the Assistant 
Commissioner (International) may make appropriate adjustments to prevent 
a foreign corporation from intentionally and artificially increasing its 
actual ratio. For example, the director of field operations or the 
Assistant Commissioner (International) may offset a loan made from or to 
one person with a loan made to or from another person if any of the 
parties to the loans are related persons, within the meaning of section 
267(b) or 707(b)(1), and one of the principal purposes for entering into 
the loans was to increase artificially the actual ratio of a foreign 
corporation. A purpose may be a principal purpose even though it is 
outweighed by other purposes (taken together or separately).
    (4) Elective fixed ratio method of determining U.S. liabilities. A 
taxpayer that is a bank as defined in section 585(a)(2)(B) (without 
regard to the second sentence thereof or whether any such activities are 
effectively connected with a trade or business within the United States) 
may elect to use a fixed ratio of 95 percent in lieu of the actual 
ratio. A taxpayer that is neither a bank nor an insurance company may 
elect to use a fixed ratio of 50 percent in lieu of the actual ratio.
    (5) Examples. The following examples illustrate the application of 
paragraph (c) of this section:

    Example 1. Classification of item not in accordance with U.S. tax 
principles. Bank Z, a resident of country X, has a branch in the United 
States through which it conducts its banking business. In preparing its 
financial statements in country X, Z treats an instrument documented as 
perpetual subordinated debt as a liability. Under U.S. tax principles, 
however, this instrument is treated as equity. Consequently, the 
classification of this instrument as a liability for purposes of 
paragraph (c)(2)(iii) of this section is not in accordance with U.S. tax 
principles.
    Example 2. Valuation of item not substantially in accordance with 
U.S. tax principles. Bank Z, a resident of country X, has a branch in 
the United States through which it conducts its banking business. Bank Z 
is a large bank as defined in section 585(c)(2). The tax rules of 
country X allow Bank Z to take deductions for additions to certain 
reserves. Bank Z decreases the value of the assets on its financial 
statements by the amounts of the reserves. The additions to the reserves 
under country X tax rules cause the value of Bank Z's assets to differ 
from the value of those assets determined under U.S. tax principles to a 
degree that materially affects the value of taxpayer's worldwide assets. 
Consequently, the valuation of Bank Z's worldwide assets under country X 
tax principles is not substantially in accordance with U.S. tax 
principles. Bank Z must increase the value of its worldwide assets under 
paragraph (c)(2)(iii) of this section by the amount of its country X 
reserves.
    Example 3. Valuation of item substantially in accordance with U.S. 
tax principles. Bank Z, a resident of country X, has a branch in the 
United States through which it conducts its banking business. In 
determining the value of its worldwide assets, Bank Z computes the 
adjusted basis of certain non-U.S. assets according to the depreciation 
methodology provided under country X tax laws, which is different than 
the depreciation methodology provided under U.S. tax law. If the 
depreciation methodology provided under country X tax laws does not 
differ from U.S. tax principles to a degree that materially affects the 
value of Bank Z's worldwide assets or Bank Z's actual ratio as computed 
under paragraph (c)(2) of this section, then the valuation of Bank Z's 
worldwide assets under paragraph (c)(2)(iv) of this section is 
substantially in accordance with U.S. tax principles.
    Example 4. [Reserved]
    Example 5. Adjustments. FC is a foreign corporation engaged in the 
active conduct of a banking business through a branch, B, in the United 
States. P, an unrelated foreign corporation, deposits $100,000 in the 
home office of FC. Shortly thereafter, in a transaction arranged by the 
home office of FC, B lends $80,000 bearing interest at an arm's length 
rate to S, a wholly owned U.S. subsidiary of P. The director of field 
operations or the Assistant Commissioner (International) determines that 
one of the principal purposes for making and incurring such loans is to 
increase FC's actual ratio. For purposes of this section, therefore, P 
is treated as having directly lent $80,000 to S. Thus, for purposes of 
paragraph (c) of this section (Step 2), the director of field operations 
or the Assistant Commissioner (International) may offset FC's liability 
and asset arising from this transaction, resulting in a net liability of 
$20,000 that is not a booked liability of B. Because the loan to S from 
B was initiated and arranged by the home office of FC, with no material 
participation by B, the loan to S will not be treated as a U.S. asset.


[[Page 471]]


    (d) Step 3: Determination of amount of interest expense allocable to 
ECI under the adjusted U.S. booked liabilities method--(1) General rule. 
The adjustment to the amount of interest expense paid or accrued on U.S. 
booked liabilities is determined by comparing the amount of U.S.-
connected liabilities for the taxable year, as determined under 
paragraph (c) of this section, with the average total amount of U.S. 
booked liabilities, as determined under paragraphs (d)(2) and (3) of 
this section. If the average total amount of U.S. booked liabilities 
equals or exceeds the amount of U.S.-connected liabilities, the 
adjustment to the interest expense on U.S. booked liabilities is 
determined under paragraph (d)(4) of this section. If the amount of 
U.S.-connected liabilities exceeds the average total amount of U.S. 
booked liabilities, the adjustment to the amount of interest expense 
paid or accrued on U.S. booked liabilities is determined under paragraph 
(d)(5) of this section.
    (2) U.S. booked liabilities--(i) In general. A liability is a U.S. 
booked liability if it is properly reflected on the books of the U.S. 
trade or business, within the meaning of paragraph (d)(2)(ii) or (iii) 
of this section.
    (ii) Properly reflected on the books of the U.S. trade or business 
of a foreign corporation that is not a bank--(A) In general. A 
liability, whether interest bearing or non-interest bearing, is properly 
reflected on the books of the U.S. trade or business of a foreign 
corporation that is not a bank as described in section 585(a)(2)(B) 
(without regard to the second sentence thereof) if--
    (1) The liability is secured predominantly by a U.S. asset of the 
foreign corporation;
    (2) The foreign corporation enters the liability on a set of books 
reasonably contemporaneously with the time at which the liability is 
incurred and the liability relates to an activity that produces ECI.
    (3) The foreign corporation maintains a set of books and records 
relating to an activity that produces ECI and the Director of Field 
Operations determines that there is a direct connection or relationship 
between the liability and that activity. Whether there is a direct 
connection between the liability and an activity that produces ECI 
depends on the facts and circumstances of each case.
    (B) Identified liabilities not properly reflected. A liability is 
not properly reflected on the books of the U.S. trade or business merely 
because a foreign corporation identifies the liability pursuant to Sec.  
1.884-4(b)(1)(ii) and (b)(3).
    (iii) Properly reflected on the books of the U.S. trade or business 
of a foreign corporation that is a bank--
    (A) In general. A liability, whether interest bearing or non-
interest bearing, is properly reflected on the books of the U.S. trade 
or business of a foreign corporation that is a bank as described in 
section 585(a)(2)(B) (without regard to the second sentence thereof) 
if--
    (1) The bank enters the liability on a set of books before the close 
of the day on which the liability is incurred, and the liability relates 
to an activity that produces ECI; and
    (2) There is a direct connection or relationship between the 
liability and that activity. Whether there is a direct connection 
between the liability and an activity that produces ECI depends on the 
facts and circumstances of each case. For example, a liability that is 
used to fund an interbranch or other asset that produces non-ECI may 
have a direct connection to an ECI producing activity and may constitute 
a U.S.-booked liability if both the interbranch or non-ECI activity is 
the same type of activity in which ECI assets are also reflected on the 
set of books (for example, lending or money market interbank 
placements), and such ECI activities are not de minimis. Such U.S. 
booked liabilities may still be subject to paragraph (d)(2)(v) of this 
section.
    (B) Inadvertent error. If a bank fails to enter a liability in the 
books of the activity that produces ECI before the close of the day on 
which the liability was incurred, the liability may be treated as a U.S. 
booked liability only if, under the facts and circumstances, the 
taxpayer demonstrates a direct connection or relationship between the 
liability and the activity that produces ECI and the failure to enter 
the liability in those books was due to inadvertent error.

[[Page 472]]

    (iv) Liabilities of insurance companies. [Reserved]
    (v) Liabilities used to increase artificially interest expense on 
U.S. booked liabilities. U.S. booked liabilities shall not include a 
liability if one of the principal purposes for incurring or holding the 
liability is to increase artificially the interest expense on the U.S. 
booked liabilities of a foreign corporation. Whether a liability is 
incurred or held for the purpose of artificially increasing interest 
expense will depend upon all the facts and circumstances of each case. 
Factors to be considered in determining whether one of the principal 
purposes for incurring or holding a liability is to increase 
artificially the interest expense on U.S. booked liabilities of a 
foreign corporation include whether the interest expense on the 
liability is excessive when compared to other liabilities of the foreign 
corporation denominated in the same currency and whether the currency 
denomination of the liabilities of the U.S. branch substantially matches 
the currency denomination of the U.S. branch's assets. A purpose may be 
a principal purpose even though it is outweighed by other purposes 
(taken together or separately).
    (vi) Hedging transactions. [Reserved]
    (vii) Amount of U.S. booked liabilities of a partner. A partner's 
share of liabilities of a partnership is considered a booked liability 
of the partner provided that it is properly reflected on the books 
(within the meaning of paragraph (d)(2)(ii) of this section) of the U.S. 
trade or business of the partnership.
    (viii) Interbranch transactions. A transaction of any type between 
separate offices or branches of the same taxpayer does not result in the 
creation of a liability.
    (3) Average total amount of U.S. booked liabilities. The average 
total amount of U.S. booked liabilities for the taxable year is the 
average of the sums of the amounts (determined under paragraph (d)(2) of 
this section) of U.S. booked liabilities. The amount of U.S. booked 
liabilities shall be computed at the most frequent, regular intervals 
for which data are reasonably available. In no event shall the amount of 
U.S. booked liabilities be computed less frequently than monthly by a 
large bank (as defined in section 585(c)(2)) and semi-annually by any 
other taxpayer.
    (4) Interest expense where U.S. booked liabilities equal or exceed 
U.S. liabilities--(i) In general. If the average total amount of U.S. 
booked liabilities (as determined in paragraphs (d)(2) and (3) of this 
section) exceeds the amount of U.S.-connected liabilities (as determined 
under paragraph (c) of this section (Step 2)), the interest expense 
allocable to ECI is the product of the total amount of interest paid or 
accrued within the taxable year by the U.S. trade or business on U.S. 
booked liabilities and the scaling ratio set out in paragraph (d)(4)(ii) 
of this section. For purposes of this section, the reduction resulting 
from the application of the scaling ratio is applied pro-rata to all 
interest expense paid or accrued by the foreign corporation. A similar 
reduction in income, expense, gain, or loss from a hedging transaction 
(as described in paragraph (d)(2)(vi) of this section) must also be 
determined by multiplying such income, expense, gain, or loss by the 
scaling ratio. If the average total amount of U.S. booked liabilities 
(as determined in paragraph (d)(3) of this section) equals the amount of 
U.S.-connected liabilities (as determined under Step 2), the interest 
expense allocable to ECI is the total amount of interest paid or accrued 
within the taxable year by the U.S. trade or business on U.S. booked 
liabilities.
    (ii) Scaling ratio. For purposes of this section, the scaling ratio 
is a fraction the numerator of which is the amount of U.S.-connected 
liabilities and the denominator of which is the average total amount of 
U.S. booked liabilities.
    (iii) Special rules for insurance companies. [Reserved]
    (5) U.S.-connected interest rate where U.S. booked liabilities are 
less than U.S.-connected liabilities--(i) In general. If the amount of 
U.S.-connected liabilities (as determined under paragraph (c) of this 
section (Step 2)) exceeds the average total amount of U.S. booked 
liabilities, the interest expense allocable to ECI is the total amount 
of interest paid or accrued within the taxable year by the U.S. trade or 
business on U.S. booked liabilities, plus the excess of

[[Page 473]]

the amount of U.S.-connected liabilities over the average total amount 
of U.S. booked liabilities multiplied by the interest rate determined 
under paragraph (d)(5)(ii) of this section.
    (ii) Interest rate on excess U.S.-connected liabilities--(A) General 
rule. The applicable interest rate on excess U.S.-connected liabilities 
is determined by dividing the total interest expense paid or accrued for 
the taxable year on U.S.-dollar liabilities that are not U.S.-booked 
liabilities (as defined in paragraph (d)(2) of this section) and that 
are shown on the books of the offices or branches of the foreign 
corporation outside the United States by the average U.S.-dollar 
denominated liabilities (whether interest-bearing or not) that are not 
U.S.-booked liabilities and that are shown on the books of the offices 
or branches of the foreign corporation outside the United States for the 
taxable year.
    (B) Annual published rate election. For each taxable year beginning 
with the first year end for which the original tax return due date 
(including extensions) is after August 17, 2006, in which a taxpayer is 
a bank within the meaning of section 585(a)(2)(B) (without regard to the 
second sentence thereof or whether any such activities are effectively 
connected with a trade or business within the United States), such 
taxpayer may elect to compute its excess interest by reference to a 
published average 30-day London Interbank Offering Rate (LIBOR) for the 
year. The election may be made for any eligible year by indicating the 
rate used on Schedule I (Form 1120-F) attached to the timely filed 
return. Once selected, the rate may not be changed by the taxpayer. If a 
taxpayer that is eligible to make the 30-day LIBOR election either does 
not file a timely return or files a calculation that allocates interest 
expense under the scaling ratio in paragraph (d)(4) of this section and 
it is determined by the Director of Field Operations that the taxpayer's 
U.S.-connected liabilities exceed its U.S.-booked liabilities, then the 
Director of Field Operations, and not the taxpayer, may choose whether 
to determine the taxpayer's excess interest rate under paragraph 
(d)(5)(ii)(A) or (B) of this section and may select the published 30-day 
LIBOR rate.
    (6) Examples. The following examples illustrate the rules of this 
section:

    Example 1. Computation of interest expense; actual ratio. (i) Facts. 
(A) FC is a foreign corporation that is not a bank and that actively 
conducts a real estate business through a branch, B, in the United 
States. For the taxable year, FC's balance sheet and income statement is 
as follows (assume amounts are in U.S. dollars and computed in 
accordance with paragraphs (b)(2) and (b)(3) of this section):

------------------------------------------------------------------------
                                                        Value
------------------------------------------------------------------------
Asset 1.............................................    $2,000
Asset 2.............................................     2,500
Asset 3.............................................     5,500
                                                       Amount   Interest
                                                                 Expense
Liability 1.........................................      $800        56
Liability 2.........................................     3,200       256
Capital.............................................     6,000         0
------------------------------------------------------------------------

    (B) Asset 1 is the stock of FC's wholly-owned domestic subsidiary 
that is also actively engaged in the real estate business. Asset 2 is a 
building in the United States producing rental income that is entirely 
ECI to FC. Asset 3 is a building in the home country of FC that produces 
rental income. Liabilities 1 and 2 are loans that bear interest at the 
rates of 7% and 8%, respectively. Liability 1 is a booked liability of 
B, and Liability 2 is booked in FC's home country. Assume that FC has 
not elected to use the fixed ratio in Step 2.
    (ii) Step 1. Under paragraph (b)(1) of this section, Assets 1 and 3 
are not U.S. assets, while Asset 2 qualifies as a U.S. asset. Thus, 
under paragraph (b)(3) of this section, the total value of U.S. assets 
for the taxable year is $2,500, the value of Asset 2.
    (iii) Step 2. Under paragraph (c)(1) of this section, the amount of 
FC's U.S.-connected liabilities for the taxable year is determined by 
multiplying $2,500 (the value of U.S. assets determined under Step 1) by 
the actual ratio for the taxable year. The actual ratio is the average 
amount of FC's worldwide liabilities divided by the average value of 
FC's worldwide assets. The amount of Liability 1 is $800, and the amount 
of Liability 2 is $3,200. Thus, the numerator of the actual ratio is 
$4,000. The average value of worldwide assets is $10,000 (Asset 1 + 
Asset 2 + Asset 3). The actual ratio, therefore, is 40% ($4,000/
$10,000), and the amount of U.S.-connected liabilities for the taxable 
year is $1,000 ($2,500 U.S. assets x 40%).
    (iv) Step 3. Because the amount of FC's U.S.-connected liabilities 
($1,000) exceeds the average total amount of U.S. booked liabilities of 
B ($800), FC determines its interest expense in accordance with 
paragraph (d)(5)

[[Page 474]]

of this section by adding the interest paid or accrued on U.S. booked 
liabilities, and the interest expense associated with the excess of its 
U.S.-connected liabilities over its average total amount of U.S. booked 
liabilities. Under paragraph (d)(5)(ii) of this section, FC determines 
the interest rate attributable to its excess U.S.-connected liabilities 
by dividing the interest expense paid or accrued by the average amount 
of U.S.-dollar denominated liabilities, which produces an interest rate 
of 8% ($256/$3200). Therefore, FC's allocable interest expense is $72 
($56 of interest expense from U.S. booked liabilities plus $16 ($200 x 
8%) of interest expense attributable to its excess U.S.-connected 
liabilities).
    Example 2. Computation of interest expense; fixed ratio. (i) The 
facts are the same as in Example 1, except that FC makes a fixed ratio 
election under paragraph (c)(4) of this section. The conclusions under 
Step 1 are the same as in Example 1.
    (ii) Step 2. Under paragraph (c)(1) of this section, the amount of 
U.S.-connected liabilities for the taxable year is determined by 
multiplying $2,500 (the value of U.S. assets determined under Step 1) by 
the fixed ratio for the taxable year, which, under paragraph (c)(4) of 
this section is 50 percent. Thus, the amount of U.S.-connected 
liabilities for the taxable year is $1,250 ($2,500 U.S. assets x 50%).
    (iii) Step 3. As in Example 1, the amount of FC's U.S.-connected 
liabilities exceed the average total amount of U.S. booked liabilities 
of B, requiring FC to determine its interest expense under paragraph 
(d)(5) of this section. In this case, however, FC has excess U.S.-
connected liabilities of $450 ($1,250 of U.S.-connected liabilities--
$800 U.S. booked liabilities). FC therefore has allocable interest 
expense of $92 ($56 of interest expense from U.S. booked liabilities 
plus $36 ($450 x 8%) of interest expense attributable to its excess 
U.S.-connected liabilities).
    Example 3. Scaling ratio. (i) Facts. Bank Z, a resident of country 
X, has a branch in the United States through which it conducts its 
banking business. For the taxable year, Z has U.S.-connected 
liabilities, determined under paragraph (c) of this section, equal to 
$300. Z, however, has U.S. booked liabilities of $300 and U500. 
Therefore, assuming an exchange rate of the U to the U.S. dollar of 5:1, 
Z has U.S. booked liabilities of $400 ($300 + (U500 / 5)).
    (ii) U.S.-connected liabilities. Because Z's U.S. booked liabilities 
of $400 exceed its U.S.-connected liabilities by $100, all of Z's 
interest expense allocable to its U.S. trade or business must be scaled 
back pro-rata. To determine the scaling ratio, Z divides its U.S.-
connected liabilities by its U.S. booked liabilities, as required by 
paragraph (d)(4) of this section. Z's interest expense is scaled back 
pro rata by the resulting ratio of \3/4\ ($300 / $400). Z's income, 
expense, gain or loss from hedging transactions described in paragraph 
(d)(2)(vi) of this section must be similarly reduced.
    Example 4. [Reserved]
    Example 5. U.S. booked liabilities--direct relationship. (i) Facts. 
Bank A, a resident of Country X maintains a banking office in the U.S. 
that records transactions on three sets of books for State A, an 
International Banking Facility (IBF) for its bank regulatory approved 
international transactions, and a shell branch licensed operation in 
Country C. Bank A records substantial ECI assets from its bank lending 
and placement activities and a mix of interbranch and non-ECI producing 
assets from the same or similar activities on the books of State A 
branch and on its IBF. Bank A's Country C branch borrows substantially 
from third parties, as well as from its home office, and lends all of 
its funding to its State A branch and IBF to fund the mix of ECI, 
interbranch and non-ECI activities on those two books. The consolidated 
books of State A branch and IBF indicate that a substantial amount of 
the total book assets constitute U.S. assets under paragraph (b) of this 
section. Some of the third-party borrowings on the books of the State A 
branch are used to lend directly to Bank A's home office in Country X. 
These borrowings reflect the average borrowing rate of the State A 
branch, IBF and Country C branches as a whole. All third-party 
borrowings reflected on the books of State A branch, the IBF and Country 
C branch were recorded on such books before the close of business on the 
day the liabilities were acquired by Bank A.
    (ii) U.S. booked liabilities. The facts demonstrate that the 
separate State A branch, IBF and Country C branch books taken together, 
constitute a set of books within the meaning of paragraph 
(d)(2)(iii)(A)(1) of this section. Such set of books as a whole has a 
direct relationship to an ECI activity under paragraph (d)(2)(iii)(A)(2) 
of this section even though the Country C branch books standing alone 
would not. The third-party liabilities recorded on the books of Country 
C constitute U.S. booked liabilities because they were timely recorded 
and the overall set of books on which they were reflected has a direct 
relationship to a bank lending and interbank placement ECI producing 
activity. The third-party liabilities that were recorded on the books of 
State A branch that were used to lend funds to Bank A's home office also 
constitute U.S. booked liabilities because the interbranch activity the 
funds were used for is a lending activity of a type that also gives rise 
to a substantial amount of ECI that is properly reflected on the same 
set of books as the interbranch loans. Accordingly, the liabilities are 
not traced to their specific interbranch use but to the

[[Page 475]]

overall activity of bank lending and interbank placements which gives 
rise to substantial ECI. The facts show that the liabilities were not 
acquired to increase artificially the interest expense of Bank A's U.S. 
booked liabilities as a whole under paragraph (d)(2)(v) of this section. 
The third-party liabilities also constitute U.S. booked liabilities for 
purposes of determining Bank A's branch interest under Sec.  1.884-
4(b)(1)(i)(A) regardless of whether Bank A uses the Adjusted U.S. booked 
liability method, or the Separate Currency Pool method to allocate its 
interest expense under paragraph 5(e) of this section.

    (e) Separate currency pools method--(1) General rule. If a foreign 
corporation elects to use the method in this paragraph, its total 
interest expense allocable to ECI is the sum of the separate interest 
deductions for each of the currencies in which the foreign corporation 
has U.S. assets. The separate interest deductions are determined under 
the following three-step process.
    (i) Determine the value of U.S. assets in each currency pool. First, 
the foreign corporation must determine the amount of its U.S. assets, 
using the methodology in paragraph (b) of this section, in each currency 
pool. The foreign corporation may convert into U.S. dollars any currency 
pool in which the foreign corporation holds less than 3% of its U.S. 
assets. A transaction (or transactions) that hedges a U.S. asset shall 
be taken into account for purposes of determining the currency 
denomination and the value of the U.S. asset.
    (ii) Determine the U.S.-connected liabilities in each currency pool. 
Second, the foreign corporation must determine the amount of its U.S.-
connected liabilities in each currency pool by multiplying the amount of 
U.S. assets (as determined under paragraph (b)(3) of this section) in 
the currency pool by the foreign corporation's actual ratio (as 
determined under paragraph (c)(2) of this section) for the taxable year 
or, if the taxpayer has made an election in accordance with paragraph 
(c)(4) of this section, by the fixed ratio.
    (iii) Determine the interest expense attributable to each currency 
pool. Third, the foreign corporation must determine the interest expense 
attributable to each currency pool by multiplying the U.S.-connected 
liabilities in each currency pool by the prescribed interest rate as 
defined in paragraph (e)(2) of this section.
    (2) Prescribed interest rate. For each currency pool, the prescribed 
interest rate is determined by dividing the total interest expense that 
is paid or accrued for the taxable year with respect to the foreign 
corporation's worldwide liabilities denominated in that currency, by the 
foreign corporation's average worldwide liabilities (whether interest 
bearing or not) denominated in that currency. The interest expense and 
liabilities are to be stated in that currency.
    (3) Hedging transactions. [Reserved]
    (4) Election not available if excessive hyperinflationary assets. 
The election to use the separate currency pools method of this paragraph 
(e) is not available if the value of the foreign corporation's U.S. 
assets denominated in a hyperinflationary currency, as defined in Sec.  
1.985-1, exceeds ten percent of the value of the foreign corporation's 
total U.S. assets. If a foreign corporation made a valid election to use 
the separate currency pools method in a prior year but no longer 
qualifies to use such method pursuant to this paragraph (e)(4), the 
taxpayer must use the method provided by paragraphs (b) through (d) of 
this section.
    (5) Examples. The separate currency pools method of this paragraph 
(e) is illustrated by the following examples:

    Example 1. Separate currency pools method--(i) Facts. (A) Bank Z, a 
resident of country X, has a branch in the United States through which 
it conducts its banking business. For its 1997 taxable year, Z has U.S. 
assets, as defined in paragraph (b) of this section, that are 
denominated in U.S. dollars and in U, the country X currency. 
Accordingly, Z's U.S. assets are as follows:

------------------------------------------------------------------------
                                                                Average
                                                                 value
------------------------------------------------------------------------
U.S. Dollar Assets...........................................    $20,000
U Assets.....................................................    U 5,000
------------------------------------------------------------------------

    (B) Z's worldwide liabilities are also denominated in U.S. Dollars 
and in U. The average interest rates on Z's worldwide liabilities, 
including those in the United States, are 6% on its U.S. dollar 
liabilities, and 12% on its liabilities denominated in U. Assume that Z 
has properly elected to use its actual ratio of 95% to determine its 
U.S.-connected liabilities in Step 2, and has also properly

[[Page 476]]

elected to use the separate currency pools method provided in paragraph 
(e) of this section.
    (ii) Determination of interest expense. Z determines the interest 
expense attributable to its U.S.-connected liabilities according to the 
steps described below.
    (A) First, Z separates its U.S. assets into two currency pools, one 
denominated in U.S. dollars ($20,000) and the other denominated in U 
(U5,000).
    (B) Second, Z multiplies each pool of assets by the applicable ratio 
of worldwide liabilities to assets, which in this case is 95%. Thus, Z 
has U.S.-connected liabilities of $19,000 ($20,000 x 95%), and U4750 
(U5000 x 95%).
    (C) Third, Z calculates its interest expense by multiplying each 
pool of its U.S.-connected liabilities by the relevant interest rates. 
Accordingly, Z's allocable interest expense for the year is $1140 
($19,000 x 6%), the sum of the expense associated with its U.S. dollar 
liabilities, plus U570 (U4750 x 12%), the interest expense associated 
with its liabilities denominated in U. Z must translate its interest 
expense denominated in U in accordance with the rules provided in 
section 988, and then must determine whether it is subject to any other 
provision of the Code that would disallow or defer any portion of its 
interest expense so determined.
    Example 2. [Reserved]

    (f)(1) Effective/applicability date (1) This section is applicable 
for taxable years ending on or after August 15, 2009. A taxpayer, 
however, may choose to apply Sec.  1.882-5T, rather than applying the 
final regulations, for any taxable year beginning on or after August 16, 
2008 but before August 15, 2009.
    (2) Special rules for financial products. [Reserved]

[T.D. 8658, 61 FR 9329, Mar. 8, 1996; 61 FR 15891, Apr. 10, 1996, as 
amended by T.D. 9281, 71 FR 47448, Aug. 17, 2006; 71 FR 56868, Sept. 28, 
2006; T.D. 9465, 74 FR 49320, Sept. 28, 2009; 74 FR 57252, Nov. 5, 2009]



Sec.  1.883-0  Outline of major topics.

    This section lists the major paragraphs contained in Sec. Sec.  
1.883-1 through 1.883-5.

 Sec.  1.883-1 Exclusion of income from the international operation of 
                           ships or aircraft.

    (a) General rule.
    (b) Qualified income.
    (c) Qualified foreign corporation.
    (1) General rule.
    (2) Stock ownership test.
    (3) Substantiation and reporting requirements.
    (i) General rule.
    (ii) Further documentation.
    (A) General rule.
    (B) Names and permanent addresses of certain shareholders.
    (4) Commissioner's discretion to cure defects in documentation.
    (d) Qualified foreign country.
    (e) Operation of ships or aircraft.
    (1) General rule.
    (2) Pool, partnership, strategic alliance, joint operating 
agreement, code-sharing arrangement or other joint venture.
    (3) Activities not considered operation of ships or aircraft.
    (4) Examples.
    (5) Definitions.
    (i) Bareboat charter.
    (ii) Code-sharing arrangement.
    (iii) Dry lease.
    (iv) Entity.
    (v) Fiscally transparent entity under the income tax laws of the 
United States.
    (vi) Full charter.
    (vii) Nonvessel operating common carrier.
    (viii) Space or slot charter.
    (ix) Time charter.
    (x) Voyage charter.
    (xi) Wet lease.
    (f) International operation of ships or aircraft.
    (1) General rule.
    (2) Determining whether income is derived from international 
operation of ships or aircraft.
    (i) International carriage of passengers.
    (A) General rule.
    (B) Round trip travel on ships.
    (ii) International carriage of cargo.
    (iii) Bareboat charter of ships or dry lease of aircraft used in 
international operation of ships or aircraft.
    (iv) Charter of ships or aircraft for hire.
    (g) Activities incidental to the international operation of ships or 
aircraft.
    (1) General rule.
    (2) Activities not considered incidental to the international 
operation of ships or aircraft.
    (3) Other Services. [Reserved]
    (4) Activities involved in a pool, partnership, strategic alliance, 
joint operating agreement, code-sharing arrangement or other joint 
venture.
    (h) Equivalent exemption.
    (1) General rule.
    (2) Determining equivalent exemptions for each category of income.
    (3) Special rules with respect to income tax conventions.
    (i) Countries with only an income tax convention.
    (ii) Countries with both an income tax convention and an equivalent 
exemption.
    (A) General rule.

[[Page 477]]

    (B) Special rule for claiming simultaneous benefits under section 
883 and an income tax convention.
    (iii) Participation in certain joint ventures.
(iv) Independent interpretation of income tax conventions.
    (4) Exemptions not qualifying as equivalent exemptions.
    (i) General rule.
    (ii) Reduced tax rate or time limited exemption.
    (iii) Inbound or outbound freight tax.
    (iv) Exemptions for limited types of cargo.
    (v) Territorial tax systems.
    (vi) Countries that tax on a residence basis.
    (vii) Exemptions within categories of income.
    (i) Treatment of possessions.
    (j) Expenses related to qualified income.

        Sec.  1.883-2 Treatment of publicly-traded corporations.

    (a) General rule.
    (b) Established securities market.
    (1) General rule.
    (2) Exchanges with multiple tiers.
    (3) Computation of dollar value of stock traded.
    (4) Over-the-counter market.
    (5) Discretion to determine that an exchange does not qualify as an 
established securities market.
    (c) Primarily traded.
    (d) Regularly traded.
    (1) General rule.
    (2) Classes of stock traded on a domestic established securities 
market treated as meeting trading requirements.
    (3) Closely-held classes of stock not treated as meeting trading 
requirements.
    (i) General rule.
    (ii) Exception.
    (iii) Five-percent shareholders.
    (A) Related persons.
    (B) Investment companies.
    (4) Anti-abuse rule.
    (5) Example.
    (e) Substantiation that a foreign corporation is publicly traded.
    (1) General rule.
    (2) Availability and retention of documents for inspection.
    (f) Reporting requirements.

       Sec.  1.883-3 Treatment of controlled foreign corporations.

    (a) General rule.
    (b) Qualified U.S. person ownership test.
    (1) General rule.
    (2) Qualified U.S. person.
    (3) Treatment of bearer shares.
    (4) Ownership attribution through certain domestic entities.
    (5) Examples.
    (c) Substantiation of CFC stock ownership.
    (1) In general.
    (2) Ownership statements from qualified U.S. persons.
    (3) Ownership statements from intermediaries.
    (4) Three-year period of validity.
    (5) Availability and retention of documents for inspection.
    (d) Reporting requirements.

        Sec.  1.883-4 Qualified shareholder stock ownership test.

    (a) General rule.
    (b) Qualified shareholder.
    (1) General rule.
    (2) Residence of individual shareholders.
    (i) General rule.
    (ii) Tax home.
    (3) Certain income tax convention restrictions applied to 
shareholders.
    (4) Not-for-profit organizations.
    (5) Pension funds.
    (i) Pension fund defined.
    (ii) Government pension funds.
    (iii) Nongovernment pension funds.
    (iv) Beneficiary of a pension fund.
    (c) Rules for determining constructive ownership.
    (1) General rules for attribution.
    (2) Partnerships.
    (i) General rule.
    (ii) Partners resident in the same country.
    (iii) Examples.
    (3) Trusts and estates.
    (i) Beneficiaries.
    (ii) Grantor trusts.
    (4) Corporations that issue stock.
    (5) Taxable nonstock corporations.
    (6) Mutual insurance companies and similar entities.
    (7) Computation of beneficial interests in nongovernment pension 
funds.
    (d) Substantiation of stock ownership.
    (1) General rule.
    (2) Application of general rule.
    (i) Ownership statements.
    (ii) Three-year period of validity.
    (3) Special rules.
    (i) Substantiating residence of certain shareholders.
    (ii) Special rule for registered shareholders owning less than one 
percent of widely-held corporations.
    (iii) Special rule for beneficiaries of pension funds.
    (A) Government pension fund.
    (B) Nongovernment pension fund.
    (iv) Special rule for stock owned by publicly-traded corporations.
    (v) Special rule for not-for-profit organizations.
    (vi) Special rule for a foreign airline covered by an air services 
agreement.
    (vii) Special rule for taxable nonstock corporations.

[[Page 478]]

    (viii) Special rule for closely-held corporations traded in the 
United States.
    (4) Ownership statements from shareholders.
    (i) Ownership statements from individuals.
    (ii) Ownership statements from foreign governments.
    (iii) Ownership statements from publicly-traded corporate 
shareholders.
    (iv) Ownership statements from not-for-profit organizations.
    (v) Ownership statements from intermediaries.
    (A) General rule.
    (B) Ownership statements from widely-held intermediaries with 
registered shareholders owning less than one percent of such widely-held 
intermediary.
    (C) Ownership statements from pension funds.
    (1) Ownership statements from government pension funds.
    (2) Ownership statements from nongovernment pension funds.
    (3) Time for making determinations.
    (D) Ownership statements from taxable nonstock corporations.
    (5) Availability and retention of documents for inspection.
    (e) Reporting requirements.

                     Sec.  1.883-5 Effective dates.

    (a) General rule.
    (b) Election for retroactive application.
    (c) Transitional information reporting rule.
    (d) Effective/applicability dates.

[T.D. 9087, 68 FR 51399, Aug. 26, 2003, as amended by T.D. 9332, 72 FR 
34604, June 25, 2007; T.D. 9502, 75 FR 56861, Sept. 17, 2010]



Sec.  1.883-1  Exclusion of income from the international operation 
of ships or aircraft.

    (a) General rule. Qualified income derived by a qualified foreign 
corporation from its international operation of ships or aircraft is 
excluded from gross income and exempt from United States Federal income 
tax. Paragraph (b) of this section defines the term qualified income. 
Paragraph (c) of this section defines the term qualified foreign 
corporation. Paragraph (f) of this section defines the term 
international operation of ships or aircraft.
    (b) Qualified income. Qualified income is income derived from the 
international operation of ships or aircraft that--
    (1) Is properly includible in any of the income categories described 
in paragraph (h)(2) of this section; and
    (2) Is the subject of an equivalent exemption, as defined in 
paragraph (h) of this section, granted by the qualified foreign country, 
as defined in paragraph (d) of this section, in which the foreign 
corporation seeking qualified foreign corporation status is organized.
    (c) Qualified foreign corporation--(1) General rule. A qualified 
foreign corporation is a corporation that is organized in a qualified 
foreign country and considered engaged in the international operation of 
ships or aircraft. The term corporation is defined in section 7701(a)(3) 
and the regulations thereunder. Paragraph (d) of this section defines 
the term qualified foreign country. Paragraph (e) of this section 
defines the term operation of ships or aircraft, and paragraph (f) of 
this section defines the term international operation of ships or 
aircraft. To be a qualified foreign corporation, the corporation must 
satisfy the stock ownership test of paragraph (c)(2) of this section and 
satisfy the substantiation and reporting requirements described in 
paragraph (c)(3) of this section. A corporation may be a qualified 
foreign corporation with respect to one category of qualified income but 
not with respect to another such category. See paragraph (h)(2) of this 
section for a discussion of the categories of qualified income.
    (2) Stock ownership test. To be a qualified foreign corporation, a 
foreign corporation must satisfy the publicly-traded test of Sec.  
1.883-2(a), the CFC stock ownership test of Sec.  1.883-3(a), or the 
qualified shareholder stock ownership test of Sec.  1.883-4(a).
    (3) Substantiation and reporting requirements--(i) General rule. To 
be a qualified foreign corporation, a foreign corporation must include 
the following information in its Form 1120-F, ``U.S. Income Tax Return 
of a Foreign Corporation,'' in the manner prescribed by such form and 
its accompanying instructions--
    (A) The corporation's name and address (including mailing code);
    (B) The corporation's U.S. taxpayer identification number;
    (C) The foreign country in which the corporation is organized;
    (D) The applicable authority for an equivalent exemption, for 
example, the

[[Page 479]]

citation of a statute in the country where the corporation is organized, 
a diplomatic note between the United States and such country, or an 
income tax convention between the United States and such country in the 
case of a corporation described in paragraphs (h)(3)(i), (ii) and (iii) 
of this section;
    (E) The category or categories of qualified income for which an 
exemption is being claimed;
    (F) A reasonable estimate of the gross amount of income in each 
category of qualified income for which the exemption is claimed, to the 
extent such amounts are readily determinable;
    (G) A statement as to whether any shares of the foreign corporation 
or of any intermediary corporation that are relied on to satisfy any 
stock ownership test described in paragraph (c)(2) of this section are 
issued in bearer form and whether the bearer shares are maintained in a 
dematerialized book-entry system in which the bearer shares are 
represented only by book entries and no physical certificates are issued 
or transferred, or in an immobilized book-entry system in which evidence 
of ownership is maintained on the books and records of the corporate 
issuer or by a broker or financial institution;
    (H) Any other information required under Sec.  1.883-2(f), Sec.  
1.883-3(d), or Sec.  1.883-4(e), as applicable; and
    (I) Any other relevant information specified in Form 1120-F, ``U.S. 
Income Tax Return of a Foreign Corporation,'' and its accompanying 
instructions.
    (ii) Further documentation--(A) General rule. Except as provided in 
paragraph (c)(3)(ii)(B) of this section, if the Commissioner requests in 
writing that the foreign corporation provide documentation or 
substantiate any representations made under paragraph (c)(3)(i) of this 
section, or under Sec.  1.883-2(f), Sec.  1.883-3(d), or Sec.  1.883-
4(e), as applicable, the foreign corporation must provide the requested 
documentation or substantiation within 60 days of receiving the written 
request. If the foreign corporation does not provide the requested 
documentation or substantiation within the 60-day period, but 
demonstrates that the failure was due to reasonable cause and not 
willful neglect, the Commissioner may grant the foreign corporation a 
30-day extension to provide the requested documentation or 
substantiation. Whether a failure to provide the documentation or 
substantiation in a timely manner was due to reasonable cause and not 
willful neglect shall be determined by the Commissioner based on all the 
facts and circumstances.
    (B) Names and permanent addresses of certain shareholders. If the 
Commissioner requests the names and permanent addresses of individual 
qualified shareholders of a foreign corporation, as represented on each 
individual's ownership statement, to substantiate the requirements of 
the exception to the closely-held test in the publicly-traded test in 
Sec.  1.883-2(e), the qualified shareholder stock ownership test in 
Sec.  1.883-4(a), or the qualified U.S. person ownership test in Sec.  
1.883-3(b), the foreign corporation must provide the requested 
information within 30 days of receiving the written request. If the 
foreign corporation does not provide the requested information within 
the 30-day period, but demonstrates that the failure was due to 
reasonable cause and not willful neglect, the Commissioner may grant the 
foreign corporation a 30-day extension to provide the requested 
information. Whether a failure to provide the requested information was 
due to reasonable cause and not willful neglect shall be determined by 
the Commissioner based on all the facts and circumstances.
    (d) Qualified foreign country. A qualified foreign country is a 
foreign country that grants to corporations organized in the United 
States an equivalent exemption, as described in paragraph (h) of this 
section, for the category of qualified income, as described in paragraph 
(h)(2) of this section, derived by the foreign corporation seeking 
qualified foreign corporation status. A foreign country may be a 
qualified foreign country with respect to one category of qualified 
income but not with respect to another such category.
    (e) Operation of ships or aircraft--(1) General rule. Except as 
provided in paragraph (e)(2) of this section, a foreign corporation is 
considered engaged in the operation of ships or aircraft

[[Page 480]]

only during the time it is an owner or lessee of one or more entire 
ships or aircraft and uses such ships or aircraft in one or more of the 
following activities--
    (i) Carriage of passengers or cargo for hire;
    (ii) In the case of a ship, the leasing out of the ship under a time 
or voyage charter (full charter), space or slot charter, or bareboat 
charter, as those terms are defined in paragraph (e)(5) of this section, 
provided the ship is used to carry passengers or cargo for hire; and
    (iii) In the case of aircraft, the leasing out of the aircraft under 
a wet lease (full charter), space, slot, or block-seat charter, or dry 
lease, as those terms are defined in paragraph (e)(5) of this section, 
provided the aircraft is used to carry passengers or cargo for hire.
    (2) Pool, partnership, strategic alliance, joint operating 
agreement, code-sharing arrangement or other joint venture. A foreign 
corporation is considered engaged in the operation of ships or aircraft 
within the meaning of paragraph (e)(1) of this section with respect to 
its participation in a pool, partnership, strategic alliance, joint 
operating agreement, code-sharing arrangement or other joint venture if 
it directly, or indirectly through one or more fiscally transparent 
entities under the income tax laws of the United States, as defined in 
paragraph (e)(5)(v) of this section--
    (i) Owns an interest in a partnership, disregarded entity, or other 
fiscally transparent entity under the income tax laws of the United 
States that itself would be considered engaged in the operation of ships 
or aircraft under paragraph (e)(1) of this section if it were a foreign 
corporation; or
    (ii) Participates in a pool, strategic alliance, joint operating 
agreement, code-sharing arrangement, or other joint venture that is not 
an entity, as defined in paragraph (e)(5)(iv) of this section, involving 
one or more activities described in paragraphs (e)(1)(i) through (iii) 
of this section, but only if--
    (A) In the case of a direct interest, the foreign corporation is 
otherwise engaged in the operation of ships or aircraft under paragraph 
(e)(1) of this section; or
    (B) In the case of an indirect interest, either the foreign 
corporation is otherwise engaged, or one of the fiscally transparent 
entities would be considered engaged if it were a foreign corporation, 
in the operation of ships or aircraft under paragraph (e)(1) of this 
section.
    (3) Activities not considered operation of ships or aircraft. 
Activities that do not constitute operation of ships or aircraft 
include, but are not limited to--
    (i) The activities of a nonvessel operating common carrier, as 
defined in paragraph (e)(5)(vii) of this section;
    (ii) Ship or aircraft management;
    (iii) Obtaining crews for ships or aircraft operated by another 
party;
    (iv) Acting as a ship's agent;
    (v) Ship or aircraft brokering;
    (vi) Freight forwarding;
    (vii) The activities of travel agents and tour operators;
    (viii) Rental by a container leasing company of containers and 
related equipment; and
    (ix) The activities of a concessionaire.
    (4) Examples. The rules of paragraphs (e)(1) through (3) of this 
section are illustrated by the following examples:

    Example 1. Three tiers of charters--(i) Facts. A, B, and C are 
foreign corporations. A purchases a ship. A and B enter into a bareboat 
charter of the ship for a term of 20 years, and B, in turn, enters into 
a time charter of the ship with C for a term of 5 years. Under the time 
charter, B is responsible for the complete operation of the ship, 
including providing the crew and maintenance. C uses the ship during the 
term of the time charter to carry its customers' freight between U.S. 
and foreign ports. C owns no ships.
    (ii) Analysis. Because A is the owner of the entire ship and leases 
out the ship under a bareboat charter to B, and because the sublessor, 
C, uses the ship to carry cargo for hire, A is considered engaged in the 
operation of a ship under paragraph (e)(1) of this section during the 
term of the time charter. B leases in the entire ship from A and leases 
out the ship under a time charter to C, who uses the ship to carry cargo 
for hire. Therefore, B is considered engaged in the operation of a ship 
under paragraph (e)(1) of this section during the term of the time 
charter. C time charters the entire ship from B and uses the ship to 
carry its customers' freight during the term of the charter. Therefore, 
C

[[Page 481]]

is also engaged in the operation of a ship under paragraph (e)(1) of 
this section during the term of the time charter.
    Example 2. Partnership with contributed shipping assets--(i) Facts. 
X, Y, and Z, each a foreign corporation, enter into a partnership, P. P 
is a fiscally transparent entity under the income tax laws of the United 
States, as defined in paragraph (e)(5)(v) of this section. Under the 
terms of the partnership agreement, each partner contributes all of the 
ships in its fleet to P in exchange for interests in the partnership and 
shares in the P profits from the international carriage of cargo. The 
partners share in the overall management of P, but each partner, acting 
in its capacity as partner, continues to crew and manage all ships 
previously in its fleet.
    (ii) Analysis. P owns the ships contributed by the partners and uses 
these ships to carry cargo for hire. Therefore, if P were a foreign 
corporation, it would be considered engaged in the operation of ships 
within the meaning of paragraph (e)(1) of this section. Accordingly, 
because P is a fiscally transparent entity under the income tax laws of 
the United States, as defined in paragraph (e)(5)(v) of this section, X, 
Y, and Z are each considered engaged in the operation of ships through 
P, within the meaning of paragraph (e)(2)(i) of this section, with 
respect to their distributive share of income from P's international 
carriage of cargo.
    Example 3. Joint venture with chartered in ships--(i) Facts. Foreign 
corporation A owns a number of foreign subsidiaries involved in various 
aspects of the shipping business, including S1, S2, S3, and S4. S4 is a 
foreign corporation that provides cruises but does not own any ships. 
S1, S2, and S3 are foreign corporations that own cruise ships. S1, S2, 
S3, and S4 form joint venture JV, in which they are all interest 
holders, to conduct cruises. JV is a fiscally transparent entity under 
the income tax laws of the United States, as defined in paragraph 
(e)(5)(v) of this section. Under the terms of the joint venture, S1, S2, 
and S3 each enter into time charter agreements with JV, pursuant to 
which S1, S2, and S3 retain control of the navigation and management of 
the individual ships, and JV will use the ships to carry passengers for 
hire. The overall management of the cruise line will be provided by S4.
    (ii) Analysis. S1, S2, and S3 each owns ships and time charters 
those ships to JV, which uses the ships to carry passengers for hire. 
Accordingly, S1, S2, and S3 are each considered engaged in the operation 
of ships under paragraph (e)(1) of this section. JV leases in entire 
ships by means of the time charters, and JV uses those ships to carry 
passengers on cruises. Thus, JV would be engaged in the operation of 
ships within the meaning of paragraph (e)(1) of this section if it were 
a foreign corporation. Therefore, although S4 does not directly own or 
lease in a ship, S4 also is engaged in the operation of ships, within 
the meaning of paragraph (e)(2)(i) of this section, with respect to its 
participation in JV.
    Example 4. Tiered partnerships--(i) Facts. Foreign corporations A, 
B, and C enter into a partnership, P1. P1 is one of several shareholders 
of Poolco, a foreign limited liability company that makes an election 
pursuant to Sec.  301.7701-3 of this chapter to be treated as a 
partnership for U.S. tax purposes. P1 acquires several ships and time 
charters them out to Poolco. Poolco slot or voyage charters such ships 
out to third parties for use in the carriage of cargo for hire. P1 and 
Poolco are fiscally transparent entities under the income tax laws of 
the United States, as defined in paragraph (e)(5)(v) of this section.
    (ii) Analysis. A, B, and C are considered engaged in the operation 
of ships under paragraph (e)(2)(i) of this section with respect to their 
direct interest in P1 and with respect to their indirect interest in 
Poolco because both P1 and Poolco are fiscally transparent entities 
under the income tax laws of the United States and would be considered 
engaged in the operation of ships under paragraph (e)(1) of this section 
if they were foreign corporations. The result would be the same if 
Poolco were a single-member disregarded entity owned solely by P1.

    (5) Definitions--(i) Bareboat charter. A bareboat charter is a 
contract for the use of a ship or aircraft whereby the lessee is in 
complete possession, control, and command of the ship or aircraft. For 
example, in a bareboat charter, the lessee is responsible for the 
navigation and management of the ship or aircraft, the crew, supplies, 
repairs and maintenance, fees, insurance, charges, commissions and other 
expenses connected with the use of the ship or aircraft. The lessor of 
the ship bears none of the expense or responsibility of operation of the 
ship or aircraft.
    (ii) Code-sharing arrangement. A code-sharing arrangement is an 
arrangement in which one air carrier puts its identification code on the 
flight of another carrier. This arrangement allows the first carrier to 
hold itself out as providing service in markets where it does not 
otherwise operate or where it operates infrequently. Code-sharing 
arrangements can range from a very limited agreement between two 
carriers involving only one market to agreements involving multiple 
markets and alliances between or among international carriers which also 
include

[[Page 482]]

joint marketing, baggage handling, one-stop check-in service, sharing of 
frequent flyer awards, and other services. For rules involving the sale 
of code-sharing tickets, see paragraph (g)(1)(vi) of this section.
    (iii) Dry lease. A dry lease is the bareboat charter of an aircraft.
    (iv) Entity. For purposes of this paragraph (e), an entity is any 
person that is treated by the United States as other than an individual 
for U.S. Federal income tax purposes. The term includes disregarded 
entities.
    (v) Fiscally transparent entity under the income tax laws of the 
United States. For purposes of this paragraph (e), an entity is fiscally 
transparent under the income tax laws of the United States if the entity 
would be considered fiscally transparent under the income tax laws of 
the United States under the principles of Sec.  1.894-1(d)(3).
    (vi) Full charter. Full charter (or full rental) means a time 
charter or a voyage charter of a ship or a wet lease of an aircraft but 
during which the full crew and management are provided by the lessor.
    (vii) Nonvessel operating common carrier. A nonvessel operating 
common carrier is an entity that does not exercise control over any part 
of a vessel, but holds itself out to the public as providing 
transportation for hire, issues bills of lading, assumes responsibility 
or is liable by law as a common carrier for safe transportation of 
shipments, and arranges in its own name with other common carriers, 
including those engaged in the operation of ships, for the performance 
of such transportation.
    (viii) Space or slot charter. A space or slot charter is a contract 
for use of a certain amount of space (but less than all of the space) on 
a ship or aircraft, and may be on a time or voyage basis. When used in 
connection with passenger aircraft this sort of charter may be referred 
to as the sale of block seats.
    (ix) Time charter. A time charter is a contract for the use of a 
ship or aircraft for a specific period of time, during which the lessor 
of the ship or aircraft retains control of the navigation and management 
of the ship or aircraft (i.e., the lessor continues to be responsible 
for the crew, supplies, repairs and maintenance, fees and insurance, 
charges, commissions and other expenses connected with the use of the 
ship or aircraft).
    (x) Voyage charter. A voyage charter is a contract similar to a time 
charter except that the ship or aircraft is chartered for a specific 
voyage or flight rather than for a specific period of time.
    (xi) Wet lease. A wet lease is the time or voyage charter of an 
aircraft.
    (f) International operation of ships or aircraft--(1) General rule. 
The term international operation of ships or aircraft means the 
operation of ships or aircraft, as defined in paragraph (e) of this 
section, with respect to the carriage of passengers or cargo on voyages 
or flights that begin or end in the United States, as determined under 
paragraph (f)(2) of this section. The term does not include the carriage 
of passengers or cargo on a voyage or flight that begins and ends in the 
United States, even if the voyage or flight contains a segment extending 
beyond the territorial limits of the United States, unless the passenger 
disembarks or the cargo is unloaded outside the United States. Operation 
of ships or aircraft beyond the territorial limits of the United States 
does not constitute in itself international operation of ships or 
aircraft.
    (2) Determining whether income is derived from international 
operation of ships or aircraft. Whether income is derived from 
international operation of ships or aircraft is determined on a 
passenger by passenger basis (as provided in paragraph (f)(2)(i) of this 
section) and on an item-of-cargo by item-of-cargo basis (as provided in 
paragraph (f)(2)(ii) of this section). In the case of the bareboat 
charter of a ship or the dry lease of an aircraft, whether the charter 
income for a particular period is derived from international operation 
of ships or aircraft is determined by reference to how the ship or 
aircraft is used by the lowest-tier lessee in the chain of lessees (as 
provided in paragraph (f)(2)(iii) of this section).
    (i) International carriage of passengers--(A) General rule. Except 
in the case of a round trip described in paragraph (f)(2)(i)(B) of this 
section, income

[[Page 483]]

derived from the carriage of a passenger will be income from 
international operation of ships or aircraft if the passenger is carried 
between a beginning point in the United States and an ending point 
outside the United States, or vice versa. Carriage of a passenger will 
be treated as ending at the passenger's final destination even if, en 
route to the passenger's final destination, a stop is made at an 
intermediate point for refueling, maintenance, or other business 
reasons, provided the passenger does not change ships or aircraft at the 
intermediate point. Similarly, carriage of a passenger will be treated 
as beginning at the passenger's point of origin even if, en route to the 
passenger's final destination, a stop is made at an intermediate point, 
provided the passenger does not change ships or aircraft at the 
intermediate point. Carriage of a passenger will be treated as beginning 
or ending at a U.S. or foreign intermediate point if the passenger 
changes ships or aircraft at that intermediate point. Income derived 
from the sale of a ticket for international carriage of a passenger will 
be treated as income derived from international operation of ships or 
aircraft even if the passenger does not begin or complete an 
international journey because of unanticipated circumstances.
    (B) Round trip travel on ships. In the case of income from the 
carriage of a passenger on a ship that begins its voyage in the United 
States, calls on one or more foreign intermediate ports, and returns to 
the same or another U.S. port, such income from carriage of a passenger 
on the entire voyage will be treated as income derived from 
international operation of ships or aircraft under paragraph 
(f)(2)(i)(A) of this section. This result obtains even if such carriage 
includes one or more intermediate stops at a U.S. port or ports and even 
if the passenger does not disembark at the foreign intermediate point.
    (ii) International carriage of cargo. Income from the carriage of 
cargo will be income derived from international operation of ships or 
aircraft if the cargo is carried between a beginning point in the United 
States and an ending point outside the United States, or vice versa. 
Carriage of cargo will be treated as ending at the final destination of 
the cargo even if, en route to that final destination, a stop is made at 
a U.S. intermediate point, provided the cargo is transported to its 
ultimate destination on the same ship or aircraft. If the cargo is 
transferred to another ship or aircraft, the carriage of the cargo may 
nevertheless be treated as ending at its final destination, if the same 
taxpayer transports the cargo to and from the U.S. intermediate point 
and the cargo does not pass through customs at the U.S. intermediate 
point. Similarly, carriage of cargo will be treated as beginning at the 
cargo's point of origin, even if en route to its final destination a 
stop is made at a U.S. intermediate point, provided the cargo is 
transported to its ultimate destination on the same ship or aircraft. If 
the cargo is transferred to another ship or aircraft at the U.S. 
intermediate point, the carriage of the cargo may nevertheless be 
treated as beginning at the point of origin, if the same taxpayer 
transports the cargo to and from the U.S. intermediate point and the 
cargo does not pass through customs at the U.S. intermediate point. 
Repackaging, recontainerization, or any other activity involving the 
unloading of the cargo at the U.S. intermediate point does not change 
these results, provided the same taxpayer transports the cargo to and 
from the U.S. intermediate point and the cargo does not pass through 
customs at the U.S. intermediate point. A lighter vessel that carries 
cargo to, or picks up cargo from, a vessel located beyond the 
territorial limits of the United States and correspondingly loads or 
unloads that cargo at a U.S. port, carries cargo between a point in the 
United States and a point outside the United States. However, a lighter 
vessel that carries cargo to, or picks up cargo from, a vessel located 
within the territorial limits of the United States, and correspondingly 
loads or unloads that cargo at a U.S. port, is not engaged in 
international operation of ships or aircraft. Income from the carriage 
of military cargo on a voyage that begins in the United States, stops at 
a foreign intermediate

[[Page 484]]

port or a military prepositioning location, and returns to the same or 
another U.S. port without unloading its cargo at the foreign 
intermediate point, will nevertheless be treated as derived from 
international operation of ships or aircraft.
    (iii) Bareboat charter of ships or dry lease of aircraft used in 
international operation of ships or aircraft. If a qualified foreign 
corporation bareboat charters a ship or dry leases an aircraft to a 
lessee, and the lowest tier lessee in the chain of ownership uses such 
ship or aircraft for the international carriage of passengers or cargo 
for hire, as described in paragraphs (f)(2)(i) and (ii) of this section, 
then the amount of charter income attributable to the period the ship or 
aircraft is used by the lowest tier lessee is income from international 
operation of ships or aircraft. The foreign corporation generally must 
determine the amount of the charter income that is attributable to such 
international operation of ships or aircraft by multiplying the amount 
of charter income by a fraction, the numerator of which is the total 
number of days of uninterrupted travel on voyages or flights of such 
ship or aircraft between the United States and the farthest point or 
points where cargo or passengers are loaded en route to, or discharged 
en route from, the United States during the smaller of the taxable year 
or the particular charter period, and the denominator of which is the 
total number of days in the smaller of the taxable year or the 
particular charter period. For this purpose, the number of days during 
which the ship or aircraft is not generating transportation income, 
within the meaning of section 863(c)(2), are not included in the 
numerator or denominator of the fraction. However, the foreign 
corporation may adopt an alternative method for determining the amount 
of the charter income that is attributable to the international 
operation of ships or aircraft if it can establish that the alternative 
method more accurately reflects the amount of such income.
    (iv) Charter of ships or aircraft for hire. For purposes of this 
section, if a foreign corporation time, voyage, or bareboat charters out 
a ship or aircraft, and the lowest-tier lessee uses the ship or aircraft 
to carry passengers or cargo on a fee basis, the ship or aircraft is 
considered used to carry passengers or cargo for hire, regardless of 
whether the ship or aircraft may be empty during a portion of the 
charter period due to a backhaul voyage or flight or for purposes of 
repositioning. If a foreign corporation time, voyage, or bareboat 
charters out a ship or aircraft, and the lowest-tier lessee uses the 
ship or aircraft for the carriage of proprietary goods, including an 
empty backhaul voyage or flight or repositioning related to such 
carriage of proprietary goods, the ship or aircraft similarly will be 
treated as used to carry cargo for hire.
    (g) Activities incidental to the international operation of ships or 
aircraft--(1) General rule. Certain activities of a foreign corporation 
engaged in the international operation of ships or aircraft are so 
closely related to the international operation of ships or aircraft that 
they are considered incidental to such operation, and income derived by 
the foreign corporation from its performance of these incidental 
activities is deemed to be income derived from the international 
operation of ships or aircraft. Examples of such activities include--
    (i) Temporary investment of working capital funds to be used in the 
international operation of ships or aircraft by the foreign corporation;
    (ii) Sale of tickets by the foreign corporation engaged in the 
international operation of ships for the international carriage of 
passengers by ship on behalf of another corporation engaged in the 
international operation of ships;
    (iii) Sale of tickets by the foreign corporation engaged in the 
international operation of aircraft for the international carriage of 
passengers by air on behalf of another corporation engaged in the 
international operation of aircraft;
    (iv) Contracting with concessionaires for performance of services 
onboard during the international operation of the foreign corporation's 
ships or aircraft;
    (v) Providing (either by subcontracting or otherwise) for the 
carriage of cargo preceding or following the international carriage of 
cargo under a

[[Page 485]]

through bill of lading, airway bill or similar document through a 
related corporation or through an unrelated person (and the rules of 
section 267(b) shall apply for purposes of determining whether a 
corporation or other person is related to the foreign corporation);
    (vi) To the extent not described in paragraph (g)(1)(iii) of this 
section, the sale or issuance by the foreign corporation engaged in the 
international operation of aircraft of intraline, interline, or code-
sharing tickets for the carriage of persons by air between a U.S. 
gateway and another U.S. city preceding or following international 
carriage of passengers, provided that all such flight segments are 
provided pursuant to the passenger's original invoice, ticket or 
itinerary and in the case of intraline tickets are a part of 
uninterrupted international air transportation (within the meaning of 
section 4262(c)(3));
    (vii) Arranging for port city hotel accommodations within the United 
States for a passenger for the one night before or after the 
international carriage of that passenger by the foreign corporation 
engaged in the international operation of ships;
    (viii) Bareboat charter of ships or dry lease of aircraft normally 
used by the foreign corporation in international operation of ships or 
aircraft but currently not needed, if the ship or aircraft is used by 
the lessee for international carriage of cargo or passengers;
    (ix) Arranging by means of a space or slot charter for the carriage 
of cargo listed on a bill of lading or airway bill or similar document 
issued by the foreign corporation on the ship or aircraft of another 
corporation engaged in the international operation of ships or aircraft;
    (x) The provision of containers and related equipment by the foreign 
corporation in connection with the international carriage of cargo for 
use by its customers, including short-term use within the United States 
immediately preceding or following the international carriage of cargo 
(for this purpose, a period of five days or less shall be presumed to be 
short-term); and
    (xi) The provision of goods and services by engineers, ground and 
equipment maintenance staff, cargo handlers, catering staff, and 
customer services personnel, and the provision of facilities such as 
passenger lounges, counter space, ground handling equipment, and 
hangars.
    (2) Activities not considered incidental to the international 
operation of ships or aircraft. Examples of activities that are not 
considered incidental to the international operation of ships or 
aircraft include--
    (i) The sale of or arranging for train travel, bus transfers, single 
day shore excursions, or land tour packages;
    (ii) Arranging for hotel accommodations within the United States 
other than as provided in paragraph (g)(1)(vii) of this section;
    (iii) The sale of airline tickets or cruise tickets other than as 
provided in paragraph (g)(1)(ii), (iii), or (vi) of this section;
    (iv) The sale or rental of real property;
    (v) Treasury activities involving the investment of excess funds or 
funds awaiting repatriation, even if derived from the international 
operation of ships or aircraft;
    (vi) The carriage of passengers or cargo on ships or aircraft on 
domestic legs of transportation not treated as either international 
operation of ships or aircraft under paragraph (f) of this section or as 
an activity that is incidental to such operation under paragraph (g)(1) 
of this section;
    (vii) The carriage of cargo by bus, truck or rail by a foreign 
corporation between a U.S. inland point and a U.S. gateway port or 
airport preceding or following the international carriage of such cargo 
by the foreign corporation; and
    (viii) The provision of containers or other related equipment by the 
foreign corporation within the United States other than as provided in 
paragraph (g)(1)(x) of this section, including warehousing.
    (3) Other services. [Reserved]
    (4) Activities involved in a pool, partnership, strategic alliance, 
joint operating agreement, code-sharing arrangement or other joint 
venture. Notwithstanding paragraph (g)(1) of this section, an activity 
is considered incidental to the

[[Page 486]]

international operation of ships or aircraft by a foreign corporation, 
and income derived by the foreign corporation with respect to such 
activity is deemed to be income derived from the international operation 
of ships or aircraft, if the activity is performed by or pursuant to a 
pool, partnership, strategic alliance, joint operating agreement, code-
sharing arrangement or other joint venture in which such foreign 
corporation participates directly, or indirectly through a fiscally 
transparent entity under the income tax laws of the United States, 
provided that--
    (i) Such activity is incidental to the international operation of 
ships or aircraft by the pool, partnership, strategic alliance, joint 
operating agreement, code-sharing arrangement or other joint venture, 
and provided that it is described in paragraph (e)(2)(i) of this 
section; or
    (ii) Such activity would be incidental to the international 
operation of ships or aircraft by the foreign corporation, or fiscally 
transparent entity if it performed such activity itself, and provided 
the foreign corporation is engaged or the fiscally transparent entity 
would be considered engaged if it were a foreign corporation in the 
operation of ships or aircraft under paragraph (e)(1) of this section.
    (h) Equivalent exemption--(1) General rule. A foreign country grants 
an equivalent exemption when it exempts from taxation income from the 
international operation of ships or aircraft derived by corporations 
organized in the United States. Whether a foreign country provides an 
equivalent exemption must be determined separately with respect to each 
category of income, as provided in paragraph (h)(2) of this section. An 
equivalent exemption may be available for income derived from the 
international operation of ships even though income derived from the 
international operation of aircraft may not be exempt, and vice versa. 
For rules regarding foreign corporations organized in countries that 
provide exemptions only through an income tax convention, see paragraph 
(h)(3) of this section. An equivalent exemption may exist where the 
foreign country--
    (i) Generally imposes no tax on income, including income from the 
international operation of ships or aircraft;
    (ii) Provides an exemption from tax for income derived from the 
international operation of ships or aircraft, either by statute, decree, 
income tax convention, or otherwise; or
    (iii) Exchanges diplomatic notes with the United States, or enters 
into an agreement with the United States, that provides for a reciprocal 
exemption for purposes of section 883.
    (2) Determining equivalent exemptions for each category of income. 
Whether a foreign country grants an equivalent exemption must be 
determined separately with respect to income from the international 
operation of ships and income from the international operation of 
aircraft for each category of income listed in paragraphs (h)(2)(i) 
through (v), (vii), and (viii) of this section. If an exemption is 
unavailable in the foreign country for a particular category of income, 
the foreign country is not considered to grant an equivalent exemption 
with respect to that category of income. Income in that category is not 
considered to be the subject of an equivalent exemption and, thus, is 
not eligible for exemption from income tax in the United States, even 
though the foreign country may grant an equivalent exemption for other 
categories of income. With respect to paragraph (h)(2)(vi) of this 
section, a foreign country may be considered to grant an equivalent 
exemption for one or more types of income described in paragraph (g)(1) 
of this section. The following categories of income derived from the 
international operation of ships or aircraft may be exempt from United 
States income tax if an equivalent exemption is available--
    (i) Income from the carriage of passengers and cargo;
    (ii) Time or voyage (full) charter income of a ship or wet lease 
income of an aircraft;
    (iii) Bareboat charter income of a ship or dry charter income of an 
aircraft;
    (iv) Incidental bareboat charter income or incidental dry lease 
income;
    (v) Incidental container-related income;

[[Page 487]]

    (vi) Income incidental to the international operation of ships or 
aircraft other than incidental income described in paragraphs (h)(2)(iv) 
and (v) of this section;
    (vii) Capital gains derived by a qualified foreign corporation 
engaged in the international operation of ships or aircraft from the 
sale, exchange or other disposition of a ship, aircraft, container or 
related equipment or other moveable property used by that qualified 
foreign corporation in the international operation of ships or aircraft; 
and
    (viii) Income from participation in a pool, partnership, strategic 
alliance, joint operating agreement, code-sharing arrangement, 
international operating agency, or other joint venture described in 
paragraph (e)(2) of this section.
    (3) Special rules with respect to income tax conventions--(i) 
Countries with only an income tax convention. If a foreign country 
grants an exemption from tax for profits from the international 
operation of ships or aircraft only under an income tax convention with 
the United States, that exemption shall constitute an equivalent 
exemption with respect to a foreign corporation organized in that 
country only if--
    (A) The foreign corporation satisfies the conditions for claiming 
benefits with respect to such profits under the income tax convention; 
and
    (B) The profits that are exempt from tax pursuant to the shipping 
and air transport or gains article of the income tax convention and are 
described within a category of income included in paragraphs (h)(2)(i) 
through (viii) of this section.
    (ii) Countries with both an income tax convention and an equivalent 
exemption--(A) General rule. If a foreign country grants an exemption 
from tax for profits from the international operation of ships or 
aircraft under the shipping and air transport or gains article of an 
income tax convention with the United States and also by some other 
means (for example, by diplomatic note or domestic law of the foreign 
country), a foreign corporation may elect annually whether to claim an 
exemption from tax under section 883 or the income tax convention. 
Except as provided in paragraph (h)(3)(ii)(B) of this section, the 
foreign corporation must apply the elected exemption (section 883 or the 
income tax convention) to all categories of income described in 
paragraph (h)(2) of this section. If the foreign corporation elects to 
claim the exemption under section 883, it must satisfy all of the 
requirements for claiming the exemption under section 883. If the 
foreign corporation elects to claim the exemption under the income tax 
convention, it must satisfy all of the requirements and conditions for 
claiming benefits under the income tax convention. See Sec.  1.883-
4(b)(3) for rules concerning relying on shareholders resident in a 
foreign country that grants an equivalent exemption under an income tax 
convention to satisfy the stock ownership test of paragraph (c)(2) of 
this section.
    (B) Special rule for claiming simultaneous benefits under section 
883 and an income tax convention. If a foreign corporation that is 
organized in a country that grants an exemption from tax under an income 
tax convention and also by some other means (such as by diplomatic note 
or domestic law of the foreign country) with respect to a specific 
category of income described in paragraph (h)(2) of this section, and 
the foreign corporation elects to claim the exemption under the income 
tax convention, the foreign corporation may nonetheless simultaneously 
claim an exemption under section 883 with respect to a category of 
income exempt from tax by such other means if the foreign corporation--
    (1) Satisfies the requirements of paragraphs (h)(3)(i)(A) and (B) of 
this section for each category of income;
    (2) Satisfies one of the stock ownership tests of paragraph (c)(2) 
of this section; and
    (3) Complies with the substantiation and reporting requirements in 
paragraph (c)(3) of this section.
    (iii) Participation in certain joint ventures. If a foreign country 
grants an exemption for a category of income only through an income tax 
convention, a foreign corporation that is organized in that country and 
that derives income,

[[Page 488]]

directly or indirectly, through a participation in a pool, partnership, 
strategic alliance, joint operating agreement, code-sharing arrangement, 
or other joint venture described in paragraph (e)(2) of this section, 
may treat that exemption as an equivalent exemption even if the foreign 
corporation would not be eligible to claim benefits under the income tax 
convention for that category of income solely because the joint venture 
was not fiscally transparent, within the meaning of Sec.  1.894-
1(d)(3)(iii)(A), with respect to that category of income under the 
income tax laws of the foreign corporation's country of residence.
    (iv) Independent interpretation of income tax conventions. Nothing 
in this section nor Sec. Sec.  1.883-2 through 1.883-5 affects the 
rights or obligations under any income tax convention between the United 
States and a foreign country. The definitions provided in this section 
and Sec. Sec.  1.883-2 through 1.883-5 shall not give meaning to similar 
or identical terms used in an income tax convention, or provide guidance 
regarding the scope of any exemption provided by such convention, unless 
the income tax convention entered into force after August 26, 2003, and 
it, or its legislative history, explicitly refers to section 883 and 
guidance promulgated under that section for its meaning.
    (4) Exemptions not qualifying as equivalent exemptions--(i) General 
rule. Certain types of exemptions provided to corporations organized in 
the United States by foreign countries do not satisfy the equivalent 
exemption requirements of this section. Paragraphs (h)(4)(ii) through 
(vii) of this section provide descriptions of some of the types of 
exemptions that do not qualify as equivalent exemptions for purposes of 
this section.
    (ii) Reduced tax rate or time limited exemption. The exemption 
granted by the foreign country's law or income tax convention must be a 
complete exemption. The exemption may not constitute merely a reduction 
to a nonzero rate of tax levied against the income of corporations 
organized in the United States derived from the international operation 
of ships or aircraft or a temporary reduction to a zero rate of tax, 
such as in the case of a tax holiday.
    (iii) Inbound or outbound freight tax. With respect to the carriage 
of cargo, the foreign country must provide an exemption from tax for 
income from transporting freight both inbound and outbound. For example, 
a foreign country that imposes tax only on outbound freight will not be 
treated as granting an equivalent exemption for income from transporting 
freight inbound into that country.
    (iv) Exemptions for limited types of cargo. A foreign country must 
provide an exemption from tax for income from transporting all types of 
cargo. For example, if a foreign country were generally to impose tax on 
income from the international carriage of cargo but were to provide a 
statutory exemption for income from transporting agricultural products, 
the foreign country would not be considered to grant an equivalent 
exemption with respect to income from the international carriage of 
cargo, including agricultural products.
    (v) Territorial tax systems. A foreign country with a territorial 
tax system will be treated as granting an equivalent exemption if it 
treats all income derived from the international operation of ships or 
aircraft derived by a U.S. corporation as entirely foreign source and 
therefore not subject to tax, including income derived from a voyage or 
flight that begins or ends in that foreign country.
    (vi) Countries that tax on a residence basis. A foreign country that 
provides an equivalent exemption to corporations organized in the United 
States but also imposes a residence-based tax on certain corporations 
organized in the United States may nevertheless be considered to grant 
an equivalent exemption if the residence-based tax is imposed only on a 
corporation organized in the United States that maintains its center of 
management and control or other comparable attributes in that foreign 
country. If the residence-based tax is imposed on corporations organized 
in the United States and engaged in the international operation of ships 
or aircraft that are not managed and controlled in that foreign country, 
the foreign country shall not be treated as a qualified foreign country 
and shall not be considered to

[[Page 489]]

grant an equivalent exemption for purposes of this section.
    (vii) Exemptions within categories of income. With respect to 
paragraphs (h)(2)(i) through (v), (vii), and (viii) of this section, a 
foreign country must provide an exemption from tax for all income in a 
category of income, as defined in paragraph (h)(2) of this section. For 
example, a country that exempts income from the bareboat charter of 
passenger aircraft but not the bareboat charter of cargo aircraft does 
not provide an equivalent exemption. However, an equivalent exemption 
may be available for income derived from the international operation of 
ships even though income derived from the international operation of 
aircraft may not be exempt, and vice versa. With respect to paragraph 
(h)(2)(vi) of this section, a foreign country may be considered to grant 
an equivalent exemption for one or more types of income described in 
paragraph (g)(1) of this section.
    (i) Treatment of possessions. For purposes of this section, a 
possession of the United States will be treated as a foreign country. A 
possession of the United States will be considered to grant an 
equivalent exemption and will be treated as a qualified foreign country 
if it applies a mirror system of taxation. If a possession does not 
apply a mirror system of taxation, the possession may nevertheless be a 
qualified foreign country if, for example, it provides for an equivalent 
exemption through its internal law. A possession applies the mirror 
system of taxation if the U.S. Internal Revenue Code of 1986, as 
amended, applies in the possession with the name of the possession used 
instead of ``United States'' where appropriate.
    (j) Expenses related to qualified income. If a qualified foreign 
corporation derives qualified income from the international operation of 
ships or aircraft as well as income that is not qualified income, and 
the nonqualified income is effectively connected with the conduct of a 
trade or business within the United States, the foreign corporation may 
not deduct from such nonqualified income any amount otherwise allowable 
as a deduction from qualified income, if that qualified income is 
excluded under this section. See section 265(a)(1).

[T.D. 9087, 68 FR 51400, Aug. 26, 2003; 69 FR 7995, Feb. 20, 2004, as 
amended by T.D. 9332, 72 FR 34605, June 25, 2007; 72 FR 45159, Aug. 13, 
2007; T.D. 9502, 75 FR 56861, Sept. 17, 2010]



Sec.  1.883-2  Treatment of publicly-traded corporations.

    (a) General rule. A foreign corporation satisfies the stock 
ownership test of Sec.  1.883-1(c)(2) if it is considered a publicly-
traded corporation and satisfies the substantiation and reporting 
requirements of paragraphs (e) and (f) of this section. To be considered 
a publicly-traded corporation, the stock of the foreign corporation must 
be primarily traded and regularly traded, as defined in paragraphs (c) 
and (d) of this section, respectively, on one or more established 
securities markets, as defined in paragraph (b) of this section, in 
either the United States or any qualified foreign country.
    (b) Established securities market--(1) General rule. For purposes of 
this section, the term established securities market means, for any 
taxable year--
    (i) A foreign securities exchange that is officially recognized, 
sanctioned, or supervised by a governmental authority of the qualified 
foreign country in which the market is located, and has an annual value 
of shares traded on the exchange exceeding $1 billion during each of the 
three calendar years immediately preceding the beginning of the taxable 
year;
    (ii) A national securities exchange that is registered under section 
6 of the Securities Act of 1934 (15 U.S.C. 78f);
    (iii) A United States over-the-counter market, as defined in 
paragraph (b)(4) of this section;
    (iv) Any exchange designated under a Limitation on Benefits article 
in a United States income tax convention; and
    (v) Any other exchange that the Secretary may designate by 
regulation or otherwise.
    (2) Exchanges with multiple tiers. If an exchange in a foreign 
country has more than one tier or market level on which stock may be 
separately listed or traded, each such tier shall be treated as a 
separate exchange.

[[Page 490]]

    (3) Computation of dollar value of stock traded. For purposes of 
paragraph (b)(1)(i) of this section, the value in U.S. dollars of shares 
traded during a calendar year shall be determined on the basis of the 
dollar value of such shares traded as reported by the International 
Federation of Stock Exchanges located in Paris, or, if not so reported, 
then by converting into U.S. dollars the aggregate value in local 
currency of the shares traded using an exchange rate equal to the 
average of the spot rates on the last day of each month of the calendar 
year.
    (4) Over-the-counter market. An over-the-counter market is any 
market reflected by the existence of an interdealer quotation system. An 
interdealer quotation system is any system of general circulation to 
brokers and dealers that regularly disseminates quotations of stocks and 
securities by identified brokers or dealers, other than by quotation 
sheets that are prepared and distributed by a broker or dealer in the 
regular course of business and that contain only quotations of such 
broker or dealer.
    (5) Discretion to determine that an exchange does not qualify as an 
established securities market. The Commissioner may determine that a 
securities exchange that otherwise meets the requirements of paragraph 
(b) of this section does not qualify as an established securities 
market, if--
    (i) The exchange does not have adequate listing, financial 
disclosure, or trading requirements (or does not adequately enforce such 
requirements); or
    (ii) There is not clear and convincing evidence that the exchange 
ensures the active trading of listed stocks.
    (c) Primarily traded. For purposes of this section, stock of a 
corporation is primarily traded in a country on one or more established 
securities markets, as defined in paragraph (b) of this section, if, 
with respect to each class of stock described in paragraph (d)(1)(i) of 
this section (relating to classes of stock relied on to meet the 
regularly traded test)--
    (1) The number of shares in each such class that are traded during 
the taxable year on all established securities markets in that country 
exceeds
    (2) The number of shares in each such class that are traded during 
that year on established securities markets in any other single country.
    (d) Regularly traded--(1) General rule. For purposes of this 
section, stock of a corporation is regularly traded on one or more 
established securities markets, as defined in paragraph (b) of this 
section, if--
    (i) One or more classes of stock of the corporation that, in the 
aggregate, represent more than 50 percent of the total combined voting 
power of all classes of stock of such corporation entitled to vote and 
of the total value of the stock of such corporation are listed on such 
market or markets during the taxable year; and
    (ii) With respect to each class relied on to meet the more than 50 
percent requirement of paragraph (d)(1)(i) of this section--
    (A) Trades in each such class are effected, other than in de minimis 
quantities, on such market or markets on at least 60 days during the 
taxable year (or \1/6\ of the number of days in a short taxable year); 
and
    (B) The aggregate number of shares in each such class that are 
traded on such market or markets during the taxable year are at least 10 
percent of the average number of shares outstanding in that class during 
the taxable year (or, in the case of a short taxable year, a percentage 
that equals at least 10 percent of the average number of shares 
outstanding in that class during the taxable year multiplied by the 
number of days in the short taxable year, divided by 365).
    (2) Classes of stock traded on a domestic established securities 
market treated as meeting trading requirements. A class of stock that is 
traded during the taxable year on an established securities market 
located in the United States shall be considered to meet the trading 
requirements of paragraph (d)(1)(ii) of this section if the stock is 
regularly quoted by dealers making a market in the stock. A dealer makes 
a market in a stock only if the dealer regularly and actively offers to, 
and in fact does, purchase the stock from, and sell the stock to, 
customers who are not related persons (as defined in section 954(d)(3)) 
with respect to the dealer in

[[Page 491]]

the ordinary course of a trade or business.
    (3) Closely-held classes of stock not treated as meeting trading 
requirements--(i) General rule. Except as provided in paragraph 
(d)(3)(ii) of this section, a class of stock of a foreign corporation 
that otherwise meets the requirements of paragraph (d)(1) or (2) of this 
section shall not be treated as meeting such requirements for a taxable 
year if, for more than half the number of days during the taxable year, 
one or more persons who own at least 5 percent of the vote and value of 
the outstanding shares of the class of stock, as determined under 
paragraph (d)(3)(iii) of this section (each a 5-percent shareholder), 
own, in the aggregate, 50 percent or more of the vote and value of the 
outstanding shares of the class of stock. If one or more 5-percent 
shareholders own, in the aggregate, 50 percent or more of the vote and 
value of the outstanding shares of the class of stock, such shares held 
by the 5-percent shareholders will constitute a closely-held block of 
stock.
    (ii) Exception. Paragraph (d)(3)(i) of this section shall not apply 
to a class of stock if the foreign corporation can establish that 
qualified shareholders, as defined in Sec.  1.883-4(b), applying the 
attribution rules of Sec.  1.883-4(c), own sufficient shares in the 
closely-held block of stock to preclude nonqualified shareholders in the 
closely-held block of stock from owning 50 percent or more of the total 
value of the class of stock of which the closely-held block is a part 
for more than half the number of days during the taxable year. Any 
shares that are owned, after application of the attribution rules in 
Sec.  1.883-4(c), by a qualified shareholder shall not also be treated 
as owned by a nonqualified shareholder in the chain of ownership for 
purposes of the preceding sentence. A foreign corporation must obtain 
the documentation described in Sec.  1.883-4(d) from the qualified 
shareholders relied upon to satisfy this exception. However, no person 
otherwise treated as a qualified shareholder under Sec.  1.883-4(b) may 
be treated for purposes of this paragraph (d)(3) as a qualified 
shareholder if such person's interest in the foreign corporation, or in 
any intermediary corporation, is held through bearer shares that are not 
maintained during the relevant period in a dematerialized or immobilized 
book-entry system, as described in Sec.  1.883-1(c)(3)(i)(G).
    (iii) Five-percent shareholders--(A) Related persons. Solely for 
purposes of determining whether a person is a 5-percent shareholder, 
persons related within the meaning of section 267(b) shall be treated as 
one person. 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 
through the application of section 1563(e)(1), and stock owned through 
the application of section 267(c). In determining 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 through the application of section 
267(e)(3).
    (B) Investment companies. For purposes of this paragraph (d)(3), an 
investment company registered under the Investment Company Act of 1940, 
as amended (54 Stat. 789), shall not be treated as a 5-percent 
shareholder.
    (4) Anti-abuse rule. Trades between or among related persons 
described in section 267(b), as modified by paragraph (d)(3)(iii) of 
this section, and trades conducted in order to meet the requirements of 
paragraph (d)(1) of this section shall be disregarded. A class of stock 
shall not be treated as meeting the trading requirements of paragraph 
(d)(1) of this section if there is a pattern of trades conducted to meet 
the requirements of that paragraph. For example, trades between two 
persons that occur several times during the taxable year may be treated 
as an arrangement or a pattern of trades conducted to meet the trading 
requirements of paragraph (d)(1)(ii) of this section.
    (5) Example. The closely-held test in paragraph (d)(3) of this 
section is illustrated by the following example:

    Example. Closely-held exception. (i) Facts. X is a foreign 
corporation organized in a qualified foreign country and engaged in the 
international operation of ships. X has one

[[Page 492]]

class of stock, which is primarily traded on an established securities 
market in the qualified foreign country. The stock of X meets the 
regularly traded requirements of paragraph (d)(1)(ii) of this section 
without regard to paragraph (d)(3)(i) of this section. A, B, C and D are 
four members of the corporation's founding family who each own, during 
the entire taxable year, 25 percent of the stock of Hold Co, a company 
that issues registered shares. Hold Co, in turn, owns 60 percent of the 
stock of X during the entire taxable year. The remaining 40 percent of 
the stock of X is not owned by any 5-percent shareholder, as determined 
under paragraph (d)(3)(iii) of this section. A, B, and C are not 
residents of a qualified foreign country, but D is a resident of a 
qualified foreign country.
    (ii) Analysis. Because Hold Co owns 60 percent of the stock of X for 
more than half the number of days during the taxable year, Hold Co is a 
5-percent shareholder that owns 50 percent or more of the value of the 
stock of X. Thus, the shares owned by Hold Co constitute a closely-held 
block of stock. Under paragraph (d)(3)(i) of this section, the stock of 
X will not be regularly traded within the meaning of paragraph (d)(1) of 
this section unless X can establish, under paragraph (d)(3)(ii) of this 
section, that qualified shareholders within the closely-held block of 
stock own sufficient shares in the closely-held block of stock to 
preclude nonqualified shareholders in the closely-held block of stock 
from owning 50 percent or more of the value of the outstanding shares in 
the class of stock for more than half the number of days during the 
taxable year. A, B, and C are not qualified shareholders within the 
meaning of Sec.  1.883-4(b) because they are not residents of a 
qualified foreign country, but D is a resident of a qualified foreign 
country and therefore is a qualified shareholder. D owns 15 percent of 
the outstanding shares of X through Hold Co (25 percent x 60 percent = 
15 percent) while A, B, and C in the aggregate own 45 percent of the 
outstanding shares of X through Hold Co. D, therefore, owns sufficient 
shares in the closely-held block of stock to preclude the nonqualified 
shareholders in the closely-held block of stock, A, B and C, from owning 
50 percent or more of the value of the class of stock (60 percent-15 
percent = 45 percent) of which the closely-held block is a part. 
Provided that X obtains from D the documentation described in Sec.  
1.883-4(d), X's sole class of stock meets the exception in paragraph 
(d)(3)(ii) of this section and will not be disqualified from the 
regularly traded test by virtue of paragraph (d)(3)(i) of this section.
    (e) Substantiation that a foreign corporation is publicly traded--
(1) General rule. A foreign corporation that relies on the publicly 
traded test of this section to meet the stock ownership test of Sec.  
1.883-1(c)(2) must substantiate that the stock of the foreign 
corporation is primarily and regularly traded on one or more established 
securities markets, as that term is defined in paragraph (b) of this 
section. If one of the classes of stock on which the foreign corporation 
relies to meet this test is closely-held within the meaning of paragraph 
(d)(3)(i) of this section, the foreign corporation must obtain an 
ownership statement described in Sec.  1.883-4(d) from each qualified 
shareholder and intermediary that it relies upon to satisfy the 
exception to the closely-held test, but only to the extent such 
statement would be required if the foreign corporation were relying on 
the qualified shareholder stock ownership test of Sec.  1.883-4 with 
respect to those shares of stock. The foreign corporation must also 
maintain and provide to the Commissioner upon request a list of its 
shareholders of record and any other relevant information known to the 
foreign corporation supporting its entitlement to an exemption under 
this section.
    (2) Availability and retention of documents for inspection. A 
foreign corporation seeking qualified foreign corporation status must 
retain the documentation described in paragraph (e)(1) of this section 
until the expiration of the statute of limitations for its taxable year 
to which the documentation relates. The foreign corporation must make 
such documentation available for inspection at such time and such place 
as the Commissioner requests in writing under Sec.  1.883-1(c)(3)(ii)(A) 
or (B).
    (f) Reporting requirements. A foreign corporation relying on this 
section to satisfy the stock ownership test of Sec.  1.883-1(c)(2) must 
provide the following information in addition to the information 
required in Sec.  1.883-1(c)(3) to be included in its Form 1120-F, 
``U.S. Income Tax Return of a Foreign Corporation,'' for the taxable 
year. The information must be current as of the end of the corporation's 
taxable year and must include the following--
    (1) The name of the country in which the stock is primarily traded;
    (2) The name of the established securities market or markets on 
which the stock is listed;

[[Page 493]]

    (3) A description of each class of stock relied upon to meet the 
requirements of paragraph (d) of this section, including whether the 
class is issued in registered or bearer form and whether any such bearer 
shares are maintained in a dematerialized or immobilized book-entry 
system, as described in Sec.  1.883-1(c)(3)(i)(G), the number of shares 
issued and outstanding in that class as of the close of the taxable 
year, and the relative value of each class in relation to the total 
value of all shares of stock of the corporation that are outstanding as 
of the close of the taxable year;
    (4) For each class of stock relied upon to meet the requirements of 
paragraph (d) of this section, if one or more 5-percent shareholders, as 
defined in paragraph (d)(3)(i) of this section, own in the aggregate 50 
percent or more of the vote and value of the outstanding shares of that 
class of stock for more than half the number of days during the taxable 
year--
    (i) The days during the taxable year of the corporation in which the 
stock was closely-held without regard to the exception in paragraph 
(d)(3)(ii) of this section and the percentage of the vote and value of 
the class of stock that is owned by 5-percent shareholders during such 
days;
    (ii) With respect to all qualified shareholders that own directly, 
or by application of the attribution rules in Sec.  1.883-4(c), shares 
of the closely-held block of stock and that the foreign corporation 
relies on to satisfy the exception provided by paragraph (d)(3)(ii) of 
this section--
    (A) The number of such qualified shareholders;
    (B) The total percentage of the value of the shares owned, directly 
or indirectly, by such qualified shareholders by country of residence, 
determined under Sec.  1.883-4(b)(2) (residence of individual 
shareholders) or Sec.  1.883-4(d)(3) (special rules for residence of 
certain shareholders); and
    (C) The number of days during the taxable year of the foreign 
corporation that such qualified shareholders owned, directly or 
indirectly, their shares in the closely held block of stock.
    (5) Any other relevant information specified by Form 1120-F and its 
accompanying instructions.

[T.D. 9087, 68 FR 51406, Aug. 26, 2003, as amended by T.D. 9332, 72 FR 
34606, June 25, 2007; T.D. 9502, 75 FR 56862, Sept. 17, 2010; 75 FR 
63380, Oct. 15, 2010]



Sec.  1.883-3  Treatment of controlled foreign corporations.

    (a) General rule. A foreign corporation satisfies the stock 
ownership test of Sec.  1.883-1(c)(2) if it satisfies the qualified U.S. 
person ownership test in paragraph (b) of this section and the 
substantiation and reporting requirements of paragraphs (c) and (d) of 
this section, respectively. A foreign corporation that fails the 
qualified U.S. person ownership test of paragraph (b) of this section 
can satisfy the stock ownership test of Sec.  1.883-1(c)(2) if it meets 
either the publicly-traded test of Sec.  1.883-2(a) or the qualified 
shareholder stock ownership test of Sec.  1.883-4(a).
    (b) Qualified U.S. person ownership test--(1) General rule. A 
foreign corporation satisfies the qualified U.S. person ownership test 
only if the following two conditions are satisfied concurrently during 
more than half the days in its taxable year:
    (i) The foreign corporation is a controlled foreign corporation 
(within the meaning of section 957(a)).
    (ii) One or more qualified U.S. persons own more than 50 percent of 
the total value of all the outstanding stock of the foreign corporation 
(within the meaning of section 958(a) and paragraph (b)(4) of this 
section).
    (2) Qualified U.S. person. For purposes of this section, a qualified 
U.S. person is a United States citizen or resident alien, a domestic 
corporation, or a domestic trust described in section 501(a), but only 
if the person provides the controlled foreign corporation an ownership 
statement described in paragraph (c)(2) of this section, and the 
controlled foreign corporation meets the reporting requirements of 
paragraph (d) of this section with respect to that person.
    (3) Treatment of bearer shares. For purposes of paragraph (b)(1)(ii) 
of this section, any shares of the foreign corporation or of any 
intermediary corporation that are issued in bearer form,

[[Page 494]]

shall be treated as not owned by qualified U.S. persons if the bearer 
shares are not maintained in a dematerialized or immobilized book-entry 
system, as described in Sec.  1.883-1(c)(3)(i)(G).
    (4) Ownership attribution through certain domestic entities. For 
purposes of paragraph (b)(1)(ii) of this section, stock owned, directly 
or indirectly, by or for a domestic partnership, a domestic trust not 
described in section 501(a), or a domestic estate, shall be treated as 
owned proportionately by the partners, beneficiaries, grantors, or other 
interest holders, respectively, under the rules of section 958(a), which 
shall be applied by treating each domestic entity as a foreign entity. 
Stock that is considered owned by a person under this paragraph (b)(4) 
shall, for purposes of applying this paragraph (b)(4) to such person, be 
treated as actually owned by such person.
    (5) Examples. The following examples illustrate the qualified U.S. 
person ownership test of paragraph (b)(1) of this section:

    Example 1. Ship Co is a controlled foreign corporation (within the 
meaning of section 957(a)) for more than half the days of its taxable 
year and is organized in a qualified foreign country. A domestic 
partnership owns all of the outstanding stock of Ship Co for the entire 
taxable year. All of the partners in the domestic partnership are 
residents of foreign countries and not citizens of the United States. 
Ship Co does not satisfy the qualified U.S. person ownership test of 
paragraph (b)(1) of this section because qualified U.S. persons do not 
own shares of Ship Co stock with a value that is greater than 50 percent 
of the total value of the outstanding stock of the corporation for at 
least half the days of Ship Co's taxable year. Therefore, to satisfy the 
stock ownership test of Sec.  1.883-1(c)(2) and constitute a qualified 
foreign corporation, Ship Co must meet the qualified shareholder stock 
ownership test of Sec.  1.883-4(a).
    Example 2. Ship Co is a controlled foreign corporation (within the 
meaning of section 957(a)) for more than half the days of its taxable 
year and is organized in a qualified foreign country. Ship Co has a 
single class of stock outstanding. For Ship Co's entire taxable year, a 
foreign corporation (Corp A), that is wholly owned by a resident of a 
foreign country who is not a U.S. citizen, owns 40 percent of the 
outstanding Ship Co stock. During that same period, a domestic 
partnership owns the remaining 60 percent of the outstanding Ship Co 
stock. The domestic partnership is wholly owned by 20 United States 
citizens, each of whom owns a 5-percent partnership interest for Ship 
Co's entire taxable year. Ship Co meets the qualified U.S. person 
ownership test of paragraph (b)(1) of this section because during more 
than half the days in its taxable year it was a controlled foreign 
corporation within the meaning of section 957(a), and, applying the 
ownership attribution rules of paragraph (b)(4) of this section, 
qualified U.S. persons (the partners in the domestic partnership) owned 
Ship Co stock with a value that is greater than 50 percent of the total 
value of all the outstanding Ship Co shares. Therefore, Ship Co will 
meet the stock ownership test of Sec.  1.883-1(c)(2) if it satisfies the 
substantiation and reporting requirements of paragraphs (c) and (d) of 
this section with respect to the partners in the domestic partnership. 
Alternatively, if four or more partners in the domestic partnership were 
not qualified U.S. persons, Ship Co would not meet the qualified U.S. 
person ownership test of paragraph (b)(1) of this section because, even 
though during more than half the days in its taxable year it would have 
been a controlled foreign corporation within the meaning of section 
957(a), qualified U.S. persons would not have owned Ship Co stock with a 
value that is greater than 50 percent of the total value of all the 
outstanding Ship Co shares during that period.
    Example 3. Ship Co is a controlled foreign corporation (within the 
meaning of section 957(a)) and is organized in a qualified foreign 
country. Ship Co has two classes of stock outstanding, Class A 
representing 60 percent of the vote and value and Class B representing 
the remaining 40 percent of the vote and value of all the shares 
outstanding of Ship Co. The Class A stock is issued in bearer form and 
is maintained in a dematerialized book-entry system, as described in 
Sec.  1.883-1(c)(3)(i)(G). The Class B stock is also issued in bearer 
form, but is not maintained in a dematerialized or immobilized book-
entry system. For Ship Co's entire taxable year, a United States citizen 
A holds all the Class A stock and nonresident alien individual B owns 
all the Class B stock. Although the Class A stock is issued in bearer 
form, Ship Co will satisfy the qualified U.S. person ownership test of 
paragraph (b)(1) of this section because the Class A stock is maintained 
in a dematerialized book-entry system on behalf of A. The Class B stock 
is not owned by a qualified U.S. person but is taken into account in 
determining the total value of Ship Co's outstanding stock. 
Alternatively, if the Class B stock were owned by a qualified U.S. 
person, the results would be similar. Class B stock would not be taken 
into account in determining if the qualified U.S. person ownership test 
were satisfied, but would be taken into account in determining the total 
value of Ship Co's outstanding stock.


[[Page 495]]


    (c) Substantiation of CFC stock ownership--(1) In general. A 
controlled foreign corporation must establish all of the facts necessary 
to demonstrate to the Commissioner that it satisfies the qualified U.S. 
person ownership test of paragraph (b)(1) of this section by obtaining a 
written ownership statement (described in paragraph (c)(2) or (3) of 
this section, as applicable), signed under penalties of perjury by an 
individual authorized to sign that person's Federal tax or information 
return, from--
    (i) Each qualified U.S. person whose ownership of stock of the 
controlled foreign corporation is taken into account for purposes of 
meeting the qualified U.S. person ownership test; and
    (ii) Each domestic intermediary described in paragraph (b)(4) of 
this section, each foreign intermediary (including a foreign 
corporation, partnership, trust, or estate), and mere legal owners or 
record holders acting as nominees in the chain of ownership between each 
such qualified U.S. person and the controlled foreign corporation, if 
any.
    (2) Ownership statements from qualified U.S. persons. An ownership 
statement from a qualified U.S. person must include--
    (i) The qualified U.S. person's name, permanent address, and 
taxpayer identification number;
    (ii) If the qualified U.S. person directly owns shares in the 
controlled foreign corporation, the number of shares of each class of 
stock of the controlled foreign corporation owned by the qualified U.S. 
person, whether any shares are issued in bearer form, whether any bearer 
shares are maintained in a dematerialized or immobilized book-entry 
system, as described in Sec.  1.883-1(c)(3)(i)(G), and the period (or 
periods) in the taxable year of the controlled foreign corporation 
during which the qualified U.S. person owned the shares;
    (iii) If the qualified U.S. person indirectly owns shares in the 
controlled foreign corporation through a foreign or domestic 
intermediary described in paragraph (c)(1)(ii) of this section, the name 
of each intermediary, the amount and nature of the qualified U.S. 
person's interest in each intermediary, the period (or periods) in the 
taxable year of the controlled foreign corporation during which the 
qualified U.S. person held such interest, and, with respect to any 
intermediary foreign corporation, whether any shares are issued in 
bearer form and whether any such bearer shares are maintained in a 
dematerialized or immobilized book-entry system, as described in Sec.  
1.883-1(c)(3)(i)(G); and
    (iv) Any other information specified in published guidance by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (3) Ownership statements from intermediaries. An ownership statement 
from a domestic or foreign intermediary must include:
    (i) The intermediary's name, permanent address, and taxpayer 
identification number, if any.
    (ii) If the intermediary directly owns stock in the controlled 
foreign corporation, the number of shares of each class of stock of the 
controlled foreign corporation owned by the intermediary, whether such 
shares are issued in bearer form and maintained in a dematerialized or 
immobilized book-entry system, as described in Sec.  1.883-
1(c)(3)(i)(G), and the period (or periods) in the taxable year of the 
controlled foreign corporation during which the intermediary owned the 
shares.
    (iii) If the intermediary indirectly owns the stock of the 
controlled foreign corporation, the name and address of each 
intermediary in the chain of ownership between it and the controlled 
foreign corporation, the period (or periods) in the taxable year of the 
controlled foreign corporation during which the intermediary owned the 
shares, the percentage of its indirect ownership interest in the 
controlled foreign corporation, and, if any intermediary in the chain of 
ownership is a foreign corporation, whether any shares of such 
intermediary are issued in bearer form and if any such bearer shares are 
maintained in a dematerialized or immobilized book- entry system, as 
described in Sec.  1.883-1(c)(3)(i)(G).
    (iv) Any other information specified in published guidance by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).

[[Page 496]]

    (4) Three-year period of validity. The rules of Sec.  1.883-
4(d)(2)(ii) shall apply for determining the validity of the ownership 
statements required under paragraph (c)(2) of this section.
    (5) Availability and retention of documents for inspection. The 
foreign corporation seeking qualified foreign corporation status must 
retain the ownership statements described in this paragraph (c) until 
the expiration of the statute of limitations for its taxable year to 
which the ownership statements relate. The ownership statements must be 
made available for inspection at such time and place as the Commissioner 
may request in writing in accordance with Sec.  1.883-1(c)(3)(ii).
    (d) Reporting requirements. A controlled foreign corporation that 
relies on this section to satisfy the stock ownership test of Sec.  
1.883-1(c)(2) must include the following information (in addition to the 
information required by Sec.  1.883-1(c)(3)) with its Form 1120-F, 
``U.S. Income Tax Return of a Foreign Corporation'', filed for its 
taxable year. This information must be consistent with the ownership 
statements obtained by the controlled foreign corporation pursuant to 
paragraph (c) of this section and must be current as of the end of the 
corporation's taxable year--
    (1) The relative value of the shares of the controlled foreign 
corporation that are owned (directly, and indirectly applying the rules 
of paragraph (b)(4) of this section) by all qualified U.S. persons 
identified in paragraph (c)(2) of this section as compared to the value 
of all outstanding shares of the corporation;
    (2) The period (or periods) in the taxable year during which such 
qualified U.S. persons held such shares;
    (3) The period (or periods) in the taxable year during which the 
foreign corporation was a controlled foreign corporation;
    (4) A statement as to whether the controlled foreign corporation or 
any intermediary corporation had bearer shares outstanding during the 
taxable year, and whether any such bearer shares taken into account for 
purposes of satisfying the qualified U.S. person ownership test are 
maintained in a dematerialized or immobilized book-entry system, as 
described in Sec.  1.883-1(c)(3)(i)(G); and
    (5) Any other information specified by Form 1120-F, and its 
accompanying instructions, or in published guidance by the Internal 
Revenue Service (see Sec.  601.601(d)(2) of this chapter).

[T.D. 9502, 75 FR 56863, Sept. 17, 2010]



Sec.  1.883-4  Qualified shareholder stock ownership test.

    (a) General rule. A foreign corporation satisfies the stock 
ownership test of Sec.  1.883-1(c)(2) if more than 50 percent of the 
value of its outstanding shares is owned, or treated as owned by 
applying the attribution rules of paragraph (c) of this section, for at 
least half of the number of days in the foreign corporation's taxable 
year by one or more qualified shareholders, as defined in paragraph (b) 
of this section. A shareholder may be a qualified shareholder with 
respect to one category of income while not being a qualified 
shareholder with respect to another. A foreign corporation will not be 
considered to satisfy the stock ownership test of Sec.  1.883-1(c)(2) 
pursuant to this section unless the foreign corporation meets the 
substantiation and reporting requirements of paragraphs (d) and (e) of 
this section.
    (b) Qualified shareholder--(1) General rule. A shareholder is a 
qualified shareholder only if the shareholder--
    (i) With respect to the category of income for which the foreign 
corporation is seeking an exemption, is--
    (A) An individual who is a resident, as described in paragraph 
(b)(2) of this section, of a qualified foreign country;
    (B) The government of a qualified foreign country (or a political 
subdivision or local authority of such country);
    (C) A foreign corporation that is organized in a qualified foreign 
country and meets the publicly traded test of Sec.  1.883-2(a);
    (D) A not-for-profit organization described in paragraph (b)(4) of 
this section that is not a pension fund as defined in paragraph (b)(5) 
of this section and that is organized in a qualified foreign country;
    (E) An individual beneficiary of a pension fund (as defined in 
paragraph

[[Page 497]]

(b)(5)(iv) of this section) that is administered in or by a qualified 
foreign country, who is treated as a resident under paragraph 
(d)(3)(iii) of this section, of a qualified foreign country; or
    (F) A shareholder of a foreign corporation that is an airline 
covered by a bilateral Air Services Agreement in force between the 
United States and the qualified foreign country in which the airline is 
organized, provided the United States has not waived the ownership 
requirement in the Air Services Agreement, or that the ownership 
requirement has not otherwise been made ineffective;
    (ii) Does not own its interest in the foreign corporation through 
bearer shares, either directly or by applying the attribution rules of 
paragraph (c) of this section, unless such bearer shares are maintained 
in a dematerialized or immobilized book-entry system, as described in 
Sec.  1.883-1(c)(3)(i)(G); and
    (iii) Provides to the foreign corporation the documentation required 
in paragraph (d) of this section and the foreign corporation meets the 
reporting requirements of paragraph (e) of this section with respect to 
such shareholder.
    (2) Residence of individual shareholders--(i) General rule. An 
individual described in paragraph (b)(1)(i)(A) of this section is a 
resident of a qualified foreign country only if the individual is fully 
liable to tax as a resident in such country (e.g., an individual who is 
liable to tax on a remittance basis in a foreign country will not be 
treated as a resident of that country unless all residents of that 
country are taxed on a remittance basis only) and, in addition--
    (A) The individual has a tax home, within the meaning of paragraph 
(b)(2)(ii) of this section, in that qualified foreign country for 183 
days or more of the taxable year; or
    (B) The individual is treated as a resident of a qualified foreign 
country based on special rules pursuant to paragraph (d)(3) of this 
section.
    (ii) Tax home. For purposes of this section, 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 his business (or lack of a business), then the individual's 
tax home is located at his regular place of abode in a real and 
substantial sense. If an individual has no regular or principal place of 
business and no regular place of abode in a real and substantial sense 
in a qualified foreign country for 183 days or more of the taxable year, 
that individual does not have a tax home for purposes of this section. A 
foreign estate or trust, as defined in section 7701(a)(31), does not 
have a tax home for purposes of this section. See paragraph (c)(3) of 
this section for alternative rules in the case of trusts or estates.
    (3) Certain income tax convention restrictions applied to 
shareholders. For purposes of paragraph (b)(1) of this section, a 
shareholder described in paragraph (b)(1) of this section may be 
considered a resident of, or organized in, a qualified foreign country 
if that foreign country provides an exemption by means of an income tax 
convention with the United States, but only if the shareholder 
demonstrates that it is treated as a resident of that country under the 
convention and qualifies for benefits under any Limitation on Benefits 
article, and that the convention provides an exemption for the relevant 
category of income. If the convention has a requirement in the shipping 
and air transport article other than residence, such as place of 
registration or documentation of the ship or aircraft, the shareholder 
is not required to demonstrate that the corporation seeking qualified 
foreign corporation status could satisfy any such additional 
requirement.
    (4) Not-for-profit organizations. The term not-for-profit 
organization means an organization that meets the following 
requirements--
    (i) It is a corporation, association taxable as a corporation, 
trust, fund, foundation, league or other entity operated exclusively for 
religious, charitable, educational, or recreational purposes, and not 
organized for profit;
    (ii) It is generally exempt from tax in its country of organization 
by virtue of its not-for-profit status; and
    (iii) Either--
    (A) More than 50 percent of its annual support is expended on behalf 
of

[[Page 498]]

individuals described in paragraph (b)(1)(i)(A) of this section (see 
paragraph (d)(3)(v) of this section for special rules to substantiate 
the residence of individual beneficiaries of not-for-profit 
organizations) and on behalf of U.S. exempt organizations that have 
received determination letters under section 501(c)(3); or
    (B) More than 50 percent of its annual support is derived from 
individuals described in paragraph (b)(1)(i)(A) of this section (see 
paragraph (d)(3)(v) of this section for special rules to substantiate 
the residence of individual supporters of not-for-profit organizations).
    (5) Pension funds--(i) Pension fund defined. The term pension fund 
shall mean a government pension fund or a nongovernment pension fund, as 
those terms are defined, respectively, in paragraphs (b)(5)(ii) and 
(iii) of this section, that is a trust, fund, foundation, or other 
entity that is established exclusively for the benefit of employees or 
former employees of one or more employers, the principal purpose of 
which is to provide retirement, disability, and death benefits to 
beneficiaries of such entity and persons designated by such 
beneficiaries in consideration for prior services rendered.
    (ii) Government pension funds. A government pension fund is a 
pension fund that is a controlled entity of a foreign sovereign within 
the principles of Sec.  1.892-2T(c)(1) (relating to pension funds 
established for the benefit of employees or former employees of a 
foreign government).
    (iii) Nongovernment pension funds. A nongovernment pension fund is a 
pension fund that--
    (A) Is administered in a foreign country and is subject to 
supervision or regulation by a governmental authority (or other 
authority delegated to perform such supervision or regulation by a 
governmental authority) in such country;
    (B) Is generally exempt from income taxation in its country of 
administration;
    (C) Has 100 or more beneficiaries; and
    (D) The trustees, directors or other administrators of which pension 
fund provide the documentation required in paragraph (d) of this 
section.
    (iv) Beneficiary of a pension fund. The term beneficiary of a 
pension fund shall mean any person who has made contributions to a 
pension fund, as that term is defined in paragraph (b)(5)(i) of this 
section, or on whose behalf contributions have been made, and who is 
currently receiving retirement, disability, or death benefits from the 
pension fund or can reasonably be expected to receive such benefits in 
the future, whether or not the person's right to receive benefits from 
the fund has vested. See paragraph (c)(7) of this section for rules 
regarding the computation of stock ownership through nongovernment 
pension funds.
    (c) Rules for determining constructive ownership (1) General rules 
for attribution. For purposes of applying paragraph (a) of this section 
and the exception to the closely-held test in Sec.  1.883-1(d)(3)(ii), 
stock owned by or for a corporation, partnership, trust, estate, or 
mutual insurance company or similar entity shall be treated as owned 
proportionately by its shareholders, partners, beneficiaries, grantors, 
or other interest holders, as provided in paragraphs (c)(2) through (7) 
of this section. The proportionate interest rules of this paragraph (c) 
shall apply successively upward through the chain of ownership, and a 
person's proportionate interest shall be computed for the relevant days 
or period taken into account in determining whether a foreign 
corporation satisfies the requirements of paragraph (a) of this section. 
Stock treated as owned by a person by reason of this paragraph (c) shall 
be treated as actually owned by such person for purposes of this 
section. An owner of an interest in an association taxable as a 
corporation shall be treated as a shareholder of such association for 
purposes of this paragraph (c). Stock issued in bearer form will not be 
treated as owned proportionately by its shareholders unless the shares 
are maintained in a dematerialized or immobilized book-entry system, as 
described in Sec.  1.883-1(c)(3)(i)(G).
    (2) Partnerships--(i) General rule. A partner shall be treated as 
having an interest in stock of a foreign corporation owned by a 
partnership in proportion to the least of--

[[Page 499]]

    (A) The partner's percentage distributive share of the partnership's 
dividend income from the stock;
    (B) The partner's percentage distributive share of gain from 
disposition of the stock by the partnership; or
    (C) The partner's percentage distributive share of the stock (or 
proceeds from the disposition of the stock) upon liquidation of the 
partnership.
    (ii) Partners resident in the same country. For purposes of this 
paragraph, all qualified shareholders that are partners in a partnership 
and that are residents of, or organized in, the same qualified foreign 
country shall be treated as one partner. Thus, the percentage 
distributive shares of dividend income, gain and liquidation rights of 
all qualified shareholders that are partners in a partnership and that 
are residents of, or organized in, the same qualified foreign country 
are aggregated prior to determining the least of the three percentages 
set out in paragraph (c)(2)(i) of this section. For the meaning of the 
term resident, see paragraph (b)(2) of this section.
    (iii) Examples. The rules of paragraph (c)(2)(ii) of this section 
are illustrated by the following examples:

    Example 1. Stock held solely by qualified shareholders through a 
partnership. Country X grants an equivalent exemption. A and B are 
individual residents of Country X and are qualified shareholders within 
the meaning of paragraph (b)(1) of this section. A and B are the sole 
partners of Partnership P. P's only asset is the stock of Corporation Z, 
a Country X corporation seeking a reciprocal exemption under this 
section. A's distributive share of P's income and gain on the 
disposition of P's assets is 80 percent, but A's distributive share of 
P's assets (or the proceeds therefrom) on P's liquidation is 20 percent. 
B's distributive share of P's income and gain is 20 percent and B is 
entitled to 80 percent of the assets (or proceeds therefrom) on P's 
liquidation. Under the attribution rules of paragraph (c)(2)(ii) of this 
section, A and B will be treated as a single partner owning in the 
aggregate 100 percent of the stock of Z owned by P.
    Example 2. Stock held by both qualified and nonqualified 
shareholders through a partnership. Assume the same facts as in Example 
1 except that C, an individual who is not a resident of a qualified 
foreign country, is also a partner in P and that C's distributive share 
of P's income is 60 percent. The distributive shares of A and B are the 
same as in Example 1, except that A's distributive share of income is 20 
percent. Under the attribution rules of paragraph (c)(2)(ii) of this 
section, qualified shareholders A and B will be treated as a single 
partner owning in the aggregate 40 percent of the stock of Z owned by P 
(i.e., the lowest aggregate percentage of A and B's distributive shares 
of dividend income (40 percent), gain (100 percent), and liquidation 
rights (100 percent) with respect to the Z stock). Thus, only 40 percent 
of the Z stock is treated as owned by qualified shareholders.
    Example 3. Stock held through tiered partnerships. Country X grants 
an equivalent exemption. A and B are individual residents of Country X 
and are qualified shareholders within the meaning of paragraph (b)(1) of 
this section. A and B are the sole partners of Partnership P. P is a 
partner in Partnership P1, which owns the stock of Corporation Z, a 
Country X corporation seeking a reciprocal exemption under this section. 
Assume that P's distributive share of the dividend income, gain and 
liquidation rights with respect to the Z stock held by P1 is 40 percent. 
Assume that of the remaining partners of P1 only D is a qualified 
shareholder. D's distributive share of P1's dividend income and gain is 
15 percent; D's distributive share of P1's assets on liquidation is 25 
percent. Under the attribution rules of paragraph (c)(2)(ii) of this 
section, A and B, treated as a single partner, will own 40 percent of 
the Z stock owned by P1 (100 percent x 40 percent) and D will be treated 
as owning 15 percent of the Z stock owned by P1 (the least of D's 
dividend income (15 percent), gain (15 percent), and liquidation rights 
(25 percent) with respect to the Z stock). Thus, 55 percent of the Z 
stock owned by P1 is treated as owned by qualified shareholders.

    (3) Trusts and estates--(i) Beneficiaries. In general, an individual 
shall be treated as having an interest in stock of a foreign corporation 
owned by a trust or estate in proportion to the individual's actuarial 
interest in the trust or estate, as provided in section 318(a)(2)(B)(i), 
except that an income beneficiary's actuarial interest in the trust will 
be determined as if the trust's only asset were the stock. The interest 
of a remainder beneficiary in stock will be equal to 100 percent minus 
the sum of the percentages of any interest in the stock held by income 
beneficiaries. The ownership of an interest in stock owned by a trust 
shall not be attributed to any beneficiary whose interest cannot be 
determined under the preceding sentence, and any such interest, to the 
extent

[[Page 500]]

not attributed by reason of this paragraph (c)(3)(i), shall not be 
considered owned by a beneficiary unless all potential beneficiaries 
with respect to the stock are qualified shareholders. In addition, a 
beneficiary's actuarial interest will be treated as zero to the extent 
that someone other than the beneficiary is treated as owning the stock 
under paragraph (c)(3)(ii) of this section. A substantially separate and 
independent share of a trust, within the meaning of section 663(c), 
shall be treated as a separate trust for purposes of this paragraph 
(c)(3)(i), provided that payment of income, accumulated income or corpus 
of a share of one beneficiary (or group of beneficiaries) cannot affect 
the proportionate share of income, accumulated income or corpus of 
another beneficiary (or group of beneficiaries).
    (ii) Grantor trusts. A person is treated as the owner of stock of a 
foreign corporation owned by a trust to the extent that the stock is 
included in the portion of the trust that is treated as owned by the 
person under sections 671 through 679 (relating to grantors and others 
treated as substantial owners).
    (4) Corporations that issue stock. A shareholder of a corporation 
that issues stock shall be treated as owning stock of a foreign 
corporation that is owned by such corporation on any day in a proportion 
that equals the value of the stock owned by such shareholder to the 
value of all stock of such corporation. If, however, there is an 
agreement, express or implied, that a shareholder of a corporation will 
not receive distributions from the earnings of stock owned by the 
corporation, the shareholder will not be treated as owning that stock 
owned by the corporation.
    (5) Taxable nonstock corporations. A taxable nonstock corporation 
that is entitled in its country of organization to deduct from its 
taxable income amounts distributed for charitable purposes may deem a 
recipient of such charitable distributions to be a shareholder of such 
taxable nonstock corporation in the same proportion as the amount that 
such beneficiary receives in the taxable year bears to the total income 
of such taxable nonstock corporation in the taxable year. Whether each 
such recipient is a qualified shareholder may then be determined under 
paragraph (b) of this section or under the special rules of paragraph 
(d)(3)(vii) of this section.
    (6) Mutual insurance companies and similar entities. Stock held by a 
mutual insurance company, mutual savings bank, or similar entity 
(including an association taxable as a corporation that does not issue 
stock interests) shall be considered owned proportionately by the 
policyholders, depositors, or other owners in the same proportion that 
such persons share in the surplus of such entity upon liquidation or 
dissolution.
    (7) Computation of beneficial interests in nongovernment pension 
funds. Stock held by a pension fund shall be considered owned by the 
beneficiaries of the fund equally on a pro-rata basis if--
    (i) The pension fund meets the requirements of paragraph (b)(5)(iii) 
of this section;
    (ii) The trustees, directors or other administrators of the pension 
fund have no knowledge, and no reason to know, that a pro-rata 
allocation of interests of the fund to all beneficiaries would differ 
significantly from an actuarial allocation of interests in the fund (or, 
if the beneficiaries' actuarial interest in the stock held directly or 
indirectly by the pension fund differs from the beneficiaries' actuarial 
interest in the pension fund, the actuarial interests computed by 
reference to the beneficiaries' actuarial interest in the stock);
    (iii) Either--
    (A) Any overfunding of the pension fund would be payable, pursuant 
to the governing instrument or the laws of the foreign country in which 
the pension fund is administered, only to, or for the benefit of, one or 
more corporations that are organized in the country in which the pension 
fund is administered, individual beneficiaries of the pension fund or 
their designated beneficiaries, or social or charitable causes (the 
reduction of the obligation of the sponsoring company or companies to 
make future contributions to the pension fund by reason of overfunding 
shall not itself result in such overfunding being deemed to be payable 
to

[[Page 501]]

or for the benefit of such company or companies); or
    (B) The foreign country in which the pension fund is administered 
has laws that are designed to prevent overfunding of a pension fund and 
the funding of the pension fund is within the guidelines of such laws; 
or
    (C) The pension fund is maintained to provide benefits to employees 
in a particular industry, profession, or group of industries or 
professions and employees of at least 10 companies (other than companies 
that are owned or controlled, directly or indirectly, by the same 
interests) contribute to the pension fund or receive benefits from the 
pension fund; and
    (iv) The trustees, directors or other administrators provide the 
relevant documentation as required in paragraph (d) of this section.
    (d) Substantiation of stock ownership-- (1) General rule. A foreign 
corporation that relies on this section to satisfy the stock ownership 
test of Sec.  1.883-1(c)(2), must establish all the facts necessary to 
satisfy the Commissioner that more than 50 percent of the value of its 
shares is owned, or treated as owned applying paragraph (c) of this 
section, by qualified shareholders for the relevant period. If a foreign 
corporation relies upon bearer shares in the chain of ownership to 
satisfy one of the stock ownership tests, the foreign corporation must 
also establish all of the facts necessary to satisfy the Commissioner 
that such shares are maintained in a dematerialized book-entry system, 
as described in Sec.  1.883-1(c)(3)(i)(G), for the benefit of the 
relevant shareholder.
    (2) Application of general rule--(i) Ownership statements. Except as 
provided in paragraph (d)(3) of this section, a person shall only be 
treated as a qualified shareholder of a foreign corporation if--
    (A) For the relevant period, the person completes an ownership 
statement described in paragraph (d)(4) of this section or has a valid 
ownership statement in effect under paragraph (d)(2)(ii) of this 
section;
    (B) In the case of a person owning stock in the foreign corporation 
indirectly through one or more intermediaries (including mere legal 
owners or recordholders acting as nominees), each intermediary in the 
chain of ownership between that person and the foreign corporation 
seeking qualified foreign corporation status completes an intermediary 
ownership statement described in paragraph (d)(4)(v) of this section or 
has a valid intermediary ownership statement in effect under paragraph 
(d)(2)(ii) of this section; and
    (C) The foreign corporation seeking qualified foreign corporation 
status obtains the statements described in paragraphs (d)(2)(i)(A) and 
(B) of this section.
    (ii) Three-year period of validity. The ownership statements 
required in paragraph (d)(2)(i) of this section shall remain valid until 
the earlier of the last day of the third calendar year following the 
year in which the ownership statement is signed, or the day that a 
change of circumstance occurs that makes any information on the 
ownership statement incorrect. For example, an ownership statement 
signed on September 30, 2000, remains valid through December 31, 2003, 
unless a change of circumstance occurs that makes any information on the 
ownership statement incorrect.
    (3) Special rules--(i) Substantiating residence of certain 
shareholders. A foreign corporation seeking qualified foreign 
corporation status or an intermediary that is a direct or indirect 
shareholder of such foreign corporation may substantiate the residence 
of certain shareholders, for purposes of paragraph (b)(2)(i)(B) of this 
section, under one of the following special rules in paragraphs 
(d)(3)(ii) through (viii) of this section, in lieu of obtaining the 
ownership statements required in paragraph (d)(2)(i) of this section 
from such shareholders.
    (ii) Special rule for registered shareholders owning less than one 
percent of widely-held corporations. A foreign corporation with at least 
250 registered shareholders, that is not a publicly-traded corporation, 
as described in Sec.  1.883-2 (a widely-held corporation), is not 
required to obtain an ownership statement from an individual shareholder 
owning less than one percent of the widely-held corporation at all times 
during the taxable year if the requirements of paragraphs (d)(3)(ii)(A)

[[Page 502]]

and (B) of this section are satisfied. If the widely-held foreign 
corporation is the foreign corporation seeking qualified foreign 
corporation status, or an intermediary that meets the documentation 
requirements of paragraphs (d)(4)(v)(A) and (B) of this section, the 
widely-held foreign corporation may treat the address of record in its 
ownership records as the residence of any less than one percent 
individual shareholder if--
    (A) The individual's address of record is a specific street address 
and not a nonresidential address, such as a post office box or in care 
of a financial intermediary or stock transfer agent; and
    (B) The officers and directors of the widely-held corporation 
neither know nor have reason to know that the individual does not reside 
at that address.
    (iii) Special rule for beneficiaries of pension funds--(A) 
Government pension fund. An individual who is a beneficiary of a 
government pension fund, as defined in paragraph (b)(5)(ii) of this 
section, may be treated as a resident of the country in which the 
pension fund is administered if the pension fund satisfies the 
documentation requirements of paragraphs (d)(4)(v)(A) and (C)(1) of this 
section.
    (B) Nongovernment pension fund. An individual who is a beneficiary 
of a nongovernment pension fund, as described in paragraph (b)(5)(iii) 
of this section, may be treated as a resident of the country of the 
beneficiary's address as it appears on the records of the fund, provided 
it is not a nonresidential address, such as a post office box or an 
address in care of a financial intermediary, and provided none of the 
trustees, directors or other administrators of the pension fund know, or 
have reason to know, that the beneficiary is not an individual resident 
of such foreign country. The rules of this paragraph (d)(3)(iii)(B) 
shall apply only if the nongovernment pension fund satisfies the 
documentation requirements of paragraphs (d)(4)(v)(A) and (C)(2) of this 
section.
    (iv) Special rule for stock owned by publicly-traded corporations. 
Any stock in a foreign corporation seeking qualified foreign corporation 
status that is owned by a publicly-traded corporation will be treated as 
owned by an individual resident in the country where the publicly-traded 
corporation is organized if the foreign corporation receives the 
statement described in paragraph (d)(4)(iii) of this section from the 
publicly-traded corporation and copies of any relevant ownership 
statements from shareholders of the publicly-traded corporation relied 
on to satisfy the exception to the closely-held test of Sec.  1.883-
2(d)(3)(ii), as required in paragraph (d)(2)(i) of this section.
    (v) Special rule for not-for-profit organizations. For purposes of 
meeting the ownership requirements of paragraph (a) of this section, a 
not-for-profit organization may rely on the addresses of record of its 
individual beneficiaries and supporters to determine the residence of an 
individual beneficiary or supporter, within the meaning of paragraph 
(b)(2)(i)(B) of this section, to the extent required under paragraph 
(b)(4) of this section, provided that--
    (A) The addresses of record are not nonresidential addresses such as 
a post office box or in care of a financial intermediary;
    (B) The officers, directors or administrators of the organization do 
not know or have reason to know that the individual beneficiaries or 
supporters do not reside at that address; and
    (C) The foreign corporation seeking qualified foreign corporation 
status receives the statement required in paragraph (d)(4)(iv) of this 
section from the not-for-profit organization.
    (vi) Special rule for a foreign airline covered by an air services 
agreement. A foreign airline that is covered by a bilateral Air Services 
Agreement in force between the United States and the qualified foreign 
country in which the airline is organized may rely exclusively on the 
Air Services Agreement currently in effect and will not have to 
otherwise substantiate its ownership under this section, provided that 
the United States has not waived the ownership requirements in the 
agreement or that the ownership requirements have not otherwise been 
made ineffective. Such an airline will be treated as owned by qualified 
shareholders resident in the country where the foreign airline is 
organized.

[[Page 503]]

    (vii) Special rule for taxable nonstock corporations. Any stock in a 
foreign corporation seeking qualified foreign corporation status that is 
owned by a taxable nonstock corporation will be treated as owned, in any 
taxable year, by the recipients of distributions made during that 
taxable year, as set out in paragraph (c)(5) of this section. The 
taxable nonstock corporation may treat the address of record in its 
distribution records as the residence of any recipient if--
    (A) An individual recipient's address is in a qualified foreign 
country and is a specific street address and not a nonresidential 
address, such as a post office box or in care of a financial 
intermediary or stock transfer agent;
    (B) The address of a nonindividual recipient's principal place of 
business is in a qualified foreign country;
    (C) The officers and directors of the taxable nonstock corporation 
neither know nor have reason to know that the recipients do not reside 
or have their principal place of business at such addresses; and
    (D) The foreign corporation receives the statement described in 
paragraph (d)(4)(v)(D) of this section from the taxable nonstock 
corporation intermediary.
    (viii) Special rule for closely-held corporations traded in the 
United States. To demonstrate that a class of stock is not closely-held 
for purposes of Sec.  1.883-2(d)(3)(i), a foreign corporation whose 
stock is traded on an established securities market in the United States 
may rely on current Schedule 13D and Schedule 13G filings with the 
Securities and Exchange Commission to identify its 5-percent 
shareholders in each class of stock relied upon to meet the regularly 
traded test, without having to make any independent investigation to 
determine the identity of the 5-percent shareholder. However, if any 
class of stock is determined to be closely-held within the meaning of 
Sec.  1.883-2(d)(3)(i), the publicly traded corporation cannot satisfy 
the requirements of Sec.  1.883-2(e) unless it obtains sufficient 
documentation described in this paragraph (d) to demonstrate that the 
requirements of Sec.  1.883-2(d)(3)(ii) are met with respect to the 5-
percent shareholders.
    (4) Ownership statements from shareholders--(i) Ownership statements 
from individuals. An ownership statement from an individual is a written 
statement signed by the individual under penalties of perjury stating--
    (A) The individual's name, permanent address, and country where the 
individual is fully liable to tax as a resident, if any;
    (B) If the individual was not a resident of the country for the 
entire taxable year of the foreign corporation seeking qualified foreign 
corporation status, each of the foreign countries in which the 
individual resided and the dates of such residence during the taxable 
year of such foreign corporation;
    (C) If the individual directly owns shares of stock in the 
corporation seeking qualified foreign corporation status, the name of 
the corporation, the number of shares in each class of stock of the 
corporation owned by the individual, whether any such shares are issued 
in bearer form and maintained in a dematerialized or immobilized book-
entry system, as described in Sec.  1.883-1(c)(3)(i)(G), and the period 
(or periods) in the taxable year of the foreign corporation during which 
the individual owned the shares;
    (D) If the individual directly owns an interest in a corporation, 
partnership, trust, estate, or other intermediary that directly or 
indirectly owns stock in the corporation seeking qualified foreign 
corporation status, the name of the intermediary, the number and class 
of shares or the amount and nature of the interest that the individual 
holds in such intermediary, and, if the intermediary is a corporation, 
whether any such shares are issued in bearer form and maintained in a 
dematerialized or immobilized book-entry system, as described in Sec.  
1.883-1(c)(3)(i)(G), and the period (or periods) in the taxable year of 
the foreign corporation seeking qualified foreign corporation status 
during which the individual held such interest;
    (E) To the extent known by the individual, a description of the 
chain of ownership through which the individual owns stock in the 
corporation seeking qualified foreign corporation status, including the 
name and address of each intermediary standing between

[[Page 504]]

the intermediary described in paragraph (d)(4)(i)(D) of this section and 
the foreign corporation and whether this interest is owned either 
directly or indirectly through bearer shares; and
    (F) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (ii) Ownership statements from foreign governments. An ownership 
statement from a foreign government that is a qualified shareholder is a 
written statement--
    (A) Signed by any one of the following--
    (1) An official of the governmental authority, agency or office who 
has supervisory authority with respect to the government's ownership 
interest and who is authorized to sign such a statement on behalf of the 
authority, agency or office; or
    (2) The competent authority of the foreign country (as defined in 
the income tax convention between the United States and the foreign 
country); or
    (3) An income tax return preparer that, for purposes of this 
paragraph (d)(4)(ii) only, shall mean a firm of licensed or certified 
public accountants, a law firm whose principals or members are admitted 
to practice in one or more states, territories or possessions of the 
United States or the country of such government, or a bank or other 
financial institution licensed to do business in such foreign country 
and having assets at least equivalent to 50 million U.S. dollars and who 
is authorized to represent the government or governmental authority; and
    (B) That provides--
    (1) The title of the official or other person signing the statement;
    (2) The name and address of the government authority, agency or 
office that has supervisory authority and, if applicable, the income tax 
preparer which has prepared such ownership statement;
    (3) The information described in paragraphs (d)(4)(i)(C) through (E) 
of this section (as if the language applied ``government'' instead of 
``individual'') with respect to the government's direct or indirect 
ownership of stock in the corporation seeking qualified resident status;
    (4) In the case of an ownership statement prepared by an income tax 
return preparer, a statement under penalties of perjury identifying the 
documentation relied upon in the conduct of due diligence for the 
taxable year to determine the aggregate government investment in the 
stock of the shipping or aircraft company in preparation of such 
ownership statement attached to a valid power of attorney to represent 
the taxpayer for the taxable year; and
    (5) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (iii) Ownership statements from publicly-traded corporate 
shareholders. An ownership statement from a publicly-traded corporation 
that is a direct or indirect owner of the corporation seeking qualified 
foreign corporation status is a written statement, signed under 
penalties of perjury by a person that would be authorized to sign a tax 
return on behalf of the shareholder corporation containing the following 
information--
    (A) The name of the country in which the stock is primarily traded;
    (B) The name of the established securities market or markets on 
which the stock is listed;
    (C) A description of each class of stock relied upon to meet the 
requirements of Sec.  1.883-2(d)(1), including the number of shares 
issued and outstanding as of the close of the taxable year;
    (D) For each class of stock relied upon to meet the requirements of 
Sec.  1.883-2(d)(1), if one or more 5-percent shareholders, as defined 
in Sec.  1.883-2(d)(3)(i), own in the aggregate 50 percent or more of 
the vote and value of the outstanding shares of that class of stock for 
more than half the number of days during the taxable year--
    (1) The days during the taxable year of the corporation in which the 
stock was closely-held without regard to the exception in paragraph 
(d)(3)(ii) of this section and the percentage of the vote and value of 
the class of stock that is owned by 5-percent shareholders during such 
days;

[[Page 505]]

    (2) For each qualified shareholder who owns or is treated as owning 
stock in the closely-held block upon whom the corporation intends to 
rely to satisfy the exception to the closely-held test of Sec.  1.883-
2(d)(3)(ii)--
    (i) The name of each such shareholder;
    (ii) The percentage of the total value of the class of stock held by 
each such shareholder and the days during which the stock was held;
    (iii) The address of record of each such shareholder; and
    (iv) The country of residence of each such shareholder, determined 
under paragraph (b)(2) or (d)(3) of this section;
    (E) The information described in paragraphs (d)(4)(i)(C) through (E) 
of this section (as if the language applied ``publicly-traded 
corporation'' instead of ``individual'') with respect to the publicly-
traded corporation's direct or indirect ownership of stock in the 
corporation seeking qualified resident status; and
    (F) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (iv) Ownership statements from not-for-profit organizations. An 
ownership statement from a not-for-profit organization (other than a 
pension fund as defined in paragraph (b)(5) of this section) is a 
written statement signed by a person authorized to sign a tax return on 
behalf of the organization under penalties of perjury stating--
    (A) The name, permanent address, and principal location of the 
activities of the organization (if different from its permanent 
address);
    (B) The information described in paragraphs (d)(4)(i)(C) through (E) 
of this section (as if the language applied ``not-for-profit 
organization'' instead of ``individual'');
    (C) A representation that the not-for-profit organization satisfies 
the requirements of paragraph (b)(4) of this section; and
    (D) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (v) Ownership statements from intermediaries--(A) General rule. The 
foreign corporation seeking qualified foreign corporation status under 
the shareholder stock ownership test must obtain an intermediary 
ownership statement from each intermediary standing in the chain of 
ownership between it and the qualified shareholders on whom it relies to 
meet this test. An intermediary ownership statement is a written 
statement signed under penalties of perjury by the intermediary (if the 
intermediary is an individual) or a person who would be authorized to 
sign a tax return on behalf of the intermediary (if the intermediary is 
not an individual) containing the following information--
    (1) The name, address, country of residence, and principal place of 
business (in the case of a corporation or partnership) of the 
intermediary, and, if the intermediary is a trust or estate, the name 
and permanent address of all trustees or executors (or equivalent under 
foreign law), or if the intermediary is a pension fund, the name and 
permanent address of place of administration of the intermediary;
    (2) The information described in paragraphs (d)(4)(i)(C) through (E) 
of this section (as if the language applied ``intermediary'' instead of 
``individual'');
    (3) If the intermediary is a nominee for a shareholder or another 
intermediary, the name and permanent address of the shareholder, or the 
name and principal place of business of such other intermediary;
    (4) If the intermediary is not a nominee for a shareholder or 
another intermediary, the name and country of residence (within the 
meaning of paragraph (b)(2) of this section) and the proportionate 
interest in the intermediary of each direct shareholder, partner, 
beneficiary, grantor, or other interest holder (or if the direct holder 
is a nominee, of its beneficial shareholder, partner, beneficiary, 
grantor, or other interest holder), on which the foreign corporation 
seeking qualified foreign corporation status intends to rely to satisfy 
the requirements of paragraph (a) of this section. In addition, such 
intermediary must obtain from all such persons an ownership statement 
that includes the period of time during the taxable year for which

[[Page 506]]

the interest in the intermediary was owned by the shareholder, partner, 
beneficiary, grantor or other interest holder. For purposes of this 
paragraph (d)(4)(v)(A), the proportionate interest of a person in an 
intermediary is the percentage interest (by value) held by such person, 
determined using the principles for attributing ownership in paragraph 
(c) of this section;
    (5) If the intermediary is a widely-held corporation with registered 
shareholders owning less than one percent of the stock of such widely-
held corporation, the statement set out in paragraph (d)(4)(v)(B) of 
this section, relating to ownership statements from widely-held 
intermediaries with registered shareholders owning less than one percent 
of such widely-held intermediaries;
    (6) If the intermediary is a pension fund, within the meaning of 
paragraph (b)(5) of this section, the statement set out in paragraph 
(d)(4)(v)(C) of this section, relating to ownership statements from 
pension funds;
    (7) If the intermediary is a taxable nonstock corporation, within 
the meaning of paragraph (c)(5) of this section, the statement set out 
in paragraph (d)(4)(v)(D) of this section, relating to ownership 
statements from intermediaries that are taxable nonstock corporations; 
and
    (8) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (B) Ownership statements from widely-held intermediaries with 
registered shareholders owning less than one percent of such widely-held 
intermediary. An ownership statement from an intermediary that is a 
corporation with at least 250 registered shareholders, but that is not a 
publicly-traded corporation within the meaning of Sec.  1.883-2, and 
that relies on paragraph (d)(3)(ii) of this section, relating to the 
special rule for registered shareholders owning less than one percent of 
widely-held corporations, must provide the following information in 
addition to the information required in paragraph (d)(4)(v)(A) of this 
section--
    (1) The aggregate proportionate interest by country of residence in 
the widely-held corporation of such registered shareholders or other 
interest holders whose address of record is a specific street address 
and not a nonresidential address, such as a post office box or in care 
of a financial intermediary or stock transfer agent; and
    (2) A representation that the officers and directors of the widely-
held intermediary neither know nor have reason to know that the 
individual shareholder does not reside at his or her address of record 
in the corporate records; and
    (3) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (C) Ownership statements from pension funds--(1) Ownership 
statements from government pension funds. A government pension fund (as 
defined in paragraph (b)(5)(ii) of this section) that relies on 
paragraph (d)(3)(iii) of this section (relating to the special rules for 
pension funds) generally must provide the documentation required in 
paragraph (d)(4)(v)(A) of this section, and, in addition, the government 
pension fund must also provide the following information--
    (i) The name of the country in which the plan is administered;
    (ii) A representation that the fund is established exclusively for 
the benefit of employees or former employees of a foreign government, or 
employees or former employees of a foreign government and 
nongovernmental employees or former employees that perform or performed 
governmental or social services;
    (iii) A representation that the funds that comprise the trust are 
managed by trustees who are employees of, or persons appointed by, the 
foreign government;
    (iv) A representation that the trust forming part of the pension 
plan provides for retirement, disability, or death benefits in 
consideration for prior services rendered;
    (v) A representation that the income of the trust satisfies the 
obligations of the foreign government to the participants under the 
plan, rather than inuring to the benefit of a private person; and

[[Page 507]]

    (vi) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (2) Ownership statements from nongovernment pension funds. The 
trustees, directors, or other administrators of the nongovernment 
pension fund, as defined in paragraph (b)(5)(iii) of this section, that 
rely on paragraph (d)(3)(iii) of this section, relating to the special 
rules for pension funds, generally must provide the pension fund's 
intermediary ownership statement described in paragraph (d)(4)(v)(A) of 
this section. In addition, the nongovernment pension fund must also 
provide the following information--
    (i) The name of the country in which the pension fund is 
administered;
    (ii) A representation that the pension fund is subject to 
supervision or regulation by a governmental authority (or other 
authority delegated to perform such supervision or regulation by a 
governmental authority) in such country, and, if so, the name of the 
governmental authority (or other authority delegated to perform such 
supervision or regulation);
    (iii) A representation that the pension fund is generally exempt 
from income taxation in its country of administration;
    (iv) The number of beneficiaries in the pension plan;
    (v) The aggregate percentage interest of beneficiaries by country of 
residence based on addresses shown on the books and records of the fund, 
provided the addresses are not nonresidential addresses, such as a post 
office box or an address in care of a financial intermediary, and 
provided none of the trustees, directors or other administrators of the 
pension fund know, or have reason to know, that the beneficiary is not a 
resident of such foreign country;
    (vi) A representation that the pension fund meets the requirements 
of paragraph (b)(5)(iii) of this section;
    (vii) A representation that the trustees, directors or other 
administrators of the pension fund have no knowledge, and no reason to 
know, that a pro-rata allocation of interests of the fund to all 
beneficiaries would differ significantly from an actuarial allocation of 
interests in the fund (or, if the beneficiaries' actuarial interest in 
the stock held directly or indirectly by the pension fund differs from 
the beneficiaries' actuarial interest in the pension fund, the actuarial 
interests computed by reference to the beneficiaries' actuarial interest 
in the stock);
    (viii) A representation that any overfunding of the pension fund 
would be payable, pursuant to the governing instrument or the laws of 
the foreign country in which the pension fund is administered, only to, 
or for the benefit of, one or more corporations that are organized in 
the country in which the pension fund is administered, individual 
beneficiaries of the pension fund or their designated beneficiaries, or 
social or charitable causes (the reduction of the obligation of the 
sponsoring company or companies to make future contributions to the 
pension fund by reason of overfunding shall not itself result in such 
overfunding being deemed to be payable to or for the benefit of such 
company or companies); or that the foreign country in which the pension 
fund is administered has laws that are designed to prevent overfunding 
of a pension fund and the funding of the pension fund is within the 
guidelines of such laws; or that the pension fund is maintained to 
provide benefits to employees in a particular industry, profession, or 
group of industries or professions, and that employees of at least 10 
companies (other than companies that are owned or controlled, directly 
or indirectly, by the same interests) contribute to the pension fund or 
receive benefits from the pension fund; and
    (ix) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (3) Time for making determinations. The determinations required to 
be made under this paragraph (d)(4)(v)(C) shall be made using 
information shown on the records of the pension fund for a date during 
the foreign corporation's taxable year to which the determination is 
relevant.
    (D) Ownership statements from taxable nonstock corporations. An 
ownership statement from an intermediary that is a taxable nonstock 
corporation must provide the following information in

[[Page 508]]

addition to the information required in paragraph (d)(4)(v)(A) of this 
section--
    (1) With respect to paragraph (d)(4)(v)(A)(7) of this section, for 
each beneficiary that is treated as a qualified shareholder, the name, 
address of residence (in the case of an individual beneficiary, the 
address must be a specific street address and not a nonresidential 
address, such as a post office box or in care of a financial 
intermediary; in the case of a nonindividual beneficiary, the address of 
the principal place of business) and percentage that is the same 
proportion as the amount that the beneficiary receives in the tax year 
bears to the total net income of the taxable nonstock corporation in the 
tax year;
    (2) A representation that the officers and directors of the taxable 
nonstock corporation neither know nor have reason to know that the 
individual beneficiaries do not reside at the address listed in 
paragraph (d)(4)(v)(D)(1) of this section or that any other 
nonindividual beneficiary does not conduct its primary activities at 
such address or in such country of residence; and
    (3) Any other information as specified in guidance published by the 
Internal Revenue Service (see Sec.  601.601(d)(2) of this chapter).
    (5) Availability and retention of documents for inspection. The 
documentation described in paragraphs (d)(3) and (4) of this section 
must be retained by the corporation seeking qualified foreign 
corporation status (the foreign corporation) until the expiration of the 
statute of limitations for the taxable year of the foreign corporation 
to which the documentation relates. Such documentation must be made 
available for inspection by the Commissioner at such time and place as 
the Commissioner may request in writing.
    (e) Reporting requirements. A foreign corporation relying on the 
qualified shareholder stock ownership test of this section to meet the 
stock ownership test of Sec.  1.883-1(c)(2) must provide the following 
information in addition to the information required in Sec.  1.883-
1(c)(3) to be included in its Form 1120-F, ``U.S. Income Tax Return of a 
Foreign Corporation,'' for each taxable year. The information should be 
current as of the end of the corporation's taxable year. The information 
must include the following--
    (1) A representation that more than 50 percent of the value of the 
outstanding shares of the corporation is owned (or treated as owned by 
reason of paragraph (c) of this section) by qualified shareholders for 
each category of income for which the exemption is claimed;
    (2) With respect to all qualified shareholders relied upon to 
satisfy the 50 percent ownership test of paragraph (a) of this section, 
the total number of such qualified shareholders as defined in paragraph 
(b)(1) of this section; the total percentage of the value of the 
outstanding shares owned, applying the attribution rules of paragraph 
(c) of this section, by such qualified shareholders by country of 
residence or organization, whichever is applicable; and the period 
during the taxable year of the foreign corporation that such stock was 
held by qualified shareholders; and
    (3) Any other relevant information specified by the Form 1120-F, 
``U.S. Income Tax Return of a Foreign Corporation,'' and its 
accompanying instructions, or in published guidance by the Internal 
Revenue Service (see Sec.  601.601(d)(2) of this chapter).

[T.D. 9087, 68 FR 51406, Aug. 26, 2003; 69 FR 7995, Feb. 20, 2004, as 
amended by T.D. 9332, 72 FR 34608, June 25, 2007; T.D. 9502, 75 FR 
56865, Sept. 17, 2010]



Sec.  1.883-5  Effective/applicability dates.

    (a) General rule. Sections 1.883-1 through 1.883-4 apply to taxable 
years of a foreign corporation seeking qualified foreign corporation 
status beginning after September 24, 2004.
    (b) Election for retroactive application. Taxpayers may elect to 
apply Sec. Sec.  1.883-1 through 1.883-4 for any open taxable year of 
the foreign corporation beginning after December 31, 1986, except that 
the substantiation and reporting requirements of Sec.  1.883-1(c)(3) 
(relating to the substantiation and reporting required to be treated as 
a qualified foreign corporation) or Sec. Sec.  1.883-2(f), 1.883-3(d) 
and 1.883-4(e) (relating to additional information to be included in the 
return to demonstrate whether the foreign corporation satisfies the 
stock ownership test) will not apply to any

[[Page 509]]

year beginning before September 25, 2004. Such election shall apply to 
the taxable year of the election and to all subsequent taxable years 
beginning before September 25, 2004.
    (c) Transitional information reporting rule. For taxable years of 
the foreign corporation beginning after September 24, 2004, and until 
such time as the Form 1120-F, ``U.S. Income Tax Return of a Foreign 
Corporation,'' or its instructions are revised to provide otherwise, the 
information required in Sec.  1.883-1(c)(3) and Sec.  1.883-2(f), Sec.  
1.883-3(d) or Sec.  1.883-4(e), as applicable, must be included on a 
wirtten statement attached to the Form 1120-F and file with the return.
    (d) Effective/applicability dates. Except as otherwise provided in 
this paragraph (d), Sec. Sec.  1.883-1, 1.883-2, 1.883-3, and 1.883-4 
apply to taxable years of the foreign corporation beginning after June 
25, 2007, and may be applied to any open taxable years of the foreign 
corporation beginning on or after December 31, 2004. The portion of any 
provision concerning bearer shares maintained in a dematerialized or 
immobilized book-entry system, as described in Sec.  1.883-
1(c)(3)(i)(G), applies to taxable years of a foreign corporation 
beginning on or after September 17, 2010.

[T.D. 9218, 70 FR 45530, Aug. 8, 2005, as amended by T.D. 9332, 72 FR 
34609, June 25, 2007; T.D. 9502, 75 FR 56865, Sept. 17, 2010; 75 FR 
63380, Oct. 15, 2010]



Sec.  1.884-0  Overview of regulation provisions for section 884.

    (a) Introduction. Section 884 consists of three main parts: a branch 
profits tax on certain earnings of a foreign corporation's U.S. trade or 
business; a branch-level interest tax on interest paid, or deemed paid, 
by a foreign corporation's U.S. trade or business; and an anti-treaty 
shopping rule. A foreign corporation is subject to section 884 by virtue 
of owning an interest in a partnership, trust, or estate that is engaged 
in a U.S. trade or business or has income treated as effectively 
connected with the conduct of a trade or business in the United States. 
An international organization (as defined in section 7701(a)(18)) is not 
subject to the branch profits tax by reason of section 884(e)(5). A 
foreign government treated as a corporate resident of its country of 
residence under section 892(a)(3) shall be treated as a corporation for 
purposes of section 884. The preceding sentence shall be effective for 
taxable years ending on or after September 11, 1992, except that, for 
the first taxable year ending on or after that date, the branch profits 
tax shall not apply to effectively connected earnings and profits of the 
foreign government earned prior to that date nor to decreases in the 
U.S. net equity of a foreign government occurring after the close of the 
preceding taxable year and before that date. Similarly, Sec.  1.884-4 
shall apply, in the case of branch interest, only with respect to 
amounts of interest accrued and paid by a foreign government on or after 
that date, or, in the case of excess interest, only with respect to 
amounts attributable to interest accrued by a foreign government on or 
after that date and apportioned to ECI, as defined in Sec.  1.884-
1(d)(1)(iii). Except as otherwise provided, for purposes of the 
regulations under section 884, the term ``U.S. trade or business'' 
includes all the U.S. trades or businesses of a foreign corporation.
    (1) The branch profits tax. Section 1.884-1 provides rules for 
computing the branch profits tax and defines various terms that affect 
the computation of the tax. In general, section 884(a) imposes a 30-
percent branch profits tax on the after-tax earnings of a foreign 
corporation's U.S. trade or business that are not reinvested in a U.S. 
trade or business by the close of the taxable year, or are disinvested 
in a later taxable year. Changes in the value of the equity of the 
foreign corporation's U.S. trade or business are used as the measure of 
whether earnings have been reinvested in, or disinvested form, a U.S. 
trade or business. An increase in the equity during the taxable year is 
generally treated as a reinvestment of the earnings for the current 
taxable year; a decrease in the equity during the taxable year is 
generally treated as a disinvestment of prior years' earnings that have 
not previously been subject to the branch profits tax. The amount 
subject to the branch profits tax for the taxable year is the dividend 
equivalent amount. Section 1.884-2T contains special rules relating to 
the effect on

[[Page 510]]

the branch profits tax of the termination or incorporation of a U.S. 
trade or business or the liquidation or reorganization of a foreign 
corporation or its domestic subsidiary.
    (2) The branch-level interest tax. Section 1.884-4 provides rules 
for computing the branch-level interest tax. In general, interest paid 
by a U.S. trade or business of a foreign corporation (``branch 
interest'', as defined in Sec.  1.884-4(b)) is treated as if it were 
paid by a domestic corporation and may be subject to tax under section 
871(a) or 881, and to withholding under section 1441 or 1442. In 
addition, if the interest apportioned to ECI exceeds branch interest, 
the excess is treated as interest paid to the foreign corporation by a 
wholly-owned domestic corporation and is subject to tax under section 
881(a).
    (3) Qualified resident. Section 1.884-5 provides rules for 
determining whether a foreign corporation is a qualified resident of a 
foreign country. In general, a foreign corporation must be a qualified 
resident of a foreign country with which the United States has an income 
tax treaty in order to claim an exemption or rate reduction with respect 
to the branch profits tax, the branch-level interest tax, and the tax on 
dividends paid by the foreign corporation.
    (b) Special rules for U.S. possessions. (1) Section 884 does not 
apply to a corporation created or organized in, or under the law of, 
American Samoa, Guam, the Northern Mariana Islands, or the U.S. Virgin 
Islands, provided that the conditions of Sec.  1.881-5(c)(1) through 
(c)(3) are satisfied with respect to such corporation. The preceding 
sentence applies for taxable years ending after April 9, 2008.
    (2) Section 884 does not apply for purposes of determining tax 
liability incurred to a section 935 possession or the U.S. Virgin 
Islands by a corporation created or organized in, or under the law of, 
such possession or the United States. The preceding sentence applies for 
taxable years ending after April 9, 2008.
    (c) Outline of major topics in Sec. Sec.  1.884-1 through 1.884-5.

                    Sec.  1.884-1 Branch profits tax.

    (a) General rule.
    (b) Dividend equivalent amount.
    (1) Definition.
    (2) Adjustment for increase in U.S. net equity.
    (3) Adjustment for decrease in U.S. net equity.
    (4) Examples.
    (c) U.S. net equity.
    (1) Definition.
    (2) Definition of amount of a U.S. asset.
    (3) Definition of determination date.
    (d) U.S. assets.
    (1) Definition of a U.S. asset.
    (2) Special rules for certain assets.
    (3) Interest in a partnership.
    (4) Interest in a trust or estate.
    (5) Property that is not a U.S. asset.
    (6) E&P basis of a U.S. asset.
    (e) U.S. liabilities.
    (1) Liabilities based on Sec.  1.882-5.
    (2) Insurance reserves.
    (3) Election to reduce liabilities.
    (4) Artificial decrease in U.S. liabilities.
    (5) Examples.
    (f) Effectively connected earnings and profits.
    (1) In general.
    (2) Income that does not produce ECEP.
    (3) Allocation of deductions attributable to income that does not 
produce ECEP.
    (4) Examples.
    (g) Corporations resident in countries with which the United States 
has an income tax treaty.
    (1) General rule.
    (2) Special rules for foreign corporations that are qualified 
residents on the basis of their ownership.
    (3) Exemptions for foreign corporations resident in certain 
countries with income tax treaties in effect on January 1, 1987.
    (4) Modifications with respect to other income tax treaties.
    (5) Benefits under treaties other than income tax treaties.
    (h) Stapled entities.
    (i) Effective date.
    (1) General rule.
    (2) Election to reduce liabilities.
    (3) Separate election for installment obligations.
    (4) Special rule for certain U.S. assets and liabilities.
    (j) Transition rules.
    (1) General rule.
    (2) Installment obligations.

Sec.  1.884-2T Special rules for termination or incorporation of a U.S. 
    trade or business or liquidation or reorganization of a foreign 
           corporation or its domestic subsidiary (temporary).

    (a) Complete termination of a U.S. trade or business.

[[Page 511]]

    (1) General rule.
    (2) Operating rules.
    (3) Complete termination in the case of a section 338 election.
    (4) Complete termination in the case of a foreign corporation with 
income under section 864(c)(6) or 864(c)(7).
    (5) Special rule if a foreign corporation terminates an interest in 
a trust. [Reserved]
    (6) Coordination with second-level withholding tax.
    (b) Election to remain engaged in a U.S. trade or business.
    (1) General rule.
    (2) Marketable security.
    (3) Identification requirements.
    (4) Treatment of income from deemed U.S. assets.
    (5) Method of election.
    (6) Effective date.
    (c) Liquidation, reorganization, etc., of a foreign corporation.
    (1) Inapplicability of paragraph (a)(1) to section 381 (a) 
transactions.
    (2) Transferor's dividend equivalent amount for the taxable year in 
which a section 381 (a) transaction occurs.
    (3) Transferor's dividend equivalent amount for any taxable year 
succeeding the taxable year in which the section 381 (a) transaction 
occurs.
    (4) Earnings and profits of the transferor carried over to the 
transferee pursuant to the section 381 (a) transaction.
    (5) Determination of U.S. net equity of a transferee that is a 
foreign corporation.
    (6) Special rules in the case of the disposition of stock or 
securities in a domestic transferee or in the transferor.
    (d) Incorporation under section 351.
    (1) In general.
    (2) Inapplicability of paragraph (a)(1) of this section to section 
351 transactions.
    (3) Transferor's dividend equivalent amount for the taxable year in 
which a section 351 transaction occurs.
    (4) Election to increase earnings and profits.
    (5) Dispositions of stock or securities of the transferee by the 
transferor.
    (6) Example.
    (e) Certain transactions with respect to a domestic subsidiary.
    (f) Effective date.

   Sec.  1.884-3T Coordination of branch profits tax with second-tier 
                   withholding (temporary). [Reserved]

                Sec.  1.884-4 Branch-level interest tax.

    (a) General rule.
    (1) Tax on branch interest.
    (2) Tax on excess interest.
    (3) Original issue discount.
    (4) Examples.
    (b) Branch interest.
    (1) Definition of branch interest.
    (2) [Reserved]
    (3) Requirements relating to specifically identified liabilities.
    (4) [Reserved]
    (5) Increase in branch interest where U.S. assets constitute 80 
percent or more of a foreign corporation's assets.
    (6) Special rule where branch interest exceeds interest apportioned 
to ECI of a foreign corporation.
    (7) Effect of election under paragraph (c)(1) of this section to 
treat interest as if paid in year of accrual.
    (8) Effect of treaties.
    (c) Rules relating to excess interest.
    (1) Election to compute excess interest by treating branch interest 
that is paid and accrued in different years as if paid in year of 
accrual.
    (2) Interest paid by a partnership.
    (3) Effect of treaties.
    (4) Examples.
    (d) Stapled entities.
    (e) Effective dates.
    (1) General rule.
    (2) Special rule.
    (f) Transition rules.
    (1) Election under paragraph (c)(1) of this section.
    (2) Waiver of notification requirement for non-banks under Notice 
89-80.
    (3) Waiver of legending requirement for certain debt issued prior to 
January 3, 1989.

                    Sec.  1.884-5 Qualified resident.

    (a) Definition of qualified resident.
    (b) Stock ownership requirement.
    (1) General rule.
    (2) Rules for determining constructive ownership.
    (3) Required documentation.
    (4) Ownership statements from qualifying shareholders.
    (5) Certificate of residency.
    (6) Intermediary ownership statement.
    (7) Intermediary verification statement.
    (8) Special rules for pension funds.
    (9) Availability of documents for inspection.
    (10) Examples.
    (c) Base erosion.
    (d) Publicly-traded corporations.
    (1) General rule.
    (2) Established securities market.
    (3) Primary traded.
    (4) Regularly traded.
    (5) Burden of proof for publicly-traded corporations.
    (e) Active trade or business.
    (1) General rule.
    (2) Active conduct of a trade or business.
    (3) Substantial presence test.
    (4) Integral part of an active trade or business in the foreign 
corporation's country of residence.
    (f) Qualified resident ruling.
    (1) Basis for ruling.

[[Page 512]]

    (2) Factors.
    (3) Procedural requirements.
    (g) Effective dates.
    (h) Transition rule.

[T.D. 8432, 57 FR 41649, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1992; 57 
FR 60126, Dec. 18, 1992, as amended by T.D. 8657, 61 FR 9338, Mar. 8, 
1996; T.D. 9194, 70 FR 18930, Apr. 11, 2005; T.D. 9391, 73 FR 19360, 
Apr. 9, 2008; 73 FR 27728, May 14, 2008]



Sec.  1.884-1  Branch profits tax.

    (a) General rule. A foreign corporation shall be liable for a branch 
profits tax in an amount equal to 30 percent of the foreign 
corporation's dividend equivalent amount for the taxable year. The 
branch profits tax shall be in addition to the tax imposed by section 
882 and shall be reported on a foreign corporation's income tax return 
for the taxable year. The tax shall be due and payable as provided in 
section 6151 and such other provisions of Subtitle F of the Internal 
Revenue Code as apply to the income tax liability of corporations. 
However, no estimated tax payments shall be due with respect to a 
foreign corporation's liability for the branch profits tax. See 
paragraph (g) of this section for the application of the branch profits 
tax to corporations that are residents of countries with which the 
United States has an income tax treaty, and Sec.  1.884-2T for the 
effect on the branch profits tax of the termination or incorporation of 
a U.S. trade or business, or the liquidation or reorganization of a 
foreign corporation or its domestic subsidiary.
    (b) Dividend equivalent amount--(1) Definition. The term ``dividend 
equivalent amount'' means a foreign corporation's effectively connected 
earnings and profits (``ECEP'', as defined in paragraph (f)(1) of this 
section) for the taxable year, adjusted pursuant to paragraph (b) (2) or 
(3) of this section, as applicable. The dividend equivalent amount 
cannot be less than zero.
    (2) Adjustment for increase in U.S. net equity. If a foreign 
corporation's U.S. net equity (as defined in paragraph (c) of this 
section) as of the close of the taxable year exceeds the foreign 
corporation's U.S. net equity as of the close of the preceding taxable 
year, then, for purposes of computing the foreign corporation's dividend 
equivalent amount for the taxable year, the foreign corporation's ECEP 
for the taxable year shall be reduced (but not below zero) by the amount 
of such excess.
    (3) Adjustment for decrease in U.S. net equity--(i) In general. 
Except as provided in paragraph (b)(3)(ii) of this section, if a foreign 
corporation's U.S. net equity as of the close of the taxable year is 
less than the foreign corporation's U.S. net equity as of the close of 
the preceding taxable year, then, for purposes of computing the foreign 
corporation's dividend equivalent amount for the taxable year, the 
foreign corporation's ECEP for the taxable year shall be increased by 
the amount of such difference.
    (ii) Limitation based on accumulated ECEP. The increase of a foreign 
corporation's ECEP under paragraph (b)(3)(i) of this section shall not 
exceed the accumulated ECEP of the foreign corporation as of the 
beginning of the taxable year. The term ``accumulated ECEP'' means the 
aggregate amount of ECEP of a foreign corporation for preceding taxable 
years beginning after December 31, 1986, minus the aggregate dividend 
equivalent amounts for such preceding taxable years. Accumulated ECEP 
may be less than zero.
    (4) Examples. The principles of paragraph (b) (2) and (3) of this 
section are illustrated by the following examples.

    Example 1. Reinvestment of all ECEP. Foreign corporation A, a 
calendar year taxpayer, had $1,000 U.S. net equity as of the close of 
1986 and $100 of ECEP for 1987. A acquires $100 of additional U.S. 
assets during 1987 and its U.S. net equity as of the close of 1987 is 
$1,100. In computing A's dividend equivalent amount for 1987, A's ECEP 
of $100 is reduced under paragraph (b)(2) of this section by the $100 
increase in U.S. net equity between the close of 1986 and the close of 
1987. A has no dividend equivalent amount for 1987.
    Example 2. Partial reinvestment of ECEP. Assume the same facts as in 
Example 1 except that A acquires $40 (rather than $100) of U.S. assets 
during 1987 and its U.S. net equity as of the close of 1987 is $1,040. 
In computing A's dividend equivalent amount for 1987, A's ECEP of $100 
is reduced under paragraph (b)(2) of this section by the $40 increase in 
U.S. net equity between the close of 1986 and the close of 1987. A has a 
dividend equivalent amount of $60 for 1987.
    Example 3. Disinvestment of prior year's ECEP. Assume the same facts 
as in Example 1 for 1987. A has no ECEP for 1988. A's U.S.

[[Page 513]]

net equity decreases by $40 (to $1,060) as of the close of 1988. A has a 
dividend equivalent amount of $40 for 1988, even though it has no ECEP 
for 1988. A's ECEP of $0 for 1988 is increased under paragraph (b)(3)(i) 
of this section by the $40 reduction in U.S. net equity (subject to the 
limitation in paragraph (b)(3)(ii) of this section of $100 of 
accumulated ECEP).
    Example 4. Accumulated ECEP limitation. Assume the same facts as in 
Example 2 for 1987. For 1988, A has $125 of ECEP and its U.S. net equity 
decreases by $50. A's U.S. net equity as of the close of 1988 is $990 
($1,040-$50). In computing A's dividend equivalent amount for 1988, the 
$125 of ECEP for 1988 is not increased under paragraph (b)(3)(i) of this 
section by the full amount of the $50 decrease in U.S. net equity during 
1988. Rather, the increase in ECEP resulting from the decrease in U.S. 
net equity is limited to A's accumulated ECEP as of the beginning of 
1988. A had $100 of ECEP for 1987 and a dividend equivalent amount of 
$60 for that year, so A had $40 of accumulated ECEP as of the beginning 
of 1988. The increase in ECEP resulting from a decrease in U.S. net 
equity is thus limited to $40, and the dividend equivalent amount for 
1988 is $165 ($125 ECEP + $40 decrease in U.S. net equity).
    Example 5. Effect of deficits in ECEP. Foreign corporation A, a 
calendar year taxpayer, has $150 of accumulated ECEP as of the beginning 
of 1991 ($200 aggregate ECEP less $50 aggregate dividend equivalent 
amounts for years preceding 1991). A has U.S. net equity of $450 as of 
the close of 1990, U.S. net equity of $350 as of the close of 1991 
(i.e., a $100 decrease in U.S. net equity) and a $90 deficit in ECEP for 
1991. A's dividend equivalent amount is $10 for 1991, i.e., A's deficit 
of $90 in ECEP for 1991 increased by $100, the decrease in A's U.S. net 
equity during 1991. A portion of the reduction in U.S. net equity in 
1991 ($90) is attributable to A's deficit in ECEP for that year. The 
reduction in U.S. net equity in 1991 ($100) triggers a dividend 
equivalent amount only to the extent it exceeds the $90 current year 
deficit in ECEP for 1991. As of the beginning of 1992, A has $50 of 
accumulated ECEP (i.e., $110 aggregate ECEP less $60 aggregate dividend 
equivalent amounts for years preceding 1992).
    Example 6. Nimble dividend equivalent amount. Foreign corporation A, 
a calendar year taxpayer, had a deficit in ECEP of $100 for 1987 and 
$100 for 1988, and has $90 of ECEP for 1989. A had $2,000 U.S. net 
equity as of the close of 1988 and has $2,000 U.S. net equity as of the 
close of 1989. A has a dividend equivalent amount of $90 for 1989, its 
ECEP for the year, even though it has a net deficit of $110 in ECEP for 
the period 1987-1989.

    (c) U.S. net equity--(1) Definition. The term ``U.S. net equity'' 
means the aggregate amount of the U.S. assets (as defined in paragraphs 
(c)(2) and (d)(1) of this section) of a foreign corporation as of the 
determination date (as defined in paragraph (c)(3) of this section), 
reduced (including below zero) by the U.S. liabilities (as defined in 
paragraph (e) of this section) of the foreign corporation as of the 
determination date.
    (2) Definition of the amount of a U.S. asset--(i) In general. For 
purposes of this section, the term ``amount of a U.S. asset'' means the 
U.S. asset's adjusted basis for purposes of computing earnings and 
profits (``E&P basis'') multiplied by the proportion of the asset that 
is treated as a U.S. asset under paragraphs (d) (1) through (4) of this 
section. The amount of a U.S. asset that is money shall be its face 
value. See paragraph (d)(6) of this section for rules concerning the 
computation of the E&P basis of a U.S. asset.
    (ii) Bad debt reserves. A bank described in section 585(a)(2)(B) 
(without regard to the second sentence thereof) that uses the reserve 
method of accounting for bad debts for U.S. federal income tax purposes 
shall decrease the amount of loans that qualify as U.S. assets by any 
reserve that is permitted under section 585.
    (3) Definition of determination date. For purposes of this section, 
the term ``determination date'' means the close of the day on which the 
amount of U.S. net equity is required to be determined. Unless otherwise 
provided, the U.S. net equity of a foreign corporation is required to be 
determined as of the close of the foreign corporation's taxable year.
    (d) U.S. assets--(1) Definition of a U.S. asset--(i) General rule. 
Except as provided in paragraph (d)(5) of this section, the term ``U.S. 
asset'' means an asset of a foreign corporation (other than an interest 
in a partnership, trust, or estate) that is held by the corporation as 
of the determination date if--
    (A) All income produced by the asset on the determination date is 
ECI (as defined in paragraph (d)(1)(iii) of this section) (or would be 
ECI if the asset produced income on that date); and
    (B) All gain from the disposition of the asset would be ECI if the 
asset were disposed of on that date and the disposition produced gain.


[[Page 514]]



For purposes of determining whether income or gain from an asset would 
be ECI under this paragraph (d)(1)(i), it is immaterial whether the 
asset is of a type that is unlikely to, or cannot, produce income or 
gain. For example, money may be a U.S. asset although it does not 
produce income or gain. In the case of an asset that does not produce 
income, however, the determination of whether income from the asset 
would be ECI shall be made under the principles of section 864 and the 
regulations thereunder, but without regard to Sec.  1.864-
4(c)(2)(iii)(b). For purposes of determining whether an asset is a U.S. 
asset under this paragraph (d)(1), a foreign corporation may presume, 
unless it has reason to know otherwise, that gain from the sale of 
personal property (including inventory property) would be U.S. source if 
gain from the sale of that type of property would ordinarily be 
attributable to an office or other fixed place of business of the 
foreign corporation within the United States (within the meaning of 
section 865(e)(2)).
    (ii) Special rules for assets not described in paragraph (d)(1)(i) 
of this section. An asset of a foreign corporation that is held by the 
corporation as of the determination date and is not described in 
paragraph (d)(1)(i) of this section shall be treated as a U.S. asset to 
the extent provided in paragraph (d)(2) of this section (relating to 
special rules for certain assets, including assets that produce income 
or gain at least a portion of which is ECI), and in paragraphs (d) (3) 
and (4) of this section (relating to special rules for interests in a 
partnership, trust, and estate).
    (iii) Definition of ECI. For purposes of the regulations under 
section 884, the term ``ECI'' means income that is effectively connected 
with the conduct of a trade or business in the United States and income 
that is treated as effectively connected with the conduct of a trade or 
business in the United States under any provision of the Code. The term 
``ECI'' also includes all income that is or is treated as effectively 
connected with the conduct of a U.S. trade or business whether or not 
the income is included in gross income (for example, interest income 
earned with respect to tax-exempt bonds).
    (2) Special rules for certain assets--(i) Depreciable and 
amortizable property. An item of depreciable personal property or an 
item of amortizable intangible property shall be treated as a U.S. asset 
of a foreign corporation in the same proportion that the amount of the 
depreciation or amortization with respect to the item of property that 
is allowable as a deduction, or is includible in cost of goods sold, for 
the taxable year in computing the effectively connected taxable income 
of the foreign corporation bears to the total amount of depreciation or 
amortization computed for the taxable year with respect to the item of 
property.
    (ii) Inventory. An item or pool of inventory property (as defined in 
section 865(i)(1)) shall be treated as a U.S. asset in the same 
proportion as the amount of gross receipts from the sale or exchange of 
such property for the three preceding taxable years (or for such part of 
the three-year period as the corporation has been in existence) that is 
effectively connected with the conduct of a U.S. trade or business bears 
to the total amount of gross receipts from the sale or exchange of such 
property during such period (or part thereof). If a foreign corporation 
has not sold or exchanged such property during such three-year period 
(or part thereof), then the property shall be treated as a U.S. asset in 
the same proportion that the anticipated amount of gross receipts from 
the sale or exchange of the property that is reasonably anticipated to 
be ECI bears to the anticipated total amount of gross receipts from the 
sale or exchange of the property.
    (iii) Installment obligations. An installment obligation received in 
connection with an installment sale (as defined in section 453(b)) for 
which an election under section 453(d) has not been made shall be 
treated as a U.S. asset to the extent that it is received in connection 
with the sale of a U.S. asset. If an obligation is received in 
connection with the sale of an asset that is wholly a U.S. asset, it 
shall be treated as a U.S. asset in its entirety. If a single obligation 
is received in connection with the sale of an asset that is in part a 
U.S. asset under the rules of paragraphs (d) (2) through (4) of this

[[Page 515]]

section, or in connection with the sale of several assets including one 
or more non-U.S. assets, the obligation shall be treated as a U.S. asset 
in the same proportion as--
    (A) The sum of the amount of gain from the installment sale that 
would be ECI if the obligation were satisfied in full on the 
determination date and the adjusted basis of the obligation on such date 
(as determined under section 453B) attributable to the amount of gain 
that would be ECI bears to
    (B) The sum of the total amount of gain from the sale if the 
obligation were satisfied in full and the adjusted basis of the 
obligation on such date (as determined under section 453B).


However, the obligation will only be treated as a U.S. asset if the 
interest income or original issue discount with respect to the 
obligation is ECI or the foreign corporation elects to treat the 
interest or original issue discount as ECI in the same proportion that 
the obligation is treated as a U.S. asset. A foreign corporation may 
elect to treat interest income or original issue discount as ECI by 
reporting such interest income or original issue discount as ECI on its 
income tax return or an amended return for the taxable year. See 
paragraph (d)(6)(ii) of this section to determine the E&P basis of an 
installment obligation for purposes of this paragraph (d)(2)(iii).
    (iv) Receivables--(A) Receivables arising from the sale or exchange 
of inventory property. An account or note receivable (whether or not 
bearing stated interest) with a maturity not exceeding six months that 
arises from the sale or exchange of inventory property (as defined in 
section 865(i)(1)) shall be treated as a U.S. asset in the proportion 
determined under paragraph (d)(2)(iii) of this section as if the 
receivable were an installment obligation.
    (B) Receivables arising from the performance of services or leasing 
of property. An account or note receivable (whether or not bearing 
stated interest) with a maturity not exceeding six months that arises 
from the performance of services or the leasing of property in the 
ordinary course of a foreign corporation's trade or business shall be 
treated as a U.S. asset in the same proportion that the amount of gross 
income represented by the receivable that is ECI bears to the total 
amount of gross income represented by the receivable. For purposes of 
this paragraph (d)(2)(iv)(B), the amount of income represented by a 
receivable shall not include interest income or original issue discount.
    (v) Bank and other deposits. A deposit or credit balance with a 
person described in section 871(i)(3) or a Federal Reserve Bank that is 
interest-bearing shall be treated as a U.S. asset if all income derived 
by the foreign corporation with respect to the deposit or credit balance 
during the taxable year is ECI. Any other deposit or credit balance 
shall only be treated as a U.S. asset if the deposit or credit balance 
is needed in a U.S. trade or business within the meaning of Sec.  1.864-
4(c)(2)(iii)(a).
    (vi) Debt instruments. A debt instrument, as defined in section 
1275(a)(1) (other than an asset treated as a U.S. asset under any other 
subdivision of this paragraph (d)) shall be treated as a U.S. asset, 
notwithstanding the fact that gain from the sale or exchange of the 
obligation on the determination date would not be ECI, if--
    (A) All income derived by the foreign corporation from such 
obligation during the taxable year is ECI; and
    (B) The yield for the period that the instrument was held during the 
taxable year equals or exceeds the Applicable Federal Rate for 
instruments of similar type and maturity.


Shares in a regulated investment company that purchases solely 
instruments that, under this paragraph (d)(2)(vi), would be U.S. assets 
if held directly by the foreign corporation shall also be treated as a 
U.S. asset.
    (vii) Securities held by a foreign corporation engaged in a banking, 
financing or similar business. Securities described in Sec.  1.864-
4(c)(5)(ii)(b)(3) held by a foreign corporation engaged in the active 
conduct of a banking, financing, or similar business in the United 
States during the taxable year shall be treated as U.S. assets in the 
same proportion that income, gain, or loss from such securities is ECI 
for the taxable year under Sec.  1.864-4(c)(5)(ii).
    (viii) Federal income taxes. An overpayment of Federal income taxes 
shall be treated as a U.S. asset to the extent

[[Page 516]]

that the tax would reduce a foreign corporation's ECEP for the taxable 
year but for the fact that the tax does not accrue during the taxable 
year.
    (ix) Losses involving U.S. assets. A foreign corporation that 
sustains, with respect to a U.S. asset, a loss for which a deduction is 
not allowed under section 165 (in whole or in part) because there exists 
a reasonable prospect of recovering compensation for the loss shall be 
treated as having a U.S. asset (``loss property'') from the date of the 
loss in the same proportion that the asset was treated as a U.S. asset 
immediately before the loss. See paragraph (d)(6)(iv) of this section to 
determine the E&P basis of the loss property.
    (x) Ruling for involuntary conversion. If property that is a U.S. 
asset of a foreign corporation is compulsorily or involuntarily 
converted into property not similar or related in service or use (within 
the meaning of section 1033), the foreign corporation may apply to the 
Commissioner for a ruling to determine its U.S. assets for the taxable 
year of the involuntary conversion.
    (xi) Examples. The principles of paragraphs (c) and (d) (1) and (2) 
of this section are illustrated by the following examples.

    Example 1. Depreciable property. Foreign corporation A, a calendar 
year taxpayer, is engaged in a trade or business in the United States. A 
owns equipment that is used in its manufacturing business in country X 
and in the United States. Under Sec.  1.861-8, A's depreciation 
deduction with respect to the equipment is allocated to sales income and 
is apportioned 70 percent to ECI and 30 percent to income that is not 
ECI. Under paragraph (d)(2)(ii) of this section, the equipment is 70 
percent a U.S. asset. The equipment has an E&P basis of $100 at the 
beginning of 1993. A's depreciation deduction (for purposes of computing 
earnings and profits) with respect to the equipment is $10 for 1993. To 
determine the amount of A's U.S. asset at the close of 1993, the 
equipment's $90 E&P basis at the close of 1993 is multiplied by 70 
percent (the proportion of the asset that is a U.S. asset). The amount 
of the U.S. asset as of the close of 1993 is $63.
    Example 2. U.S. real property interest connected to a U.S. business. 
FC is a foreign corporation that is a bank, within the meaning of 
section 585(a)(2)(B) (without regard to the second sentence thereof), 
and is engaged in the business of taking deposits and making loans 
through its branch in the United States. In 1996, FC makes a loan in the 
ordinary course of its lending business in the United States, securing 
the loan with a mortgage on the U.S. real property being financed by the 
borrower. In 1997, after the borrower has defaulted on the loan, FC 
takes title to the real property that secures the loan. On December 31, 
1997, FC continues to hold the property, classifying it on its financial 
statement as Other Real Estate Owned. Because all income and gain from 
the property would be ECI to FC under the principles of section 
864(c)(2), the U.S. real property constitutes a U.S. asset within the 
meaning of paragraph (d) of this section.
    Example 3. U.S. real property interest not connected to a U.S. 
business. Foreign corporation A owns a condominium apartment in the 
United States. Assume that holding the apartment does not constitute a 
U.S. trade or business and the foreign corporation has not made an 
election under section 882(d) to treat income with respect to the 
property as ECI. The condominium apartment is not a U.S. asset of A 
because the income, if any, from the asset would not be ECI. However, 
the disposition by A of the condominium apartment at a gain will give 
rise to ECEP.
    Example 4. Stock in a domestically-controlled REIT. As an 
investment, foreign corporation A owns stock in a domestically-
controlled REIT, within the meaning of section 897(h)(4)(B). Under 
section 897(h)(2), gain on disposition of stock in the REIT is not 
treated as ECI. For this reason the stock does not qualify as a U.S. 
asset under paragraph (d)(1) of this section even if dividend 
distributions from the REIT are treated as ECI. Thus, A will have a 
dividend equivalent amount based on the ECEP attributable to a 
distribution of ECI from the REIT, even if A invests the proceeds from 
the dividend in additional stock of the REIT. (Stock in a REIT that is 
not a domestically-controlled REIT is also not a U.S. asset. See Sec.  
1.884-1(d)(5)).
    Example 5. Section 864(c)(7) property. Foreign corporation A is 
engaged in the equipment leasing business in the United States and 
Canada. A transfers the equipment leased by its U.S. trade or business 
to its Canadian business after the equipment is fully depreciated in the 
United States. The Canadian business sells the equipment two years 
later. Section 864(c)(7) would treat the gain on the disposition of the 
equipment by A as taxable under section 882 as if the sale occurred 
immediately before the equipment was transferred to the Canadian 
business. The equipment would not be treated as a U.S. asset even if the 
gain was ECI because the income from the equipment in the year of the 
sale in Canada would not be ECI.

    (3) Interest in a partnership--(i) In general. A foreign corporation 
that is a partner in a partnership must take

[[Page 517]]

into account its interest in the partnership (and not the partnership 
assets) in determining its U.S. assets. For purposes of determining the 
proportion of the partnership interest that is a U.S. asset, a foreign 
corporation may elect to use either the asset method described in 
paragraph (d)(3)(ii) of this section or the income method described in 
paragraph (d)(3)(iii) of this section.
    (ii) Asset method--(A) In general. A partner's interest in a 
partnership shall be treated as a U.S. asset in the same proportion that 
the sum of the partner's proportionate share of the adjusted bases of 
all partnership assets as of the determination date, to the extent that 
the assets would be treated as U.S. assets if the partnership were a 
foreign corporation, bears to the sum of the partner's proportionate 
share of the adjusted bases of all partnership assets as of the 
determination date. Generally a partner's proportionate share of a 
partnership asset is the same as its proportionate share of all items of 
income, gain, loss, and deduction that may be generated by the asset.
    (B) Non-uniform proportionate shares. If a partner's proportionate 
share of all items of income, gain, loss, and deduction that may be 
generated by a single asset of the partnership throughout the period 
that includes the taxable year of the partner is not uniform, then, for 
purposes of determining the partner's proportionate share of the 
adjusted basis of that asset, a partner must take into account the 
portion of the adjusted basis of the asset that reflects the partner's 
economic interest in that asset. A partner's economic interest in an 
asset of the partnership must be determined by applying the following 
presumptions. These presumptions may, however, be rebutted if the 
partner or the Internal Revenue Service shows that the presumption is 
inconsistent with the partner's true economic interest in the asset 
during the corporation's taxable year.
    (1) If a partnership asset ordinarily generates directly 
identifiable income, a partner's economic interest in the asset is 
determined by reference to its proportionate share of income that may be 
generated by the asset for the partnership's taxable year ending with or 
within the partner's taxable year.
    (2) If a partnership asset ordinarily generates current deductions 
and ordinarily generates no directly identifiable income, for example 
because the asset contributes equally to the generation of all the 
income of the partnership (such as an asset used in general and 
administrative functions), a partner's economic interest in the asset is 
determined by reference to its proportionate share of the total 
deductions that may be generated by the asset for the partnership's 
taxable year ending with or within the partner's taxable year.
    (3) For other partnership assets not described in paragraph 
(d)(3)(ii)(B) (1) or (2) of this section, a partner's economic interest 
in the asset is determined by reference to its proportionate share of 
the total gain or loss to which it would be entitled if the asset were 
sold at a gain or loss in the partnership's taxable year ending with or 
within the partner's taxable year.
    (C) Partnership election under section 754. If a partnership files 
an election in accordance with section 754, then for purposes of this 
paragraph (d)(3)(ii), the basis of partnership property shall reflect 
adjustments made pursuant to sections 734 (relating to distributions of 
property to a partner) and 743 (relating to the transfer of an interest 
in a partnership). However, adjustments made pursuant to section 743 may 
be made with respect to a transferee partner only.
    (iii) Income method. Under the income method, a partner's interest 
in a partnership shall be treated as a U.S. asset in the same proportion 
that its distributive share of partnership ECI for the partnership's 
taxable year that ends with or within the partner's taxable year bears 
to its distributive share of all partnership income for that taxable 
year.
    (iv) Manner of election--(A) In general. In determining the 
proportion of a foreign corporation's interest in a partnership that is 
a U.S. asset, a foreign corporation must elect one of the methods 
described in paragraph (d)(3) of this section on a timely filed return 
for the first taxable year beginning on

[[Page 518]]

or after the effective date of this section. An amended return does not 
qualify for this purpose, nor shall the provisions of Sec.  301.9100-1 
of this chapter and any guidance promulgated thereunder apply. An 
election shall be made by the foreign corporation calculating its U.S. 
assets in accordance with the method elected. An elected method must be 
used for a minimum period of five years before the foreign corporation 
may elect a different method. To change an election before the end of 
the requisite five-year period, a foreign corporation must obtain the 
consent of the Commissioner or her delegate. The Commissioner or her 
delegate will generally consent to a foreign corporation's request to 
change its election only in rare and unusual circumstances. A foreign 
corporation that is a partner in more than one partnership is not 
required to elect to use the same method for each partnership interest.
    (B) Elections with tiered partnerships. If a foreign corporation 
elects to use the asset method with respect to an interest in a 
partnership, and that partnership is a partner in a lower-tier 
partnership, the foreign corporation may apply either the asset method 
or the income method to determine the proportion of the upper-tier 
partnership's interest in the lower-tier partnership that is a U.S. 
asset.
    (v) Failure to make proper election. If a foreign corporation, for 
any reason, fails to make an election to use one of the methods required 
by paragraph (d)(3) of this section in a timely fashion, the director of 
field operations or the Assistant Commissioner (International) may make 
the election on behalf of the foreign corporation and such election 
shall be binding as if made by that corporation.
    (vi) Special rule for determining a partner's adjusted basis in a 
partnership interest. For purposes of paragraphs (d)(3) and (6) of this 
section, a partner's adjusted basis in a partnership interest shall be 
the partner's basis in such interest (determined under section 705) 
reduced by the partner's share of the liabilities of the partnership 
determined under section 752 and increased by a proportionate share of 
each liability of the partnership equal to the partner's proportionate 
share of the expense, for income tax purposes, attributable to such 
liability for the taxable year. A partner's adjusted basis in a 
partnership interest cannot be less than zero.
    (vii) E&P basis of a partnership interest. See paragraph (d)(6)(iii) 
of this section for special rules governing the calculation of a foreign 
corporation's E&P basis in a partnership interest.
    (viii) The application of this paragraph (d)(3) is illustrated by 
the following examples:

    Example 1. General rule. (i) Facts. Foreign corporation, FC, is a 
partner in partnership ABC, which is engaged in a trade or business 
within the United States. FC and ABC are both calendar year taxpayers. 
ABC owns and manages two office buildings located in the United States, 
each with an adjusted basis of $50. ABC also owns a non-U.S. asset with 
an adjusted basis of $100. ABC has no liabilities. Under the partnership 
agreement, FC has a 50 percent interest in the capital of ABC and a 50 
percent interest in all items of income, gain, loss, and deduction that 
may be generated by the partnership's assets. FC's adjusted basis in ABC 
is $100. In determining the proportion of its interest in ABC that is a 
U.S. asset, FC elects to use the asset method described in paragraph 
(d)(3)(ii) of this section.
    (ii) Analysis. FC's interest in ABC is treated as a U.S. asset in 
the same proportion that the sum of FC's proportionate share of the 
adjusted bases of all ABC's U.S. assets (50% of $100), bears to the sum 
of FC's proportionate share of the adjusted bases of all of ABC's assets 
(50% of $200). Under the asset method, the amount of FC's interest in 
ABC that is a U.S. asset is $50 ($100 x $50/$100).
    Example 2. Special allocation of gain with respect to real property. 
(i) Facts. The facts are the same as in Example 1, except that under the 
partnership agreement, FC is allocated 20 percent of the income from the 
partnership property but 80 percent of the gain on disposition of the 
partnership property.
    (ii) Analysis. Assuming that the buildings ordinarily generate 
directly identifiable income, there is a rebuttable presumption under 
paragraph (d)(3)(ii)(B)(1) of this section that FC's proportionate share 
of the adjusted basis of the buildings is FC's proportionate share of 
the income generated by the buildings (20%) rather than the total gain 
that it would be entitled to under the partnership agreement (80%) if 
the buildings were sold at a gain on the determination date. Thus, the 
sum of FC's proportionate share of the adjusted bases in ABC's U.S. 
assets (the buildings) is presumed to be $20 [(20% of $50) + (20% of 
$50)]. Assuming that the non-U.S. asset is not income-producing and does 
not generate current deductions,

[[Page 519]]

there is a rebuttable presumption under paragraph (d)(3)(ii)(B)(3) of 
this section that FC's proportionate share of the adjusted basis of that 
asset is FC's interest in the gain on the disposition of the asset (80%) 
rather than its proportionate share of the income that may be generated 
by the asset (20%). Thus, FC's proportionate share of the adjusted basis 
of ABC's non-U.S. asset is presumed to be $80 (80% of $100). FC's 
proportionate share of the adjusted bases of all of the assets of ABC is 
$100 ($20 + $80). The amount of FC's interest in ABC that is a U.S. 
asset is $20 ($100 x $20/$100).
    Example 3. Tiered partnerships (asset method). (i) Facts. The facts 
are the same as in Example 1, except that FC's adjusted basis in ABC is 
$175 and ABC also has a 50 percent interest in the capital of 
partnership DEF. DEF owns and operates a commercial shopping center in 
the United States with an adjusted basis of $200 and also owns non-U.S. 
assets with an adjusted basis of $100. DEF has no liabilities. ABC's 
adjusted basis in its interest in DEF is $150 and ABC has a 50 percent 
interest in all the items of income, gain, loss and deduction that may 
be generated by the assets of DEF.
    (ii) Analysis. Because FC has elected to use the asset method 
described in paragraph (d)(3)(ii) of this section, it must determine 
what proportion of ABC's partnership interest in DEF is a U.S. asset. As 
permitted by paragraph (d)(3)(iv)(B) of this section, FC also elects to 
use the asset method with respect to ABC's interest in DEF. ABC's 
interest in DEF is treated as a U.S. asset in the same proportion that 
the sum of ABC's proportionate share of the adjusted bases of all DEF's 
U.S. assets (50% of $200), bears to the sum of ABC's proportionate share 
of the adjusted bases of all of DEF's assets (50% of $300). Thus, the 
amount of ABC's interest in DEF that is a U.S. asset is $100 ($150 x 
$100/$150). FC must then apply the rules of paragraph (d)(3)(ii) of this 
section to all the assets of ABC, including ABC's interest in DEF that 
is treated in part as a U.S. asset ($100) and in part as a non-U.S. 
asset ($50). FC's interest in ABC is treated as a U.S. asset in the same 
proportion that the sum of FC's proportionate share of the adjusted 
bases of the U.S. assets of ABC (including ABC's interest in DEF), bears 
to the sum of FC's proportionate share of the adjusted bases of all 
ABC's assets (including ABC's interest in DEF). Thus, the amount of FC's 
interest in ABC that is a U.S. asset is $100 (FC's adjusted basis in ABC 
($175) multiplied by FC's proportionate share of the sum of the adjusted 
bases of ABC's U.S. assets ($100)) over FC's proportionate share of the 
sum of the adjusted bases of ABC's assets ($175)).
    Example 4. Tiered partnerships (income method). (i) Facts. The facts 
are the same as in Example 3, except that FC has elected to use the 
income method described in paragraph (d)(3)(iii) of this section to 
determine the proportion of its interest in ABC that is a U.S. asset. 
The two office buildings located in the United States generate $60 of 
income that is ECI for the taxable year. The non-U.S. asset is not-
income producing. In addition ABC's distributive share of income from 
DEF consists of $40 of income that is ECI and $140 of income that is not 
ECI.
    (ii) Analysis. Because FC has elected to use the income method it 
does need to determine what proportion of ABC's partnership interest in 
DEF is a U.S. asset. FC's interest in ABC is treated as a U.S. asset in 
the same proportion that its distributive share of ABC's income for the 
taxable year that is ECI ($50) ($30 earned directly by ABC + $20 
distributive share from DEF) bears to its distributive share of all 
ABC's income for the taxable year ($55) ($30 earned directly by ABC + 
$25 distributive share from DEF). Thus, FC's interest in ABC that is a 
U.S. asset is $159 ($175 x $50/$55).

    (4) Interest in a trust or estate--(i) Estates and non-grantor 
trusts. A foreign corporation that is a beneficiary of a trust or estate 
shall not be treated as having a U.S. asset by virtue of its interest in 
the trust or estate.
    (ii) Grantor trusts. If, under sections 671 through 678, a foreign 
corporation is treated as owning a portion of a trust that includes all 
the income and gain that may be generated by a trust asset (or pro rata 
portion of a trust asset), the foreign corporation will be treated as 
owning the trust asset (or pro rata portion thereof) for purposes of 
determining its U.S. assets under this section.
    (5) Property that is not a U.S. asset--(i) Property that does not 
give rise to ECEP. Property described in paragraphs (d) (1) through (4) 
of this section shall not be treated as a U.S. asset of a foreign 
corporation if, on the determination date, income from the use of the 
property, or gain or loss from the disposition of the property, would be 
described in paragraph (f)(2) of this section (relating to certain 
income that does not produce ECEP).
    (ii) Assets acquired to increase U.S. net equity artificially. U.S. 
assets shall not include assets acquired or used by a foreign 
corporation if one of the principal purposes of such acquisition or use 
is to increase artificially the U.S. assets of a foreign corporation on 
the determination date. Whether assets are acquired or used for such 
purpose will

[[Page 520]]

depend upon all the facts and circumstances of each case. Factors to be 
considered in determining whether one of the principal purposes in 
acquiring or using an asset is to increase artificially the U.S. assets 
of a foreign corporation include the length of time during which the 
asset was used in a U.S. trade or business, whether the asset was 
acquired from, or disposed of to, a related person, and whether the 
aggregate value of the U.S. assets of the foreign corporation increased 
temporarily on the determination date. For purposes of this paragraph 
(d)(5)(ii), to be one of the principal purposes, a purpose must be 
important, but it is not necessary that it be the primary purpose.
    (iii) Interbranch transactions. A transaction of any type between 
separate offices or branches of the same taxpayer does not create a U.S. 
asset.
    (6) E&P basis of a U.S. asset--(i) General rule. The E&P basis of a 
U.S. asset for purposes of this section is its adjusted basis for 
purposes of computing the foreign corporation's earnings and profits. In 
determining the E&P basis of a U.S. asset, the adjusted basis of the 
asset (for purposes of computing taxable income) must be increased or 
decreased to take into account inclusions of income or gain, and 
deductions or similar charges, that affect the basis of the asset where 
such items are taken into account in a different manner for purposes of 
computing earnings and profits than for purposes of computing taxable 
income. For example, if section 312 (k) requires that depreciation with 
respect to a U.S. asset be determined using the straight line method for 
purposes of computing earnings and profits, but depreciation with 
respect to the asset is determined using a different method for purposes 
of computing taxable income, the E&P basis of the property for purposes 
of this section must be computed using the straight line method of 
depreciation.
    (ii) Installment obligations--(A) Sales in taxable year beginning on 
or after January 1, 1987. For purposes of this section, the E&P basis of 
an installment obligation described in paragraph (d)(2)(iii) of this 
section that arises in connection with an installment sale occurring in 
a taxable year beginning on or after January 1, 1987, shall equal the 
sum of the total amount of gain from the sale if the obligation were 
satisfied in full and the adjusted basis of the property sold as of the 
date of sale, reduced by payments received with respect to the 
obligation that are not interest or original issue discount. See 
paragraph (j)(2)(ii) of this section, however, for a special E&P basis 
rule for an installment obligation arising in connection with a sale of 
a U.S. asset by a foreign corporation described in section 312(k)(4), 
where such sale occurs in a taxable year beginning in 1987.
    (B) Sales in taxable year prior to January 1, 1987. For purposes of 
this section, the E&P basis of an installment obligation described in 
paragraph (d)(2)(iii) of this section that arises in connection with an 
installment sale occurring in a taxable year beginning before January 1, 
1987, shall equal zero.
    (iii) Computation of E&P basis in a partnership. For purposes of 
this section, a foreign corporation's E&P basis in a partnership 
interest shall be the foreign corporation's adjusted basis in such 
interest (as determined under paragraph (d)(3)(vi) of this section), 
further adjusted to take into account any differences between the 
foreign corporation's distributive share of items of partnership income, 
gain, loss, and deduction for purposes of computing the taxable income 
of the foreign corporation and the foreign corporation's distributive 
share of items of partnership income, gain, loss, and deductions for 
purposes of computing the earnings and profits of the foreign 
corporation.
    (iv) Computation of E&P basis of a loss property. The E&P basis of a 
loss property (as defined in paragraph (d)(2)(ix) of this section) shall 
equal the E&P basis, immediately before the loss, of the U.S. asset with 
respect to which the loss was sustained, reduced (but not below zero) 
by--
    (A) The amount of any deduction claimed under section 165 by the 
foreign corporation with respect to the loss for earnings and profits 
purposes; and
    (B) Any compensation received with respect to the loss.
    (v) Computation of E&P basis of financial instruments. [Reserved]

[[Page 521]]

    (vi) Example. The application of paragraph (d)(6)(ii) of this 
section is illustrated by the following example.

    Example. Sale in taxable year beginning on or after January 1, 1987. 
Foreign corporation A, a calendar year taxpayer, sells a U.S. asset on 
the installment method in 1993. Under the terms of the sale, A is to 
receive $100, payable in ten annual installments of $10 beginning in 
1994, plus an arm's-length rate of interest on the unpaid balance of the 
sales price. A's adjusted basis in the property sold is $70. The 
obligation received in connection with the installment sale is treated 
as a U.S. asset with an E&P basis of $100 ($30 (the amount of gain from 
the sale if the obligation were satisfied in full) + $70 (the adjusted 
basis of the property sold)). If A receives a payment of $10 (not 
including interest) in 1994 with respect to the obligation, the 
obligation is treated as a U.S. asset with an E&P basis of $90 ($100-
$10) as of the close of 1994.

    (e) U.S. liabilities. The term U.S. liabilities means the amount of 
liabilities determined under paragraph (e)(1) of this section decreased 
by the amount of liabilities determined under paragraph (e)(3) of this 
section, and increased by the amount of liabilities determined under 
paragraph (e)(2) of this section.
    (1) Liabilities based on Sec.  1.882-5. The amount of liabilities 
determined under this paragraph (e)(1) is the amount of U.S.-connected 
liabilities of a foreign corporation under Sec.  1.882-5 if the U.S.-
connected liabilities were computed using the assets and liabilities of 
the foreign corporation as of the determination date (rather than the 
average of such assets and liabilities for the taxable year) and without 
regard to paragraph (e)(3) of this section.
    (2) Additional liabilities--(i) Insurance reserves. The amount of 
liabilities determined under this paragraph (e)(2)(i) is the amount (as 
of the determination date) of the total insurance liabilities on United 
States business (within the meaning of section 842(b)(2)(B)) of a 
foreign corporation described in section 842(a) (relating to foreign 
corporations carrying on an insurance business in the United States) to 
the extent that such liabilities are not otherwise treated as U.S. 
liabilities by reason of paragraph (e)(1) of this section.
    (ii) Liabilities described in Sec.  1.882-5(a)(1)(ii). The amount of 
liabilities determined under this paragraph (e)(2)(ii) is the amount (as 
of the determination date) of liabilities described in Sec.  1.882-
5(a)(1)(ii) (relating to liabilities giving rise to interest expense 
that is directly allocated to income from a U.S. asset).
    (3) Election to reduce liabilities--(i) General rule. The amount of 
liabilities determined under this paragraph (e)(3) is the amount by 
which a foreign corporation elects to reduce its liabilities under 
paragraph (e)(1) of this section.
    (ii) Limitation. For any taxable year, a foreign corporation may 
elect to reduce the amount of its liabilities determined under paragraph 
(e)(1) of this section by an amount that does not exceed the lesser of 
the amount of U.S. liabilities as of the determination date, or the 
amount of U.S. liability reduction needed to reduce a dividend 
equivalent amount as of the determination date to zero.
    (iii) Effect of election on interest deduction and branch-level 
interest tax. A foreign corporation that elects to reduce its 
liabilities under this paragraph (e)(3) must, for purposes of computing 
the amount of its interest apportioned to ECI under Sec.  1.882-5, 
reduce its U.S.-connected liabilities for the taxable year of the 
election by the amount of the reduction in liabilities under this 
paragraph (e)(3). The reduction of its U.S.-connected liabilities will 
also require a corresponding decrease in the amount of its interest 
apportioned to ECI under Sec.  1.882-5 for purposes of Sec.  1.884-4(a) 
and for all other Code sections for which the amount of interest 
apportioned under Sec.  1.882-5 is relevant.
    (iv) Method of election. A foreign corporation that elects the 
benefits of this paragraph (e)(3) for a taxable year shall attach a 
statement to its return for the taxable year that it has elected to 
reduce its liabilities for the taxable year under this paragraph (e)(3) 
and that it has reduced the amount of its U.S.-connected liabilities as 
provided in paragraph (e)(3)(iii) of this section and shall indicate the 
amount of such reductions on such attachment. The cumulative amount of 
all U.S. liability reductions is shown on Schedule I (Form 1120-F) in 
addition to the separate elections attached to the timely filed return. 
An election under this paragraph (e)(3)

[[Page 522]]

must be made before the due date (including extensions) for the foreign 
corporation's income tax return for the taxable year.
    (v) Effect of election on complete termination. If a foreign 
corporation completely terminates its U.S. trade or business (within the 
meaning of Sec.  1.884-2T (a)(2)), notwithstanding Sec.  1.884-2T(a), 
the foreign corporation will be subject to tax on a dividend equivalent 
amount that equals the lesser of--
    (A) The foreign corporation's accumulated ECEP that is attributable 
to an election to reduce liabilities; or
    (B) The amount by which the corporation elected to reduce 
liabilities at the end of the taxable year preceding the year of 
complete termination.


For purposes of the preceding sentence, accumulated ECEP is attributable 
to an election to reduce liabilities to the extent that the ECEP was 
accumulated because of such an election rather than because of an 
increase in U.S. assets. For example, if a foreign corporation did not 
have positive ECEP in any year for which an election was made, it would 
not be required to include an amount as a dividend equivalent amount 
under this paragraph (e)(3)(v) because any accumulated ECEP that it may 
have is not attributable to an election to reduce liabilities.
    (4) Artificial decrease in U.S. liabilities. If a foreign 
corporation repays or otherwise decreases its U.S. liabilities and one 
of the principal purposes of such decrease is to decrease artificially 
its U.S. liabilities on the determination date, then such decrease shall 
not be taken into account for purposes of computing the foreign 
corporation's U.S. net equity. Whether the U.S. liabilities of a foreign 
corporation are artificially decreased will depend on all the facts and 
circumstances of each case. Factors to be considered in determining 
whether one of the principal purposes for the repayment or decrease of 
the liabilities is to decrease artificially the U.S. liabilities of a 
foreign corporation shall include whether the aggregate liabilities are 
temporarily decreased on or before the determination date by, for 
example, the repayment of liabilities, or U.S. liabilities are 
temporarily decreased on or before the determination date by the 
acquisition with contributed funds of passive-type assets that are not 
U.S. assets. For purposes of this paragraph (e)(4), to be one of the 
principal purposes, a purpose must be important, but it is not necessary 
that it be the primary purpose.
    (5) Examples. The application of this paragraph (e) is illustrated 
by the following examples.

    Example 1. General rule for computation of U.S. liabilities. As of 
the close of 1997, foreign corporation A, a calendar year taxpayer 
computes its U.S.-connected liabilities under Sec.  1.882-5(c) using its 
actual ratio of liabilities to assets. For purposes of computing its 
U.S.- connected liabilities under Sec.  1.882-5(c), A must determine the 
average total value of its assets that are U.S. assets. Assume that the 
average value of such assets is $100, while the amount of such assets as 
of the close of 1997 is $125. For purposes of Sec.  1.882-5(c)(2), A 
must determine the ratio of the average of its worldwide liabilities for 
the year to the average total value of worldwide assets for the taxable 
year. Assume that A's average liabilities-to-assets ratio under Sec.  
1.882-5(c)(2) is 55 percent, while its liabilities-to-assets ratio at 
the close of 1997 is only 50 percent. Thus, assuming no further 
adjustments under paragraph (e)(3) of this section, A's U.S.-connected 
liabilities for purposes of Sec.  1.882-5 are $55 ($100 x 55%). However, 
A's U.S. liabilities are $62.50 for purposes of this section, the value 
of its assets determined under Sec.  1.882-5(b)(2) as of the close of 
December ($125) multiplied by the liabilities-to-assets ratio of (50%) 
as of such date.
    Example 2. Election made to reduce liabilities. (i) As of the close 
of 2007, foreign corporation A, a real estate company, owns U.S. assets 
with an E&P basis of $1000. A has $800 of liabilities under paragraph 
(e)(1) of this section. A has accumulated ECEP of $500 and in 2008, A 
has $60 of ECEP that it intends to retain for future expansion of its 
U.S. trade or business. A elects under paragraph (e)(3) of this section 
to reduce its liabilities by $60 from $800 to $740. As a result of the 
election, assuming A's U.S. assets and U.S. liabilities would otherwise 
have remained constant, A's U.S. net equity as of the close of 2007 will 
increase by the amount of the decrease in liabilities ($60) from $200 to 
$260 and its ECEP will be reduced to zero. Under paragraph (e)(3)(iii) 
of this section, A's interest expense for the taxable year is reduced by 
the amount of interest attributable to $60 of liabilities and A's excess 
interest is reduced by the same amount. A's taxable income and ECEP are 
increased by the amount of the reduction in interest expense 
attributable to the liabilities, and A may make an election under 
paragraph (e)(3) of this section to further reduce its liabilities, thus 
increasing its

[[Page 523]]

U.S. net equity and reducing the amount of additional ECEP created for 
the election.
    (ii) In 2009, assuming A again has $60 of ECEP, A may again make the 
election under paragraph (e)(3) to reduce its liabilities. However, 
assuming A's U.S. assets and liabilities under paragraph (e)(1) of this 
section remain constant, A will need to make an election to reduce its 
liabilities by $120 to reduce to zero its ECEP in 2009 and to continue 
to retain for expansion (without the payment of the branch profits tax) 
the $60 of ECEP earned in 2008. Without an election to reduce 
liabilities, A's dividend equivalent amount for 2009 would be $120 ($60 
of ECEP plus the $60 reduction in U.S. net equity from $260 to $200). If 
A makes the election to reduce liabilities by $120 (from $800 to $680), 
A's U.S. net equity will increase by $60 (from $260 at the end of the 
previous year to $320), the amount necessary to reduce its ECEP to $0. 
However, the reduction of liabilities will itself create additional ECEP 
subject to section 884 because of the reduction in interest expense 
attributable to the $120 of liabilities. A can make the election to 
reduce liabilities by $120 without exceeding the limitation on the 
election provided in paragraph (e)(3)(ii) of this section because the 
$120 reduction does not exceed the amount needed to treat the 2009 and 
2008 ECEP as reinvested in the net equity of the trade or business 
within the United States.
    (iii) If A terminates its U.S. trade or business in 2009 in 
accordance with the rules in Sec.  1.884-2T(a), A would not be subject 
to the branch profits tax on the $60 of ECEP earned in that year. Under 
paragraph (e)(3)(v) of this section, however, it would be subject to the 
branch profits tax on the portion of the $60 of ECEP that it earned in 
2008 that became accumulated ECEP because of an election to reduce 
liabilities.

    (f) Effectively connected earnings and profits--(1) In general. 
Except as provided in paragraph (f)(2) of this section and as modified 
by Sec.  1.884-2T (relating to the incorporation or complete termination 
of a U.S. trade or business or the reorganization or liquidation of a 
foreign corporation or its domestic subsidiary), the term ``effectively 
connected earnings and profits'' (``ECEP'') means the earnings and 
profits (or deficits therein) determined under section 312 and this 
paragraph (f) that are attributable to ECI (within the meaning of 
paragraph (d)(1)(iii) of this section). Because the term ``ECI'' 
includes income treated as effectively connected, income that is ECI 
under section 842(b) (relating to minimum net investment income of an 
insurance business) or 864(c)(7) (relating to gain from property 
formerly held for use in a U.S. trade or business) gives rise to ECEP. 
ECEP also includes earnings and profits attributable to ECI of a foreign 
corporation earned through a partnership, and through a trust or estate. 
For purposes of section 884, gain on the sale of a U.S. real property 
interest by a foreign corporation that has made an election to be 
treated as a domestic corporation under section 897(i) will also give 
rise to ECEP. ECEP is not reduced by distributions made by the foreign 
corporation during any taxable year or by the amount of branch profits 
tax or tax on excess interest (as defined in Sec.  1.884-4(a)(2)) paid 
by the foreign corporation. Earnings and profits are treated as 
attributable to ECI even if the earnings and profits are taken into 
account under section 312 in an earlier or later taxable year than the 
taxable year in which the ECI is taken into account.
    (2) Income that does not produce ECEP. The term ``ECEP'' does not 
include any earnings and profits attributable to--
    (i) Income excluded from gross income under section 883(a)(1) or 
883(a)(2) (relating to certain income derived from the operation of 
ships or aircraft);
    (ii) Income that is ECI by reason of section 921(d) or 926(b) 
(relating to certain income of a FSC and certain dividends paid by a FSC 
to a foreign corporation or nonresident alien) that is not otherwise 
ECI;
    (iii) Gain on the disposition of a U.S. real property interest 
described in section 897(c)(1)(A)(ii) (relating to certain interests in 
a domestic corporation);
    (iv) Income that is ECI by reason of section 953(c)(3)(C) (relating 
to certain income of a captive insurance company that a corporation 
elects to treat as ECI) that is not otherwise ECI;
    (v) Income that is exempt from tax under section 892 (relating to 
certain income of foreign governments); and
    (vi) Income that is ECI by reason of section 882(e) (relating to 
certain interest income of banks organized under the laws of a 
possession of the United States) that is not otherwise ECI.
    (3) Allocation of deductions attributable to income that does not 
produce ECEP. In determining the amount of a foreign corporation's ECEP 
for the taxable year, deductions and other adjustments shall be 
allocated and apportioned

[[Page 524]]

under the principles of Sec.  1.861-8 between ECI that gives rise to 
ECEP and income described in paragraph (f)(2) of this section (relating 
to income that is ECI but does not give rise to ECEP).
    (4) Examples. The principles of paragraph (f) of this section are 
illustrated by the following examples.

    Example 1. Tax-exempt income. Foreign corporation A owns a tax-
exempt municipal bond that is a U.S. asset as of the close of its 1989 
taxable year. The municipal bond gives rise in 1989 to ECI (even though 
the income is excluded from gross income under section 103(a) and is not 
gross income of a foreign corporation by reason of section 882(b)), and 
therefore gives rise to ECEP in 1989.
    Example 2. Income exempt under a treaty. Foreign corporation A 
derives ECI that constitutes business profits that are not attributable 
to a permanent establishment maintained by A in the United States. The 
ECI is exempt from taxation under section 882(a) by reason of an income 
tax treaty and section 894(a). The income nevertheless gives rise to 
ECEP under this paragraph (f). However, a dividend equivalent amount 
attributable to such ECEP may be exempt from the branch profits tax by 
reason of paragraph (g) of this section (relating to the application of 
the branch profits tax to corporations that are residents of countries 
with which the United States has an income tax treaty).

    (g) Corporations resident in countries with which the United States 
has an income tax treaty--(1) General rule. Except as provided in 
paragraph (g)(2) of this section, a foreign corporation that is a 
resident of a country with which the United States has an income tax 
treaty in effect for a taxable year in which it has a dividend 
equivalent amount and that meets the requirements, if any, of the 
limitation on benefits provisions of such treaty with respect to the 
dividend equivalent amount shall not be subject to the branch profits 
tax on such amount (or will qualify for a reduction in the amount of tax 
with respect to such amount) only if--
    (i) The foreign corporation is a qualified resident of such country 
for the taxable year, within the meaning of Sec.  1.884-5(a); or
    (ii) The limitation on benefits provision, or an amendment to that 
provision, entered into force after December 31, 1986.


If, after application of Sec.  1.884-5(e)(4)(iv), a foreign corporation 
is a qualified resident under Sec.  1.884-5(e) (relating to the active 
trade or business test) only with respect to one of its trades or 
businesses in the United States, i.e., the trade or business that is an 
integral part of its business conducted in its country of residence, and 
not with respect to another, the rules of this paragraph shall apply 
only to that portion of its dividend equivalent amount attributable to 
the trade or business for which the foreign corporation is a qualified 
resident.
    (2) Special rules for foreign corporations that are qualified 
residents on the basis of their ownership--(i) General rule. A foreign 
corporation that, in any taxable year, is a qualified resident of a 
country with which the United States has an income tax treaty in effect 
solely by reason of meeting the requirements of Sec.  1.884-5 (b) and 
(c) (relating, respectively, to stock ownership and base erosion) shall 
be exempt from the branch profits tax or subject to a reduced rate of 
branch profits tax under paragraph (g)(1) of this section with respect 
to the portion of its dividend equivalent amount for the taxable year 
attributable to accumulated ECEP only if the foreign corporation is a 
qualified resident of such country within the meaning of Sec.  1.884-
5(a) for the taxable years includable, in whole or in part, in a 
consecutive 36-month period that includes the taxable year of the 
dividend equivalent amount. A foreign corporation that fails the 36-
month test described in the preceding sentence shall be exempt from the 
branch profits tax or subject to the branch profits tax at a reduced 
rate under paragraph (g)(1) of this section with respect to accumulated 
ECEP (determined on a last-in-first-out basis) accumulated only during 
prior years in which the foreign corporation was a qualified resident of 
such country within the meaning of Sec.  1.884-5(a).
    (ii) Rules of application. A foreign corporation that has not 
satisfied the 36-month test as of the close of the taxable year of the 
dividend equivalent amount but satisfies the test with respect to such 
dividend equivalent amount by meeting the 36-month test by the close of 
the second taxable year succeeding the taxable year of the dividend 
equivalent amount shall be subject to the branch profits tax for the

[[Page 525]]

year of the dividend equivalent amount without regard to paragraph 
(g)(1) of this section on the portion of the dividend equivalent amount 
attributable to accumulated ECEP derived in a taxable year in which the 
foreign corporation was not a qualified resident within the meaning of 
Sec.  1.884-5(a). Upon meeting the 36-month test, the foreign 
corporation shall be entitled to claim by amended return a refund of the 
tax paid with respect to the dividend equivalent amount in excess of the 
branch profits tax calculated by taking into account paragraph (g)(2)(i) 
of this section, provided the foreign corporation establishes in the 
amended return for the taxable year that it has met the requirements of 
such paragraph. For purposes of section 6611 (dealing with interest on 
overpayments), any overpayment of branch profits tax by reason of this 
paragraph (g)(2)(ii) shall be deemed not to have been made before the 
filing date for the taxable year in which the foreign corporation 
establishes that it has met the 36-month test.
    (iii) Example. The application of this paragraph (g)(2) is 
illustrated by the following example.

    Example. (i) Foreign corporation A, a calendar year taxpayer, is a 
resident of the United Kingdom. A has a dividend equivalent amount for 
its taxable year 1991 of $300, of which $100 is attributable to 1991 
ECEP and $200 to accumulated ECEP. A is a qualified resident for its 
taxable year 1991 because for that year it meets the requirements of 
Sec.  1.884-5 (b) and (c), relating, respectively, to stock ownership 
and base erosion. For 1991 A does not meet the requirements of Sec.  
1.884-5 (d), (e), or (f) for qualified residence. A is not a qualified 
resident of the United Kingdom for any taxable year prior to 1990 but is 
a qualified resident for its taxable years 1990 and 1992.
    (ii) Because A is a qualified resident for the 3-year period (1990, 
1991, and 1992) that includes the taxable year of the dividend 
equivalent amount (1991), A satisfies the 36-month test of this 
paragraph (g)(2) and no branch profits tax is imposed on the total $300 
dividend equivalent amount. However, since A was not a qualified 
resident for any taxable year prior to 1990 and therefore cannot 
establish that it has satisfied the 36-month test until the taxable year 
following the year of the dividend equivalent amount, A must pay the 
branch profits tax for its taxable year 1991 with respect to the portion 
of the dividend equivalent amount attributable to accumulated ECEP 
relating to years prior to 1990 without regard to paragraph (g)(1) of 
this section. A may file for a refund of the branch profits tax paid 
with respect to its 1991 taxable year at any time after it establishes 
that it is a qualified resident for its 1992 taxable year.

    (3) Exemptions for foreign corporations resident in certain 
countries with income tax treaties in effect on January 1, 1987. The 
branch profits tax shall not be imposed on the portion of the dividend 
equivalent amount with respect to which a foreign corporation satisfies 
the requirements of paragraphs (g) (1) and (2) of this section for a 
country listed below, so long as the income tax treaty between the 
United States and that country, as in effect on January 1, 1987, remains 
in effect, except to the extent the treaty is modified on or after 
January 1, 1987, to expressly provide for the imposition of the branch 
profits tax:

Aruba
Austria
Belgium
People's Republic of China
Cyprus
Denmark
Egypt
Finland
Germany
Greece
Hungary
Iceland
Ireland
Italy
Jamaica
Japan
Korea
Luxembourg
Malta
Morocco
Netherlands
Netherlands Antilles
Norway
Pakistan
Philippines
Sweden
Switzerland
United Kingdom

    (4) Modifications with respect to other income tax treaties--(i) 
Limitation on rate of tax--(A) General rule. If, under paragraphs (g) 
(1) and (2) of this section, a corporation qualifies for a reduction in 
the amount of the branch profits tax and paragraph (g)(3) of this 
section does not apply, the rate of tax shall be the rate of tax on 
branch profits specified in the treaty between the United States and the 
corporation's country of residence or, if no rate of tax on branch 
profits is specified, the rate of tax that would apply under such treaty 
to dividends paid to the foreign corporation by a wholly-owned domestic 
corporation.
    (B) Certain treaties in effect on January 1, 1987. The branch 
profits tax shall generally be imposed at the following rates on the 
portion of the dividend

[[Page 526]]

equivalent amount with respect to which a foreign corporation satisfies 
the requirements of paragraphs (g) (1) and (2) of this section for a 
country listed below, for as long as the relevant provisions of those 
income tax treaties remain in effect and are not modified or superseded 
by subsequent agreement:

Australia (15%)
Barbados (5%)
Canada (10%)
France (5%)
New Zealand (5%)
Poland (5%)
Romania (10%)
South Africa (30%)
Trinidad & Tobago (10%)
U.S.S.R. (30%)


However, for special rates imposed on corporations resident in France 
and Trinidad & Tobago that have certain amounts of dividend and interest 
income, see the dividend articles of the income tax treaties with those 
countries.
    (ii) Limitations other than rate of tax. If, under paragraphs (g) 
(1) and (2) of this section, a foreign corporation qualifies for a 
reduction in the amount of branch profits tax and paragraph (g) (3) of 
this section does not apply, then--
    (A) The foreign corporation shall be entitled to the benefit of any 
limitations on imposition of a tax on branch profits (in addition to any 
limitations on the rate of tax) contained in the treaty; and
    (B) No branch profits tax shall be imposed with respect to a 
dividend equivalent amount out of ECEP or accumulated ECEP of the 
foreign corporation unless the ECEP or accumulated ECEP is attributable 
to a permanent establishment in the United States or, if not otherwise 
prohibited under the treaty, to gain from the disposition of a U.S. real 
property interest described in section 897(c)(1)(A)(i), except to the 
extent the treaty specifically permits the imposition of the branch 
profits tax on such earnings and profits.
    No article in such treaty shall be construed to provide any 
limitations on imposition of the branch profits tax other than as 
provided in this paragraph (g)(4).
    (iii) Computation of the dividend equivalent amount if a foreign 
corporation has both ECEP attributable to a permanent establishment and 
not attributable to a permanent establishment. To determine the dividend 
equivalent amount of a foreign corporation out of ECEP that is 
attributable to a permanent establishment, the foreign corporation may 
only take into account its U.S. assets, U.S. liabilities, U.S. net 
equity and ECEP attributable to its permanent establishment. Thus, a 
foreign corporation may not reduce the amount of its ECEP attributable 
to its permanent establishment by reinvesting all or a portion of that 
amount in U.S. assets not attributable to the permanent establishment.
    (iv) Limitations under the Canadian treaty. The limitations on the 
imposition of the branch profits tax under the Canadian treaty include, 
but are not limited to, those described in paragraphs (g)(4)(iv) (A) and 
(B).
    (A) Effect of deficits in earnings and profits. In the case of a 
foreign corporation that is a qualified resident of Canada, the dividend 
equivalent amount for any taxable year shall not exceed the foreign 
corporation's accumulated ECEP as of the beginning of the taxable year 
plus the corporation's ECEP for the taxable year. Thus, for example, if 
a foreign corporation that is a qualified resident of Canada has a 
deficit in accumulated ECEP of $200 as of the beginning of the taxable 
year and ECEP of $100 for the taxable year, it will have no dividend 
equivalent amount for the taxable year because it would have a 
cumulative deficit in ECEP of $100 as of the close of the taxable year. 
For purposes of this paragraph (g)(4)(iii)(A), any net deficit in 
accumulated earnings and profits attributable to taxable years beginning 
before January 1, 1987, shall be includible in determining accumulated 
ECEP.
    (B) One-time exemption of Canadian $500,000--(1) General rule. In 
the case of a foreign corporation that is a qualified resident of 
Canada, the branch profits tax shall be imposed only with respect to 
that portion of the dividend equivalent amount for the taxable year 
that, when translated into Canadian dollars and added to the dividend 
equivalent amounts for preceding taxable years translated into Canadian 
dollars, exceeds Canadian $500,000. The value of the dividend equivalent 
amount in Canadian currency shall be determined by translating the ECEP 
for each taxable

[[Page 527]]

year that is includible in the dividend equivalent amount (as determined 
in U.S. dollars under the currency translation method used in 
determining the foreign corporation's taxable income for U.S. tax 
purposes) by the weighted average exchange rate for the taxable year 
(determined under the rules of section 989(b)(3)) during which the 
earnings and profits were derived.
    (2) Reduction in amount of exemption in the case of related 
corporations. The amount of a foreign corporation's exemption under this 
paragraph (g)(4)(iii)(B) shall be reduced by the amount of any exemption 
that reduced the dividend equivalent amount of an associated foreign 
corporation with respect to the same or a similar business. For purposes 
of this paragraph (g)(4)(iii)(B), a foreign corporation is an associated 
foreign corporation if it is related to the foreign corporation for 
purposes of sectional 267(b) or it and the foreign corporation are 
stapled entities (within the meaning of section 269B(c)(2)) or are 
effectively stapled entities. A business is the same as or similar to 
another business if it involves the sale, lease, or manufacture of the 
same or a similar type of property or the provision of the same or a 
similar type of services. A U.S. real property interest described in 
section 897(c)(1)(A)(i) shall be treated as a business and all such U.S. 
real property interests shall be treated as businesses that are the same 
or similar.
    (3) Coordination with second-tier withholding tax. The value of the 
dividend equivalent amount that is exempt from the branch profits tax by 
reason of paragraph (g)(4)(iii)(B)(1) of this section shall not be 
subject to tax under section 871(a) or 881, or to withholding under 
section 1441 or 1442, when distributed by the foreign corporation.
    (5) Benefits under treaties other than income tax treaties. A treaty 
that is not an income tax treaty does not exempt a foreign corporation 
from the branch profits tax or reduce the amount of the tax.
    (h) Stapled entities. Any foreign corporation that is treated as a 
domestic corporation by reason of section 269B (relating to stapled 
entities) shall continue to be treated as a foreign corporation for 
purposes of section 884 and the regulations thereunder, notwithstanding 
section 269B or the regulations thereunder. Dividends paid by such 
foreign corporation shall be treated as paid by a domestic corporation 
and shall be subject to the tax imposed by section 871(a) or 881(a), and 
to withholding under section 1441 or 1442, as applicable, to the extent 
paid out of earnings and profits that are not subject to tax under 
section 884(a). Dividends paid by such foreign corporation out of 
earnings and profits subject to tax under section 884(a) shall be exempt 
from the tax imposed by sections 871(a) and 881(a) and shall not be 
subject to withholding under section 1441 or 1442. Whether dividends are 
paid out of earnings and profits that are subject to tax under section 
884(a) shall be determined under section 884(e)(3)(A) and the 
regulations thereunder. The limitation on the application of treaty 
benefits in section 884(e)(3)(B) (relating to qualified residents) shall 
apply to a foreign corporation described in this paragraph (h).
    (i) Effective date--(1) General rule. This section is effective for 
taxable years beginning on or after October 13, 1992. With respect to a 
taxable year beginning before October 13, 1992 and after December 31, 
1986, a foreign corporation may elect to apply this section in lieu of 
Sec.  1.884-1T of the temporary regulations (as contained in the CFR 
edition revised as of April 1, 1992), but only if the foreign 
corporation also makes an election under Sec.  1.884-4 (e) to apply 
Sec.  1.884.4 in lieu of Sec.  1.884-4T (as contained in the CFR edition 
revised as of April 1, 1992) for that taxable year, and the statute of 
limitations for assessment of a deficiency has not expired for that 
taxable year. Once an election has been made, an election under this 
section shall apply to all subsequent taxable years. However, paragraph 
(f)(2)(vi) of this section (relating to certain interest income of 
Possessions banks) shall not apply for taxable years beginning before 
January 1, 1990.
    (2) Election to reduce liabilities. A foreign corporation may make 
an election to reduce its liabilities under paragraph (e)(3) of this 
section with respect to a taxable year for which an election under 
paragraph (i)(1) of this section is

[[Page 528]]

in effect by filing an amended return for the taxable year and 
recomputing its interest deduction and any other item affected by the 
election on an amended Form 1120F to take into account the reduction in 
liabilities for such year.
    (3) Separate election for installment obligations. A foreign 
corporation may make a separate election to apply paragraphs (d)(2)(iii) 
and (d)(6)(ii) of this section (relating to installment obligations 
treated as U.S. assets) to any prior taxable year without making an 
election under paragraph (i)(1) of this section, provided the statute of 
limitations for assessment of a deficiency has not expired for that 
taxable year and each succeeding taxable year. Once an election under 
this paragraph (i)(3) has been made, it shall apply to all subsequent 
taxable years.
    (4) Special rules for certain U.S. assets and liabilities. 
Paragraphs (c)(2) (i) and (ii), (d)(3), (d)(4), (d)(5)(iii), 
(d)(6)(iii), (d)(6)(vi), (e)(2), and (e)(3)(ii), of this section are 
effective for taxable years beginning on or after June 6, 1996.
    (j) Transition rules--(1) General rule. Except as provided in 
paragraph (j)(2) of this section, in order to compute its dividend 
equivalent amount in the first taxable year to which this section 
applies (whether or not such year begins before October 13, 1992, a 
foreign corporation must recompute its U.S. net equity as of close of 
the preceding taxable year using the rules of this section and use such 
recomputed amount, rather than the amount computed under Sec.  1.884-1T 
(as contained in the CFR edition revised as of April 1, 1992), to 
determine the amount of any increase or decrease in the U.S. net equity 
as of the close of that taxable year.
    (2) Installment obligations--(i) Interest election. In recomputing 
its U.S. net equity as of the close of the preceding taxable year, a 
foreign corporation that holds an installment obligation treated as a 
U.S. asset under Sec.  1.884-1T(d)(7) (as contained in the CFR edition 
revised as of April 1, 1992) as of such date may apply the rules of 
paragraph (d)(2)(iii) of this section without regard to the rule in that 
paragraph that requires interest or original issue discount on the 
obligation to be treated as ECI in order for such obligation to be 
treated as a U.S. asset.
    (ii) 1987 sales by certain foreign corporations. The E&P basis of an 
installment obligation arising in connection with a sale of property by 
a foreign corporation described in section 312(k)(4), where such sale 
occurs in a taxable year beginning in 1987, shall equal the E&P basis of 
the property sold as of the determination date reduced by payments 
received with respect to the obligation that do not represent gain for 
earnings and profits purposes, interest or original issue discount.

[T.D. 8432, 57 FR 41651, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1992; 57 
FR 60126, Dec. 18, 1992; 58 FR 17166, Apr. 1, 1993, as amended by T.D. 
8657, 61 FR 9338, Mar. 8, 1996; 61 FR 14247, Apr. 1, 1996; T.D. 9281, 71 
FR 47451, Aug. 17, 2006; T.D. 9465, 74 FR 49320, Sept. 28, 2009; 74 FR 
57252, Nov. 5, 2009]



Sec.  1.884-2  Special rules for termination or incorporation of a U.S. trade 
or business or liquidation or reorganization of a foreign corporation 
or its domestic subsidiary.

    (a) through (a)(2)(i) [Reserved]. For further information, see Sec.  
1.884-2T(a) through (a)(2)(ii).
    (a)(2)(ii) Waiver of period of limitations. The waiver referred to 
in Sec.  1.884-2T(a)(2)(i)(D) shall be executed on Form 8848, or 
substitute form, and shall extend the period for assessment of the 
branch profits tax for the year of complete termination to a date not 
earlier than the close of the sixth taxable year following that taxable 
year. This form shall include such information as is required by the 
form and accompanying instructions. The waiver must be signed by the 
person authorized to sign the income tax returns for the foreign 
corporation (including an agent authorized to do so under a general or 
specific power of attorney). The waiver must be filed on or before the 
date (including extensions) prescribed for filing the foreign 
corporation's income tax return for the year of complete termination. 
With respect to a complete termination occurring in a taxable year 
ending prior to June 6, 1996 a foreign corporation may also satisfy the 
requirements of this paragraph (a)(2)(ii) by applying Sec.  1.884-
2T(a)(2)(ii)

[[Page 529]]

of the temporary regulations (as contained in the CFR edition revised as 
of April 1, 1995). A properly executed Form 8848, substitute form, or 
other form of waiver authorized by this paragraph (a)(2)(ii) shall be 
deemed to be consented to and signed by a Service Center Director or the 
Assistant Commissioner (International) for purposes of Sec.  
301.6501(c)-1(d) of this chapter.
    (a)(3) through (a)(4) [Reserved]. For further information, see Sec.  
1.884-2T(a)(3) through (a)(4).
    (a)(5) Special rule if a foreign corporation terminates an interest 
in a trust. A foreign corporation whose beneficial interest in a trust 
terminates (by disposition or otherwise) in any taxable year shall be 
subject to the branch profits tax on ECEP attributable to amounts 
(including distributions of accumulated income or gain) treated as ECI 
to such beneficiary in such taxable year notwithstanding any other 
provision of Sec.  1.884-2T(a).
    (b) through (c)(2)(ii) [Reserved]. For further information, see 
Sec.  1.884-2T (b) through (c)(2)(ii).
    (c)(2)(iii) Waiver of period of limitations and transferee 
agreement. In the case of a transferee that is a domestic corporation, 
the provisions of Sec.  1.884-2T(c)(2)(i) shall not apply unless, as 
part of the section 381(a) transaction, the transferee executes a Form 
2045 (Transferee Agreement) and a waiver of period of limitations as 
described in this paragraph (c)(2)(iii), and files both documents with 
its timely filed (including extensions) income tax return for the 
taxable year in which the section 381(a) transaction occurs. The waiver 
shall be executed on Form 8848, or substitute form, and shall extend the 
period for assessment of any additional branch profits tax for the 
taxable year in which the section 381(a) transaction occurs to a date 
not earlier than the close of the sixth taxable year following the 
taxable year in which such transaction occurs. This form shall include 
such information as is required by the form and accompanying 
instructions. The waiver must be signed by the person authorized to sign 
Form 2045. With respect to a complete termination occurring in a taxable 
year ending prior to June 6, 1996 a foreign corporation may also satisfy 
the requirements of this paragraph (c)(2)(iii) by applying Sec.  1.884-
2T(c)(2)(iii) of the temporary regulations (as contained in the CFR 
edition revised as of April 1, 1995). A properly executed Form 8848, 
substitute form, or other form of waiver authorized by this paragraph 
(c)(2)(iii) shall be deemed to be consented to and signed by a Service 
Center Director or the Assistant Commissioner (International) for 
purposes of Sec.  301.6501(c)-1(d) of this chapter.
    (c)(3) through (c)(6)(i)(A) [Reserved]. For further guidance, see 
Sec.  1.884-2T(c)(3) through (c)(6)(i)(A).
    (B) Shareholders of the transferee (or of the transferee's parent in 
the case of a triangular reorganization described in section 
368(a)(1)(C) or a reorganization described in sections 368(a)(1)(A) and 
368(a)(2)(D) or (E)) who in the aggregate owned more than 25 percent of 
the value of the stock of the transferor at any time within the 12-month 
period preceding the close of the year in which the section 381(a) 
transaction occurs sell, exchange or otherwise dispose of their stock or 
securities in the transferee at any time during a period of three years 
from the close of the taxable year in which the section 381(a) 
transaction occurs.
    (C) In the case of a triangular reorganization described in section 
368(a)(1)(C) or a reorganization described in sections 368(a)(1)(A) and 
368(a)(2)(D) or (E), the transferee's parent sells, exchanges, or 
otherwise disposes of its stock or securities in the transferee at any 
time during a period of three years from the close of the taxable year 
in which the section 381(a) transaction occurs.
    (D) A corporation related to any such shareholder or the shareholder 
itself if it is a corporation (subsequent to an event described in 
paragraph (c)(6)(i)(A) or (B) of this section) or the transferee's 
parent (subsequent to an event described in paragraph (c)(6)(i)(C) of 
this section), uses, directly or indirectly, the proceeds or property 
received in such sale, exchange or disposition, or property attributable 
thereto, in the conduct of a trade or business in the United States at 
any time during a period of three years from the date of sale in the 
case of a disposition of stock in the transferor,

[[Page 530]]

or from the close of the taxable year in which the section 381(a) 
transaction occurs in the case of a disposition of the stock or 
securities in the transferee (or the transferee's parent in the case of 
a triangular reorganization described in section 368(a)(1)(C) or a 
reorganization described in sections 368(a)(1)(A) and (a)(2)(D) or (E)). 
Where this paragraph (c)(6)(i) applies, the transferor's branch profits 
tax liability for the taxable year in which the section 381(a) 
transaction occurs shall be determined under Sec.  1.884-1, taking into 
account all the adjustments in U.S. net equity that result from the 
transfer of U.S. assets and liabilities to the transferee pursuant to 
the section 381(a) transaction, without regard to any provisions in this 
paragraph (c). If an event described in paragraph (c)(6)(i)(A), (B), or 
(C) of this section occurs after the close of the taxable year in which 
the section 381(a) transaction occurs, and if additional branch profits 
tax is required to be paid by reason of the application of this 
paragraph (c)(6)(i), then interest must be paid on that amount at the 
underpayment rates determined under section 6621(a)(2), with respect to 
the period between the date that was prescribed for filing the 
transferor's income tax return for the year in which the section 381(a) 
transaction occurs and the date on which the additional tax for that 
year is paid. Any such additional tax liability together with interest 
thereon shall be the liability of the transferee within the meaning of 
section 6901 pursuant to section 6901 and the regulations thereunder.
    (c)(6)(ii) through (f) [Reserved]. For further guidance, see Sec.  
1.884-2T(c)(6)(ii) through (f).
    (g) Effective dates. Paragraphs (a)(2)(ii) and (c)(2)(iii) of this 
section are effective for taxable years beginning after December 31, 
1986. Paragraph (a)(5) of this section is effective for taxable years 
beginning on or after June 6, 1996. Paragraphs (c)(6)(i)(B), (C), and 
(D), are applicable for tax years beginning after December 31, 1986, 
except that such paragraphs are applicable to transactions occurring on 
or after January 23, 2006, in the case of reorganizations described in 
sections 368(a)(1)(A) and 368(a)(2)(D) or (E).

[T.D. 8657, 61 FR 9341, Mar. 8, 1996, as amended by T.D. 9243, 71 FR 
4292, Jan. 26, 2006]



Sec.  1.884-2T  Special rules for termination or incorporation of a U.S. trade 
or business or liquidation or reorganization of a foreign corporation 
or its domestic subsidiary (temporary).

    (a) Complete termination of a U.S. trade or business--(1) General 
rule. A foreign corporation shall not be subject to the branch profits 
tax for the taxable year in which it completely terminates all of its 
U.S. trade or business within the meaning of paragraph (a)(2) of this 
section. A foreign corporation's non-previously taxed accumulated 
effectively connected earnings and profits as of the close of the 
taxable year of complete termination shall be extinguished for purposes 
of section 884 and the regulations thereunder, but not for other 
purposes (for example, sections 312, 316 and 381).
    (2) Operating rules--(i) Definition of complete termination. A 
foreign corporation shall have completely terminated all of its U.S. 
trade or business for any taxable year (``the year of complete 
termination'') only if--
    (A) As of the close of that taxable year, the foreign corporation 
either has no U.S. assets, or its shareholders have adopted an 
irrevocable resolution in that taxable year to completely liquidate and 
dissolve the corporation and, before the close of the immediately 
succeeding taxable year (also a ``year of complete termination'' for 
purposes of applying this paragraph (a)(2)), all of its U.S. assets are 
either distributed, used to pay off liabilities, or cease to be U.S. 
assets;
    (B) Neither the foreign corporation nor a related corporation uses, 
directly or indirectly, any of the U.S. assets of the terminated U.S. 
trade or business, or property attributable thereto or to effectively 
connected earnings and profits earned by the foreign corporation in the 
year of complete termination, in the conduct of a trade or business in 
the United States at any time during a period of three years from the 
close of the year of complete termination;

[[Page 531]]

    (C) The foreign corporation has no income that is, or is treated as, 
effectively connected with the conduct of a trade or business in the 
United States (other than solely by reason of section 864 (c)(6) or 
(c)(7)) during the period of three years from the close of the year of 
complete termination; and
    (D) The foreign corporation attaches to its income tax return for 
each year of complete termination a waiver of the period of limitations, 
as described in paragraph (a)(2)(ii) of this section.


If a foreign corporation fails to completely terminate all of its U.S. 
trade or business because of the failure to meet any of the requirements 
of this paragraph (a)(2), then its branch profits tax liability for the 
taxable year and all subsequent taxable years shall be determined under 
the provisions of Sec.  1.884-1, without regard to any provisions in 
this paragraph (a), taking into account any reduction in U.S. net equity 
that results from a U.S. trade or business of the foreign corporation 
ceasing to have U.S. assets. Any additional branch profits tax liability 
that may result, together with interest thereon (charged at the 
underpayment rates determined under section 6621(a)(2) with respect to 
the period between the date that was prescribed for filing the foreign 
corporation's income tax return for the taxable year with respect to 
which the branch profits tax liability arises and the date on which the 
additional tax for that year is paid), and applicable penalties, if any, 
shall be the liability of the foreign corporation (or of any person who 
is a transferee of the foreign corporation within the meaning of section 
6901).
    (ii) Waiver of period of limitations. [Reserved]. See Sec.  1.884-
2(a)(2)(ii) for rules relating to this paragraph.
    (iii) Property subject to reinvestment prohibition rule. For 
purposes of paragraph (a)(2)(i)(B) of this section--
    (A) The term U.S. assets of the terminated U.S. trade or business 
shall mean all the money and other property that qualified as U.S. 
assets of the foreign corporation as of the close of the taxable year 
immediately preceding the year of complete termination; and
    (B) Property attributable to U.S. assets or to effectively connected 
earnings and profits earned by the foreign corporation in the year of 
complete termination shall mean money or other property into which any 
part or all of such assets or effectively connected earnings and profits 
are converted at any time before the expiration of the three-year period 
specified in paragraph (a)(2)(i)(B) of this section by way of sale, 
exchange, or other disposition, as well as any money or other property 
attributable to the sale by a shareholder of the foreign corporation of 
its interest in the foreign corporation (or a successor corporation) at 
any time after a date which is 12 months before the close of the year of 
complete termination (24 months in the case of a foreign corporation 
that makes an election under paragraph (b) of this section).
    (iv) Related corporation. For purposes of paragraph (a)(2)(i)(B) of 
this section, a corporation shall be related to a foreign corporation if 
either corporation is a 10-percent shareholder of the other corporation 
or, where the foreign corporation completely liquidates, if either 
corporation would have been a 10-percent shareholder of the other 
corporation had the foreign corporation remained in existence. For this 
purpose, the term 10-percent shareholder means any person described in 
section 871(h)(3)(B) as well as any person who owns 10 percent or more 
of the total value of the stock of the corporation, and stock ownership 
shall be determined on the basis of the attribution rules described in 
section 871(h)(3)(C).
    (v) Direct or indirect use of U.S. assets. The use of any part or 
all of the property referred to in paragraph (a)(2)(i)(B) of this 
section shall include the loan thereof to a related corporation or the 
use thereof as security (as a pledge, mortgage, or otherwise) for any 
indebtedness of a related corporation.
    (3) Complete termination in the case of a section 338 election. A 
foreign corporation whose stock is acquired by another corporation that 
makes (or is deemed to make) an election under section 338 with respect 
to the stock of the foreign corporation shall be treated as having 
completely liquidated as of the close of the acquisition date (as 
defined in section 338(h)(2)) and to have completely terminated all of 
its U.S.

[[Page 532]]

trade or business with respect to the taxable year ending on such 
acquisition date provided the foreign corporation that exists prior to 
the section 338 transaction complies with the requirements of paragraph 
(a)(2)(i) (B) and (D) of this section. For purposes of the preceding 
sentence, any of the money or other property paid as consideration for 
the acquisition of the stock in the foreign corporation (and for any 
debt claim against the foreign corporation) shall be treated as property 
attributable to the U.S. assets of the terminated U.S. trade or business 
and to the effectively connected earnings and profits of the foreign 
corporation earned in the year of complete termination.
    (4) Complete termination in the case of a foreign corporation with 
income under section 864(c)(6) or 864(c)(7). No branch profits tax shall 
be imposed on effectively connected earnings and profits attributable to 
income that is treated as effectively connected with the conduct of a 
trade or business in the United States solely by reason of section 
864(c)(6) or 864(c)(7) if--
    (i) No income of the foreign corporation for the taxable year is, or 
is treated as, effectively connected with the conduct of a trade or 
business in the United States, without regard to section 864(c)(6) or 
864(c)(7),
    (ii) The foreign corporation has no U.S. assets as of the close of 
the taxable year, and
    (iii) Such effectively connected earnings and profits would not have 
been subject to branch profits tax pursuant to the complete termination 
provisions of paragraph (a)(1) of this section if income or gain subject 
to section 864(c)(6) had not been deferred or if property subject to 
section 864(c)(7) had been sold immediately prior to the date the 
property ceased to have been used in the conduct of a trade or business 
in the United States.
    (5) Special rule if a foreign corporation terminates an interest in 
a trust. [Reserved]. See Sec.  1.884-2(a)(5) for rules relating to this 
paragraph.
    (6) Coordination with second-level withholding tax. Effectively 
connected earnings and profits and non-previously taxed accumulated 
effectively connected earnings and profits of a foreign corporation that 
are exempt from branch profits tax by reason of the provisions of 
paragraph (a)(1) of this section shall not be subject to tax under 
section 871(a), 881(a), 1441 or 1442 when paid as a dividend by such 
foreign corporation (or a successor-in-interest).
    (b) Election to remain engaged in a U.S. trade or business--(1) 
General rule. A foreign corporation that would be considered to have 
completely terminated all of its U.S. trade or business for the taxable 
year under the provisions of paragraph (a)(2)(i) of this section, but 
for the provisions of paragraph (a)(2)(i)(B) of this section that 
prohibit reinvestment within a three-year period, may make an election 
under this paragraph (b) for the taxable year in which it completely 
terminates all its U.S. trade or business (as determined without regard 
to paragraph (a)(2)(i)(B) of this section) and, if it so chooses, for 
the following taxable year (but not for any succeeding taxable year). 
The election under this paragraph (b) is an election by the foreign 
corporation to designate an amount of marketable securities as U.S. 
assets for purposes of Sec.  1.884-1. The marketable securities 
identified pursuant to the election under paragraph (b)(3) of this 
section shall be treated as being U.S. assets in an amount equal, in the 
aggregate, to the lesser of the adjusted basis of the U.S. assets that 
ceased to be U.S. assets during the taxable year in which the election 
is made (determined on the date or dates the U.S. assets ceased to be 
U.S. assets) or the adjusted basis of the marketable securities as of 
the end of the taxable year. The securities must be held from the date 
that they are identified until the end of the taxable year for which the 
election is made, or if disposed of during the taxable year, must be 
replaced on the date of disposition with other marketable securities 
that are acquired on or before that date and that have a fair market 
value as of the date of substitution not less than their adjusted basis.
    (2) Marketable security. For purposes of this paragraph (b), the 
term marketable security means a security (including stock) that is part 
of an issue any portion of which is regularly traded on an established 
securities market (within the meaning of Sec.  1.884-5(d)(2) and (4))

[[Page 533]]

and a deposit described in section 871(i)(3) (A) or (B).
    (3) Identification requirements. In order to qualify for this 
election--
    (i) The marketable securities must be identified on the books and 
records of the U.S. trade or business within 30 days of the date an 
equivalent amount of U.S. assets ceases to be U.S. assets; and
    (ii) On the date a marketable security is identified, its adjusted 
basis must not exceed its fair market value.
    (4) Treatment of income from deemed U.S. assets. The income or gain 
from the marketable securities (or replacement securities) subject to an 
election under this paragraph (b) that arises in a taxable year for 
which an election is made shall be treated as ECI (other than for 
purposes of section 864(c)(7)), and losses from the disposition of such 
marketable securities shall be allocated entirely to income that is ECI. 
In addition, all such securities shall be treated as if they had been 
sold for their fair market value on the earlier of the last business day 
of a taxable year for which an election is in effect or the day 
immediately prior to the date of substitution by the foreign corporation 
of a U.S. asset for the marketable security, and any gain (but not loss) 
and accrued interest on the securities shall also be treated as ECI. The 
adjusted basis of such property shall be increased by the amount of any 
gain recognized by reason of this paragraph (b).
    (5) Method of election. A foreign corporation may make an election 
under this paragraph (b) by attaching to its income tax return for the 
taxable year a statement--
    (i) Identifying the marketable securities treated as U.S. assets 
under this paragraph (b);
    (ii) Setting forth the E&P bases of such securities; and
    (iii) Agreeing to treat any income, gain or loss as provided in 
paragraph (b)(4) of this section.


Such statement must be filed on or before the due date (including 
extensions) of the foreign corporation's income tax return for the 
taxable year. A foreign corporation shall not be permitted to make an 
election under this paragraph (b) more than once.
    (6) Effective date. This paragraph (b) is effective for taxable 
years beginning on or after October 13, 1992. However, if a foreign 
corporation has made a valid election under Sec.  1.884-1(i) to apply 
that section with respect to a taxable year beginning before October 13, 
1992 and after December 31 1986, this paragraph (b) shall be effective 
beginning with such taxable year.
    (c) Liquidation, reorganization, etc. of a foreign corporation. The 
following rules apply to the transfer by a foreign corporation engaged 
(or deemed engaged) in the conduct of a U.S. trade or business (the 
``transferor'') of its U.S. assets to another corporation (the 
``transferee'') in a complete liquidation or reorganization described in 
section 381(a) (a ``section 381(a) transaction'') if the transferor is 
engaged (or deemed engaged) in the conduct of a U.S. trade or business 
immediately prior to the section 381(a) transaction. For purposes of 
this paragraph (c), a section 381(a) transaction is considered to occur 
in the taxable year that ends on the date of distribution or transfer 
(as defined in Sec.  1.381(b)-1(b)) pursuant to the section 381(a) 
transaction.
    (1) Inapplicability of paragraph (a)(1) of this section to section 
381(a) transactions. Paragraph (a)(1) of this section (relating to the 
complete termination of a U.S. trade or business of a foreign 
corporation) does not apply to exempt the transferor from branch profits 
tax liability for the taxable year in which the section 381(a) 
transaction occurs or in any succeeding taxable year.
    (2) Transferor's dividend equivalent amount for the taxable year in 
which a section 381(a) transaction occurs. The dividend equivalent 
amount for the taxable year, including a short taxable year, in which a 
section 381(a) transaction occurs shall be determined under the 
provisions of Sec.  1.884-1, as modified under the provisions of this 
paragraph (c)(2).
    (i) U.S. net equity. The transferor's U.S. net equity as of the 
close of the taxable year shall be determined without regard to any 
transfer in that taxable year of U.S. assets to or from the transferee 
pursuant to a section 381(a) transaction, and without regard to any U.S. 
liabilities assumed or acquired by the transferee from the transferor in

[[Page 534]]

that taxable year pursuant to a section 381(a) transaction. The 
transferor's adjusted basis (for earnings and profits purposes) in U.S. 
assets transferred to the transferee pursuant to a section 381(a) 
transaction shall be the adjusted basis of those assets (for earnings 
and profits purposes) immediately prior to the section 381(a) 
transaction, adjusted as provided under section 362(b), treating the 
transferor, for that purpose, as though it were the transferee and 
treating the gain taken into account for earnings and profits purposes 
as gain recognized.
    (ii) Effectively connected earnings and profits. The transferor's 
effectively connected earnings and profits for the taxable year in which 
the section 381(a) transaction occurs and its non-previously taxed 
accumulated effectively connected earnings and profits shall be 
determined without regard to the carryover to the transferee of the 
transferor's earnings and profits under section 381 (a) and (c)(2) and 
paragraph (c)(4) of this section. Effectively connected earnings and 
profits for the taxable year in which a section 381(a) transaction 
occurs shall be adjusted by the amount of any gain recognized to the 
transferor in that year pursuant to the section 381(a) transaction (to 
the extent taken into account for earnings and profits purposes).
    (iii) Waiver of period of limitations and transferee agreement. 
[Reserved]. See Sec.  1.884-2(c)(2)(iii) for rules relating to this 
paragraph.
    (3) Transferor's dividend equivalent amount for any taxable year 
succeeding the taxable year in which the section 381(a) transaction 
occurs. Any decrease in U.S. net equity in any taxable year succeeding 
the taxable year in which the section 381(a) transaction occurs shall 
increase the transferor's dividend equivalent amount for those years 
without regard to the limitation in Sec.  1.884-1(b)(3)(ii), to the 
extent such decrease in U.S. net equity does not exceed the balance of 
effectively connected earnings and profits and non-previously taxed 
accumulated effectively connected earnings and profits carried over to 
the transferee pursuant to section 381 (a) and (c)(2), as determined 
under paragraph (c)(4) of this section.
    (4) Earnings and profits of the transferor carried over to the 
transferee pursuant to the section 381(a) transaction--(i) Amount. The 
amount of effectively connected earnings and profits and non-previously 
taxed accumulated effectively connected earnings and profits of the 
transferor that carry over to the transferee under section 381 (a) and 
(c)(2) shall be the effectively connected earnings and profits and the 
non-previously taxed accumulated effectively connected earnings and 
profits of the transferor immediately before the close of the taxable 
year in which the section 381(a) transaction occurs. For this purpose, 
the provisions in Sec.  1.381(c)(2)-1 shall generally apply with proper 
adjustments to reflect the fact that effectively connected earnings and 
profits and non-previously taxed accumulated effectively connected 
earnings and profits are not affected by distributions to shareholders 
but, rather, by dividend equivalent amounts. Therefore, the amounts of 
effectively connected earnings and profits and non-previously taxed 
accumulated effectively connected earnings and profits that carry over 
to the transferee pursuant to those provisions are reduced by the 
transferor's dividend equivalent amount for the taxable year in which 
the section 381(a) transaction occurs. Such amounts are also reduced to 
the extent of any dividend equivalent amount determined for any 
succeeding taxable year solely as a result of the provisions of 
paragraph (c)(3) of this section. For purposes of this paragraph 
(c)(4)(i), if the transferor accumulates non-previously taxed 
effectively connected earnings and profits, or incurs a deficit in 
effectively connected earnings and profits, attributable to a period 
that is after the close of the taxable year in which the section 381(a) 
transaction occurs and before the liquidation of the transferor, then 
such effectively connected earnings and profits, or deficits therein, 
shall be deemed to have been accumulated or incurred on or before the 
close of the taxable year in which the section 381(a) transaction 
occurs.
    (ii) Retention of character. All of the transferor's effectively 
connected earnings and profits and non-previously

[[Page 535]]

taxed accumulated effectively connected earnings and profits that carry 
over to the transferee shall constitute non-previously taxed accumulated 
effectively connected earnings and profits of the transferee. In the 
case of a domestic transferee, such non-previously taxed accumulated 
effectively connected earnings and profits shall also constitute 
accumulated earnings and profits of the transferee for purposes of 
section 316(a)(2).
    (iii) Treatment of distributions by a domestic transferee out of 
non-previously taxed accumulated effectively connected earnings and 
profits. In the event the transferee is a domestic corporation, 
distributions out of the transferee's non-previously taxed accumulated 
effectively connected earnings and profits that are received by a 
foreign distributee shall qualify for benefits under an applicable 
income tax treaty only (A) if the distributee qualifies for the benefits 
under such treaty and (B) to the extent that the transferor foreign 
corporation would have qualified under the principles of Sec.  1.884-
1(g) (1) and (2)(i) for an exemption or reduction in rate with respect 
to the branch profits tax if the non-previously taxed accumulated 
effectively connected earnings and profits had been reflected in a 
dividend equivalent amount for the taxable year in which the section 
381(a) transaction occurs. (The tax rate on dividends specified in the 
treaty between the distributee's country of residence and the United 
States shall apply to any dividends received by a distributee who 
qualifies for a treaty benefit under the preceding sentence.) In 
addition, distributions out of such non-previously taxed accumulated 
effectively connected earnings and profits shall retain their character 
in the hands of any domestic distributee up a chain of corporate 
shareholders for purposes of applying this paragraph (c)(4)(iii) to 
distributions made by any such person to a foreign distributee. If a 
domestic transferee has non-previously taxed accumulated effectively 
connected earnings and profits carried over from the transferor as well 
as accumulated earnings and profits, then each category of earnings and 
profits shall be accounted for in two separate pools, and any 
distribution of earnings and profits shall be treated as a distribution 
out of each pool in proportion to the respective amount of undistributed 
earnings and profits in each pool. Section 871(i) (relating, in part, to 
dividends paid by a domestic corporation meeting the 80-percent foreign 
business requirements of section 861(c)(1)) shall not apply to any 
dividends paid by a domestic transferee out of its non-previously taxed 
accumulated effectively connected earnings and profits.
    (5) Determination of U.S. net equity of a transferee that is a 
foreign corporation. In the event the transferee is a foreign 
corporation, then for purposes of determining the transferee's increase 
or decrease in U.S. net equity under Sec.  1.884-1 for its taxable year 
during which the section 381(a) transaction occurs, its U.S. net equity 
as of the close of its immediately preceding taxable year shall be 
increased by the amount of U.S. net equity acquired by the transferee 
from the transferor pursuant to the section 381(a) transaction, taking 
into account the adjustments to the basis (for earnings and profits 
purposes) of U.S. assets under the principles of section 362(b).
    (6) Special rules in the case of the disposition of stock or 
securities in a domestic transferee or in the transferor--(i) General 
rule. This paragraph (c)(6)(i) shall apply where the transferee is a 
domestic corporation, subdivision (A), (B), or (C) of this paragraph 
applies and subdivision (D) of this paragraph applies.
    (A) Shareholders of the transferor sell, exchange or otherwise 
dispose of stock in the transferor at any time during a 12-month period 
before the date of distribution or transfer (as defined in Sec.  
1.381(b)-1(b)) and the aggregate amount of such stock sold, exchanged or 
otherwise disposed of exceeds 25 percent of the value of the stock of 
the transferor, determined on a date that is 12 months before the date 
of distribution or transfer.
    (B), (C), and (D) [Reserved]. For further guidance, see Sec.  1.884-
2(c)(6)(i)(B), (C), and (D).


Where this paragraph (c)(6)(i) applies, the transferor's branch profits 
tax liability for the taxable year in which the section 381(a) 
transaction occurs

[[Page 536]]

shall be determined under Sec.  1.884-1, taking into account all the 
adjustments in U.S. net equity that result from the transfer of U.S. 
assets and liabilities to the transferee pursuant to the section 381(a) 
transaction, without regard to any provisions in this paragraph (c). If 
an event described in paragraph (c)(6)(i) (A), (B), or (C) of this 
section occurs after the close of the taxable year in which the section 
381(a) transaction occurs, and if additional branch profits tax is 
required to be paid by reason of the application of this paragraph 
(c)(6)(i), then interest must be paid on that amount at the underpayment 
rates determined under section 6621(a)(2), with respect to the period 
between the date that was prescribed for filing the transferor's income 
tax return for the year in which the section 381(a) transaction occurs 
and the date on which the additional tax for that year is paid. Any such 
additional tax liability together with interest thereon shall be the 
liability of the transferee within the meaning of section 6901 pursuant 
to section 6901 and the regulations thereunder.
    (ii) Operating rule. For purposes of paragraph (c)(6)(i) of this 
section paragraphs (a)(2) (iii)(B), (iv) and (v) of this section shall 
apply for purposes of making the determinations under paragraph 
(c)(6)(i)(D) of this section.
    (d) Incorporation under section 351--(1) In general. The following 
rules apply to the transfer by a foreign corporation engaged (or deemed 
engaged) in the conduct of a U.S. trade or business (the ``transferor'') 
of part or all of its U.S. assets to a U.S. corporation (the 
``transferee'') in exchange for stock or securities in the transferee in 
a transaction that qualifies under section 351(a) (a ``section 351 
transaction''), provided that immediately after the transaction, the 
transferor is in control (as defined in section 368(c)) of the 
transferee, without regard to other transferors.
    (2) Inapplicability of paragraph (a)(1) of this section to section 
351 transactions. Paragraph (a)(1) of this section does not apply to 
exempt the transferor from branch profits tax liability for the taxable 
year in which a section 351 transaction described in paragraph (d)(1) of 
this section occurs and shall not apply for any subsequent taxable year 
of the transferor in which it, or a successor-in-interest, owns stock or 
securities of a transferee as of the close of the transferor's taxable 
year.
    (3) Transferor's dividend equivalent amount for the taxable year in 
which a section 351 transaction occurs. The dividend equivalent amount 
of the transferor for the taxable year in which a section 351 
transaction described in paragraph (d)(1) of this section occurs shall 
be determined under the provisions of Sec.  1.884-1, as modified by the 
provisions of this paragraph (d)(3) provided that the transferee elects 
under paragraph (d)(4) of this section to be allocated a proportionate 
amount of the transferor's effectively connected earnings and profits 
and non-previously taxed accumulated effectively connected earnings and 
profits and the foreign corporation files a statement as provided in 
paragraph (d)(5)(i) of this section and complies with the agreement 
included in such statement with respect to a subsequent disposition of 
the transferee's stock.
    (i) U.S. net equity. The transferor's U.S. net equity as of the 
close of the taxable year shall be determined without regard to any 
transfer in that taxable year of U.S. assets to or from the transferee 
pursuant to a section 351 transaction, and without regard to any U.S. 
liabilities assumed or acquired by the transferee from the transferor in 
that taxable year pursuant to a section 351 transaction. The 
transferor's adjusted basis for earnings and profits purposes in U.S. 
assets transferred to the transferee pursuant to a section 351 
transaction shall be the adjusted basis of those assets for earnings and 
profits purposes immediately prior to the section 351 transaction, 
increased by the amount of any gain recognized by the transferor on the 
transfer of such assets in the section 351 transaction to the extent 
taken into account for earnings and profits purposes.
    (ii) Effectively connected earnings and profits. Subject to the 
limitation in paragraph (d)(3)(iii) of this section, the calculation of 
the transferor's dividend

[[Page 537]]

equivalent amount shall take into account the transferor's effectively 
connected earnings and profits for the taxable year in which a section 
351 transaction occurs (including any amount of gain recognized to the 
transferor pursuant to the section 351 transaction to the extent the 
gain is taken into account for earnings and profits purposes) and, for 
purposes of applying the limitation of Sec.  1.884-1(b)(3)(ii), its non-
previously taxed accumulated effectively connected earnings and profits, 
determined without regard to the allocation to the transferee of the 
transferor's effectively connected earnings and profits and non-
previously taxed accumulated effectively connected earnings and profits 
pursuant to the election under paragraph (d)(4)(i) of this section.
    (iii) Limitation on dividend equivalent amount. The dividend 
equivalent amount determined under this paragraph (d)(3) shall not 
exceed the sum of the transferor's effectively connected earnings and 
profits and non-previously taxed accumulated effectively connected 
earnings and profits determined after taking into account the allocation 
to the transferee of the transferor's earnings pursuant to an election 
under paragraph (d)(4)(i) of this section.
    (4) Election to increase earnings and profits--(i) General rule. The 
election referred to in paragraph (d)(3) of this section is an election 
by the transferee to increase its earnings and profits by the amount 
determined under paragraph (d)(4)(ii) of this section. An election under 
this paragraph (d)(4)(i) shall be effective only if the transferee 
attaches a statement to its timely filed (including extensions) income 
tax return for the taxable year in which the section 351 transaction 
occurs, in which--
    (A) It agrees to be subject to the rules of paragraph (c)(4) (ii) 
and (iii) of this section with respect to the transferor's effectively 
connected earnings and profits and non-previously taxed accumulated 
effectively connected earnings and profits allocated to the transferee 
pursuant to the election under this paragraph (d)(4)(i) in the same 
manner as if such earnings and profits had been carried over to the 
transferee pursuant to section 381 (a) and (c)(2), and
    (B) It identifies the amount of effectively connected earnings and 
profits and non-previously taxed accumulated effectively connected 
earnings and profits that are allocated from the transferor.


An election with respect to a taxable year ending on or before December 
1, 1988, may be made by filing an amended Form 1120F on or before 
January 3, 1988, to which the statement described in this paragraph 
(d)(4)(i) shall be attached.
    (ii) Amount of the transferor's effectively connected earnings and 
profits and non-previously taxed accumulated effectively connected 
earnings and profits allocated to the transferee. The amount referred to 
in paragraph (d)(4)(i) of this section is equal to the same proportion 
of the transferor's effectively connected earnings and profits and non-
previously taxed accumulated effectively connected earnings and profits 
(determined immediately prior to the section 351 transaction and without 
regard to this paragraph (d)(4) or any dividend equivalent amount for 
the taxable year) that the adjusted bases for purposes of computing 
earnings and profits in all the U.S. assets transferred to the 
transferee by the transferor pursuant to the section 351 transaction 
bear to the adjusted bases for purposes of computing earnings and 
profits in all the U.S. assets of the transferor, determined immediately 
prior to the section 351 transaction.
    (iii) Effect of election on transferor. For purposes of computing 
the transferor's dividend equivalent amount for the taxable year 
succeeding the taxable year in which a section 351 transaction occurs, 
the transferor's effectively connected earnings and profits and non-
previously taxed accumulated effectively connected earnings and profits 
as of the close of the taxable year in which the section 351 transaction 
occurs shall be reduced by the amount of its effectively connected 
earnings and profits and non-previously taxed accumulated effectively 
connected earnings and profits allocated to the transferee pursuant to 
the election under paragraph (d)(4)(i) of this section (and by its 
dividend equivalent amount for the

[[Page 538]]

taxable year in which the section 351 transaction occurs).
    (5) Dispositions of stock or securities of the transferee by the 
transferor--(i) General rule. The statement referred to in paragraph 
(d)(3) of this section is a statement executed by the transferor stating 
the transferor's agreement that, upon the disposition of part or all of 
the stock or securities it owns in the transferee (or a successor-in-
interest), it shall treat as a dividend equivalent amount for the 
taxable year in which the disposition occurs an amount equal to the 
lesser of (A) the amount realized upon such disposition or (B) the total 
amount of effectively connected earnings and profits and non-previously 
taxed accumulated effectively connected earnings and profits that was 
allocated from the transferor to that transferee pursuant to an election 
under paragraph (d)(4)(i) of this section, which amount shall be reduced 
to the extent previously taken into account by the transferor as 
dividends or dividend equivalent amounts for tax or branch profits, tax 
purposes. The extent and manner in which such dividend equivalent amount 
may be subject to the branch profits tax in the taxable year of 
disposition shall be determined under the provisions of section 884 and 
the regulations thereunder, including the provisions of paragraph (a) of 
this section (relating to complete terminations), as limited under 
paragraph (d)(2) of this section. Except as otherwise provided in 
paragraph (d)(5)(ii) of this section, the term disposition means any 
transfer that would constitute a disposition by the transferor for any 
purpose of the Internal Revenue Code and the regulations thereunder. 
This paragraph (d)(5)(i) shall apply regardless of whether the stock or 
securities of the transferee are U.S. assets in the hands of the 
transferor at the time of sale, exchange or disposition.
    (ii) Exception for certain tax-free dispositions. For purposes of 
paragraph (d)(5)(i) of this section, a disposition does not include a 
transfer of stock or securities of the transferee by the transferor in a 
transaction that qualifies as a transfer pursuant to a complete 
liquidation described in section 332(b) or a transfer pursuant to a 
reorganization described in section 368(a)(1)(F). Any other transfer 
that qualifies for non-recognition of gain or loss shall be treated as a 
disposition for purposes of paragraph (d)(5)(i) of this section, unless 
the Commissioner has, by published guidance or by prior ruling issued to 
the taxpayer upon its request, determined such transfer not to be a 
disposition for purposes of paragraph (d)(5)(i) of this section.
    (iii) Distributions governed by section 355. In the case of a 
distribution or exchange of stock or securities of a transferee to which 
section 355 applies (or so much of section 356 as relates to section 
355) and that is not in pursuance of a plan meeting the requirements of 
a reorganization as defined in section 368(a)(1)(D), Sec.  1.3l2-10(b) 
(relating to the allocation of earnings and profits in certain corporate 
separations) shall not apply to reduce the transferor's effectively 
connected earnings and profits or non-previously taxed accumulated 
effectively connected earnings and profits.
    (iv) Filing of statement. The statement referred to in paragraph 
(d)(5)(i) of this section shall be attached to a timely filed (including 
extensions) income tax return of the transferor for the taxable year in 
which the section 351 transaction occurs. An election with respect to a 
taxable year ending on or before December 1, 1988, may be made by filing 
an amended Form 1120F on or before January 3, 1988, to which the 
statement described in this paragraph (d)(5)(iv) shall be attached.
    (6) Example. The provisions of this paragraph (d) are illustrated by 
the following example.

    Example. Foreign corporation X has a calendar taxable year. X's only 
assets are U.S. assets and X computes its interest deduction using the 
actual ratio of liabilities to assets under Sec.  1.882-5(b)(2)(ii). X's 
U.S. net equity as of the close of its 1988 taxable year is $2,000, 
resulting from the following amounts of U.S. assets and liabilities:

------------------------------------------------------------------------
           U.S. assets                       U.S. liabilities
------------------------------------------------------------------------
U.S. building A.................    $l,000  Mortgage A........       800
U.S. building B.................     2,500  Mortgage B........     1,500
Other U.S. assets...............       800
                                 ----------                    ---------
    Total.......................     4,300                         2,300
------------------------------------------------------------------------


[[Page 539]]

    Assume that X's adjusted basis in its assets is equal to X's 
adjusted basis in its assets for earnings and profits purposes. On 
September 30, 1989, X transfers building A, which has a fair market 
value of $1,800, to a newly created U.S. corporation Y under section 351 
in exchange for 100% of the stock of Y with a fair market value of $800, 
other property with a fair market value of $200, and the assumption of 
Mortgage A. Assume that under sections 11 and 351(b), tax of $30 is 
imposed with respect to the $200 of other property received by X. X's 
non-previously taxed accumulated effectively connected earnings and 
profits as of the close of its 1988 taxable year are $200 and its 
effectively connected earnings and profits for its 1989 taxable year are 
$330, including $170 of gain recognized to X on the transfer as adjusted 
for earnings and profits purposes (i.e., $200 of gain recognized minus 
$30 of tax paid with respect to the gain). Y takes a $1,200 basis in the 
building transferred from X, equal to the basis in the hands of X 
($1,000) increased by the amount of gain recognized to X in the section 
351 transaction ($200). Y makes an election in the manner described in 
paragraph (d)(4)(i) of this section to increase its earnings and profits 
by the amount described in paragraph (d)(4)(ii) of this section and X 
files a statement as provided in paragraph (d)(5)(i) of this section. 
The branch profits tax consequences to X and Y in the taxable year in 
which the section 351 transaction occurs and in subsequent taxable years 
are as follows:
    (i) X's dividend equivalent amount for 1989. The determination of 
X's dividend equivalent amount for 1989 is a three-step process: 
determining X's U.S. net equity as of the close of its 1989 taxable year 
under paragraph (d)(3)(i) of this section; determining the amount of X's 
effectively connected earnings and profits and non-previously taxed 
accumulated effectively connected earnings and profits for its 1989 
taxable year under paragraph (d)(3)(ii) of this section; and applying 
the limitation in paragraph (d)(3)(iii) of this section.
    Step one: Pursuant to paragraph (d)(3)(i) of this section, X's U.S. 
net equity as of the close of its 1989 taxable year is calculated 
without regard to the section 351 transaction except that X's basis in 
its U.S. assets is increased by the $170 amount of gain it has 
recognized for earnings and profits purposes in connection with the 
section 351 transaction. Thus, X's U.S. net equity as of the close of 
its 1989 taxable year is $1,870, consisting of the following U.S. assets 
and liabilities, taking into account the fact that X's other U.S. assets 
have decreased to $500:

------------------------------------------------------------------------
           U.S. assets                       U.S. liabilities
------------------------------------------------------------------------
Building A......................    $l,170  Mortgage A........       800
Building B......................     2,500  Mortgage B........     1,500
Other U.S. assets...............       500
                                 ----------                    ---------
    Total.......................     4,170                         2,300
------------------------------------------------------------------------

    Thus, X's U.S. net equity as of the close of its 1989 taxable year 
has decreased by $130 relative to its U.S. net equity as of the close of 
its 1988 taxable year.
    Step two: Pursuant to paragraph (d)(3)(ii) of this section, X's 
effectively connected earnings and profits and non-previously taxed 
accumulated effectively connected earnings and profits for the taxable 
year are determined without taking into account the allocation to Y of 
X's effectively connected earnings and profits and non-previously taxed 
accumulated effectively connected earnings and profits pursuant to the 
election under paragraph (d)(4)(i) of this section. Thus, X's 
effectively connected earnings and profits for its 1989 taxable year are 
$330 and X's non-previously taxed accumulated effectively connected 
earnings and profits are $200. Thus, but for the limitation in paragraph 
(d)(3)(iii) of this section, X's dividend equivalent amount for the 
taxable year would be $460, equal to X's effectively connected earnings 
and profits for the taxable year ($330), increased by the decrease in 
X's U.S. net equity ($130).
    Step three: Pursuant to paragraph (d)(3)(iii) of this section, X's 
dividend equivalent amount for its 1989 taxable year may not exceed the 
sum of the transferor's effectively connected earnings and profits and 
non-previously taxed accumulated effectively connected earnings and 
profits, determined as of the close of its 1989 taxable year, after 
taking into account the allocation of the transferor's earnings and 
profits pursuant to the election under paragraph (d)(4)(i) of this 
section. Based upon subdivision (ii) of this example, X's dividend 
equivalent amount for 1989 cannot exceed $423, which is equal to the 
total amount of X's effectively connected earnings and profits and non-
previously taxed accumulated effectively connected earnings and profits, 
determined as of the close of its 1989 taxable year without regard to 
the allocation of earnings and profits to Y pursuant to Y's election 
under paragraph (d)(4)(i) of this section ($530), reduced by the amount 
of X's effectively connected earnings and profits and non-previously 
taxed accumulated effectively connected earnings and profits allocated 
to Y pursuant to Y's election under paragraph (d)(4)(i) of this section 
($107). Thus, X's dividend equivalent amount for its 1989 taxable year 
is limited to $423.
    (ii) Amount of X's effectively connected earnings and profits and 
non-previously taxed accumulated effectively connected earnings and 
profits transferred to Y. Pursuant to Y's election under paragraph 
(d)(4)(i) of this section, Y increases its earnings and profits by the

[[Page 540]]

amount prescribed in paragraph (d)(4)(ii) of this section. This amount 
is equal to the sum of X's effectively connected earnings and profits 
and non previously taxed accumulated effectively connected earnings and 
profits determined immediately before the section 351 transaction, 
without regard to X's dividend equivalent amount for the year, allocated 
in the same proportion that X's basis in the U.S. assets transferred to 
Y bears to the bases of all of X's U.S. assets, which bases are 
determined immediately prior to the section 351(a) transaction. The 
amount of X's effectively connected earnings and profits immediately 
before the section 351 transaction is assumed to be $260. The total 
amount of effectively connected earnings and profits ($260) and non-
previously taxed accumulated effectively connected earnings and profits 
($200) determined immediately before the section 351 transaction is, 
therefore, $460. The portion of $460 that is allocated to Y pursuant to 
Y's election under paragraph (d)(4)(i) of this section is $107, 
calculated as $46? multiplied by a fraction, the numerator of which is 
the basis of the U.S. assets transferred to Y pursuant to the section 
351 transaction ($1,000), and the denominator of which is the basis of 
X's U.S. assets determined immediately before the section 351 
transaction ($4,300). Pursuant to paragraph (d)(4)(i) of this section, 
the amount of $107 of X's effectively connected earnings and profits and 
non-previously taxed accumulated effectively connected earnings and 
profits allocated to Y pursuant to paragraph (d)(4)(i) of this section 
constitutes non-previously taxed accumulated effectively connected 
earnings and profits of Y.
    (iii) X's non-previously taxed accumulated effectively connected 
earnings and profits for 1990. Pursuant to paragraph (d)(4)(iii) of this 
section, X's non-previously taxed accumulated effectively connected 
earnings and profits as of the close of its 1989 taxable year for 
purposes of computing its dividend equivalent amount for its taxable 
year 1990 are zero, i.e., $530 of effectively connected earnings and 
profits and non-previously taxed accumulated effectively connected 
earnings and profits reduced by $107 of effectively connected earnings 
and profits and non-previously taxed accumulated effectively connected 
earnings and profits allocated to Y, and further reduced by X's $423 
dividend equivalent amount for its 1989 taxable year.
    (iv) X's U.S. net equity for purposes of determining the dividend 
equivalent amount for succeeding taxable years. For 1990, X must 
determine its U.S. net equity as of December 31, 1989, in order to 
determine whether there has been an increase or decrease in its U.S. net 
equity as of December 31, 1990. For this purpose, X's U.S. net equity as 
of December 31, 1989 is determined under the provisions of Sec.  1.884-1 
without regard to the special rules in paragraph (d)(3)(i) of this 
section. Thus, X.'s U.S. net equity as of December 31, 1989 is $1,500, 
consisting of the following. U.S. assets and liabilities:

------------------------------------------------------------------------
           U.S. assets                       U.S. liabilities
------------------------------------------------------------------------
Building B......................    $2,500  Mortgage B........     1,500
Other U.S. assets...............       500
                                 ----------                    ---------
    Total.......................    $3,000                         1,500
------------------------------------------------------------------------

    (e) Certain transactions with respect to a domestic subsidiary. In 
the case of a section 381(a) transaction in which a domestic subsidiary 
of a foreign corporation transfers assets to that foreign corporation or 
to another foreign corporation with respect to which the first foreign 
corporation owns stock (directly or indirectly) meeting the requirements 
of section 1504(a)(2), the transferee's non-previously taxed accumulated 
effectively connected earnings and profits for the taxable year in which 
the section 381(a) transaction occurs shall be increased by all of the 
domestic subsidiary's current earnings and profits and earnings and 
profits accumulated after December 31, 1986, that carry over to the 
transferee under sections 381(a) and (c)(1) (including non-previously 
taxed accumulated effectively connected earnings and profits, if any, 
transferred to the domestic subsidiary under paragraphs (c)(4) and 
(d)(4) of this section and treated as earnings and profits under 
paragraphs (c)(4)(ii) and (d)(4)(ii) of this section). For purposes of 
determining the transferee's dividend equivalent amount for the taxable 
year in which the section 381(a) transaction occurs, the transferee's 
U.S. net equity as of the close of its taxable year immediately 
preceding the taxable year during which the section 381(a) transaction 
occurs shall be increased by the greater of
    (1) The amount by which the transferee's U.S. net equity computed 
immediately prior to the transfer would have increased due to the 
transfer of the subsidiary's assets and liabilities if U.S. net equity 
were computed immediately prior to the transfer and immediately after 
the transfer (taking into account in the earnings and profits basis of 
the assets transferred any gain recognized on the transfer to the extent 
reflected in earnings and profits), or

[[Page 541]]

    (2) The total amount of U.S net equity transferred (directly or 
indirectly) by the foreign parent to the domestic subsidiary in one or 
more prior section 351 or 381(a) transactions.
    (f) Effective date. This section is effective for taxable years 
beginning after December 31, 1986.

[T.D. 8223, 53 FR 34059, Sept. 2, 1988, as amended by T.D. 8432, 57 FR 
41659, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1993; 57 FR 60126, Dec. 18, 
1992; T.D. 8657, 61 FR 9341, Mar. 8, 1996; T.D. 9243, 71 FR 4293, Jan. 
26, 2006]



Sec.  1.884-3T  Coordination of branch profits tax 
with second-tier withholding (temporary). [Reserved]



Sec.  1.884-4  Branch-level interest tax.

    (a) General rule--(1) Tax on branch interest. In the case of a 
foreign corporation that, during the taxable year, is engaged in trade 
or business in the United States or has gross income that is ECI (as 
defined in Sec.  1.884-1(d)(1)(iii)), any interest paid by such trade or 
business (hereinafter ``branch interest,'' as defined in paragraph (b) 
of this section) shall, for purposes of subtitle A (Income Taxes), be 
treated as if it were paid by a domestic corporation (other than a 
corporation described in section 861(c)(1), relating to a domestic 
corporation that meets the 80 percent foreign business requirement). 
Thus, for example, whether such interest is treated as income from 
sources within the United States by the person who receives the interest 
shall be determined in the same manner as if such interest were paid by 
a domestic corporation (other than a corporation described in section 
861(c)(1)). Such interest shall be subject to tax under section 871(a) 
or 881, and to withholding under section 1441 or 1442, in the same 
manner as interest paid by a domestic corporation (other than a 
corporation described in section 861(c)(1)) if received by a foreign 
person and not effectively connected with the conduct by the foreign 
person of a trade or business in the United States, unless the interest, 
if paid by a domestic corporation, would be exempt under section 871(h) 
or 881(c) (relating to exemption for certain portfolio interest received 
by a foreign person), section 871(i) or 881(d) (relating, in part, to 
exemption for certain bank deposit interest received by a foreign 
person), or another provision of the Code. Such interest shall also be 
treated as interest paid by a domestic corporation (other than a 
corporation described in section 861(c)(1)) for purposes of sections 
864(c), 871(b) and 882(a) (relating to income that is effectively 
connected with the conduct of a trade or business within the United 
States) and section 904 (relating to the limitation on the foreign tax 
credit). For purposes of this section, a foreign corporation also shall 
be treated as engaged in trade or business in the United States if, at 
any time during the taxable year, it owns an asset taken into account 
under Sec.  1.882-5(a)(1)(ii) or (b)(1) for purposes of determining the 
amount of the foreign corporation's interest expense allocated or 
apportioned to ECI. See paragraph (b)(8) of this section for the effect 
of income tax treaties on branch interest.
    (2) Tax on excess interest--(i) Definition of excess interest. For 
purposes of this section, the term ``excess interest'' means--
    (A) The amount of interest allocated or apportioned to ECI of the 
foreign corporation under Sec.  1.882-5 for the taxable year, after 
application of Sec.  1.884-1(e)(3); minus
    (B) The foreign corporation's branch interest (as defined in 
paragraph (b) of this section) for the taxable year, but not including 
interest accruing in a taxable year beginning before January 1, 1987; 
minus
    (C) The amount of interest determined under paragraph (c)(2) of this 
section (relating to interest paid by a partnership).
    (ii) Imposition of tax. A foreign corporation shall be liable for 
tax on excess interest under section 881(a) in the same manner as if 
such excess interest were interest paid to the foreign corporation by a 
wholly-owned domestic corporation (other than a corporation described in 
section 861(c)(1)) on the last day of the foreign corporation's taxable 
year. Excess interest shall be exempt from tax under section 881(a) only 
as provided in paragraph (a)(2)(iii) of this section (relating to 
treatment of certain excess interest of banks as interest on deposits) 
or paragraph (c)(3) of this section (relating to income tax treaties).

[[Page 542]]

    (iii) Treatment of a portion of the excess interest of banks as 
interest on deposits. A portion of the excess interest of a foreign 
corporation that is a bank (as defined in section 585(a)(2)(B) without 
regard to the second sentence thereof) provided that a substantial part 
of its business in the United States, as well as all other countries in 
which it operates, consists of receiving deposits and making loans and 
discounts, shall be treated as interest on deposits (as described in 
section 871(i)(3)), and shall be exempt from the tax imposed by section 
881(a) as provided in such section. The portion of the excess interest 
of the foreign corporation that is treated as interest on deposits shall 
equal the product of the foreign corporation's excess interest and the 
greater of--
    (A) The ratio of the amount of interest bearing deposits, within the 
meaning of section 871(i)(3)(A), of the foreign corporation as of the 
close of the taxable year to the amount of all interest bearing 
liabilities of the foreign corporation on such date; or
    (B) 85 percent.
    (iv) Reporting and payment of tax on excess interest. The amount of 
tax due under section 884(f) and this section with respect to excess 
interest of a foreign corporation shall be reported on the foreign 
corporation's income tax return for the taxable year in which the excess 
interest is treated as paid to the foreign corporation under section 
884(f)(1)(B) and paragraph (a)(2) of this section, and shall not be 
subject to withholding under section 1441 or 1442. The tax shall be due 
and payable as provided in section 6151 and such other sections of 
Subtitle F of the Internal Revenue Code as apply, and estimated tax 
payments shall be due with respect to a foreign corporation's liability 
for the tax on excess interest as provided in section 6655.
    (3) Original issue discount. For purposes of this section, the term 
``interest'' includes original issue discount, as defined in section 
1273(a)(1).
    (4) Examples. The application of this paragraph (a) is illustrated 
by the following examples.

    Example 1. Taxation of branch interest and excess interest. Foreign 
corporation A, a calendar year taxpayer that is not a corporation 
described in paragraph (a)(2)(iii) of this section (relating to banks), 
has $120 of interest allocated or apportioned to ECI under Sec.  1.882-5 
for 1997. A's branch interest (as defined in paragraph (b) of this 
section) for 1997 is as follows: $55 of portfolio interest (as defined 
in section 871(h)(2)) to B, a nonresident alien; $25 of interest to 
foreign corporation C, which owns 15 percent of the combined voting 
power of A's stock, with respect to bonds issued by A; and $20 to D, a 
domestic corporation. B and C are not engaged in the conduct of a trade 
or business in the United States. A, B and C are residents of countries 
with which the United States does not have an income tax treaty. The 
interest payments made to B and D are not subject to tax under section 
871(a) or 881 and are not subject to withholding under section 1441 or 
1442. The payment to C, which does not qualify as portfolio interest 
because C owns at least 10 percent of the combined voting power of A's 
stock, is subject to withholding of $7.50 ($25 x 30%). In addition, 
because A's interest allocated or apportioned to ECI under Sec.  1.882-5 
($120) exceeds its branch interest ($100), A has excess interest of $20, 
which is subject to a tax of $6 ($20 x 30%) under section 881. The tax 
on A's excess interest must be reported on A's income tax return for 
1997.
    Example 2. Taxation of excess interest of a bank. Foreign 
corporation A, a calendar year taxpayer, is a corporation described in 
paragraph (a)(2)(iii) of this section (relating to banks) and is a 
resident of a country with which the United States does not have an 
income tax treaty. A has excess interest of $100 for 1997. At the close 
of 1997, A has $10,000 of interest-bearing liabilities (including 
liabilities that give rise to branch interest), of which $8,700 are 
interest-bearing deposits. For purposes of computing the tax on A's 
excess interest, $87 of the excess interest ($100 excess interest x 
($8,700 interest-bearing deposits/$10,000 interest-bearing liabilities)) 
is treated as interest on deposits. Thus, $87 of A's excess interest is 
exempt from tax under section 881(a) and the remaining $13 of excess 
interest is subject to a tax of $3.90 ($13 x 30%) under section 881(a).

    (b) Branch interest--(1) Definition of branch interest. For purposes 
of this section, the term ``branch interest'' means interest that is--
    (i) Paid by a foreign corporation with respect to a liability that 
is--
    (A) A U.S. booked liability within the meaning of Sec.  1.882-
5(d)(2) (other than a U.S. booked liability of a partner within the 
meaning of Sec.  1.882-5(d)(2)(vii)); or
    (B) Described in Sec.  1.884-1(e)(2) (relating to insurance 
liabilities on U.S. business and liabilities giving rise to interest 
expense that is directly allocated to income from a U.S. asset); or

[[Page 543]]

    (ii) In the case of a foreign corporation other than a corporation 
described in paragraph (a)(2)(iii) of this section, a liability 
specifically identified (as provided in paragraph (b)(3)(i) of this 
section) as a liability of a U.S. trade or business of the foreign 
corporation on or before the earlier of the date on which the first 
payment of interest is made with respect to the liability or the due 
date (including extensions) of the foreign corporation's income tax 
return for the taxable year, provided that--
    (A) The amount of such interest does not exceed 85 percent of the 
amount of interest of the foreign corporation that would be excess 
interest before taking into account interest treated as branch interest 
by reason of this paragraph (b)(1)(ii);
    (B) The requirements of paragraph (b)(3)(ii) of this section 
(relating to notification of recipient of interest) are satisfied; and
    (C) The liability is not described in paragraph (b)(3)(iii) of this 
section (relating to liabilities incurred in the ordinary course of a 
foreign business or secured by foreign assets) or paragraph (b)(1)(i) of 
this section.
    (2) [Reserved]
    (3) Requirements relating to specifically identified liabilities--
(i) Method of identification. A liability described in paragraph 
(b)(1)(ii) of this section is identified as a liability of a U.S. trade 
or business only if the liability is shown on the records of the U.S. 
trade or business, or is identified as a liability of the U.S. trade or 
business on other records of the foreign corporation or on a schedule 
established for the purpose of identifying the liabilities of the U.S. 
trade or business. Each such liability must be identified with 
sufficient specificity so that the amount of branch interest 
attributable to the liability, and the name and address of the 
recipient, can be readily identified from such records or schedule. 
However, with respect to liabilities that give rise to portfolio 
interest (as defined in sections 871(h) and 881(c)) or that are payable 
183 days or less from the date of original issue, and form part of a 
larger debt issue, such liabilities may be identified by reference to 
the issue and maturity date, principal amount and interest payable with 
respect to the entire debt issue. Records or schedules described in this 
paragraph that identify liabilities that give rise to branch interest 
must be maintained in the United States by the foreign corporation or an 
agent of the foreign corporation for the entire period commencing with 
the due date (including extensions) of the income tax return for the 
taxable year to which the records or schedules relate and ending with 
the expiration of the period of limitations for assessment of tax for 
such taxable year. A foreign corporation that is subject to this section 
may identify a liability under paragraph (b)(1)(ii) of this section 
whether or not it is actually engaged in the conduct of a trade or 
business in the United States.
    (ii) Notification to recipient. Interest with respect to a liability 
described in paragraph (b)(1)(ii) of this section shall not be treated 
as branch interest unless the foreign corporation paying the interest 
either--
    (A) Makes a return, pursuant to section 6049, with respect to the 
interest payment; or
    (B) Sends a notice to the person who receives such interest in a 
confirmation of the transaction, a statement of account, or a separate 
notice, within two months of the end of the calendar year in which the 
interest was paid, stating that the interest paid with respect to the 
liability is from sources within the United States.
    (iii) Liabilities that do not give rise to branch interest under 
paragraph (b)(1)(ii) of this section. A liability is described in this 
paragraph (b)(3)(iii) (and interest with respect to the liability may 
not be treated as branch interest of a foreign corporation by reason of 
paragraph (b)(1)(ii) of this section) if--
    (A) The liability is directly incurred in the ordinary course of the 
profit-making activities of a trade or business of the foreign 
corporation conducted outside the United States, as, for example, an 
account or note payable arising from the purchase of inventory or 
receipt of services by such trade or business; or
    (B) The liability is secured (during more than half the days during 
the portion of the taxable year in which the interest accrues) 
predominantly by

[[Page 544]]

property that is not a U.S. asset (as defined in Sec.  1.884-1(d)) 
unless such liability is secured by substantially all the property of 
the foreign corporation.
    (4) [Reserved]
    (5) Increase in branch interest where U.S. assets constitute 80 
percent or more of a foreign corporation's assets--(i) General rule. If 
a foreign corporation would have excess interest before application of 
this paragraph (b) (5) and the amount of the foreign corporation's U.S. 
assets as of the close of the taxable year equals or exceeds 80 percent 
of all money and the aggregate E&P basis of all property of the foreign 
corporation on such date, then all interest paid and accrued by the 
foreign corporation during the taxable year that was not treated as 
branch interest before application of this paragraph (b)(5) and that is 
not paid with respect to a liability described in paragraph (b)(3)(iii) 
of this section (relating to liabilities incurred in the ordinary course 
of a foreign business or secured by non-U.S. assets) shall be treated as 
branch interest. However, if application of the preceding sentence would 
cause the amount of the foreign corporation's branch interest to exceed 
the amount permitted by paragraph (b)(6)(i) of this section (relating to 
branch interest in excess of a foreign corporation's interest allocated 
or apportioned to ECI under Sec.  1.882-5) the amount of branch interest 
arising by reason of this paragraph shall be reduced as provided in 
paragraphs (b)(6) (ii) and (iii) of this section, as applicable.
    (ii) Example. The application of this paragraph (b)(5) is 
illustrated by the following example.

    Example. Application of 80 percent test. Foreign corporation A, a 
calendar year taxpayer, has $90 of interest allocated or apportioned to 
ECI under Sec.  1.882-5 for 1993. Before application of this paragraph 
(b)(5), A has $40 of branch interest in 1993. A pays $60 of other 
interest during 1993, none of which is attributable to a liability 
described in paragraph (b)(3)(iii) of this section (relating to 
liabilities incurred in the ordinary course of a foreign business and 
liabilities predominantly secured by foreign assets). As of the close of 
1993, A has an amount of U.S. assets that exceeds 80 percent of the 
money and E&P bases of all A's property. Before application of this 
paragraph (b)(5), A would have $50 of excess interest (i.e., the $90 
interest allocated or apportioned to its ECI under Sec.  1.882-5 less 
$40 of branch interest). Under this paragraph (b)(5), the $60 of 
additional interest paid by A is also treated as branch interest. 
However, to the extent that treating the $60 of additional interest as 
branch interest would create an amount of branch interest that would 
exceed the amount of branch interest permitted under paragraph (b)(6) of 
this section (relating to branch interest that exceeds a foreign 
corporation's interest allocated or apportioned to ECI under Sec.  
1.882-5) the amount of the additional branch interest is reduced under 
paragraph (b)(6)(iii) of this section, which generally allows a foreign 
corporation to specify certain liabilities that do not give rise to 
branch interest or paragraph (b) (6) (ii) of this section, which 
generally specifies liabilities that do not give rise to branch interest 
beginning with the most-recently incurred liability.

    (6) Special rule where branch interest exceeds interest allocated or 
apportioned to ECI of a foreign corporation--(i) General rule. If the 
amount of branch interest that is both paid and accrued by a foreign 
corporation during the taxable year (including interest that the foreign 
corporation elects under paragraph (c)(1) of this section to treat as 
paid during the taxable year) exceeds the amount of interest allocated 
or apportioned to ECI of a foreign corporation under Sec.  1.882-5 for 
the taxable year, then the amount of the foreign corporation's branch 
interest shall be reduced by the amount of such excess as provided in 
paragraphs (b)(6)(ii) and (iii) of this section, as applicable. The 
rules of paragraphs (b)(6)(ii) and (iii) of this section shall also 
apply where the amount of branch interest with respect to liabilities 
identified under paragraph (b)(1)(ii) of this section exceeds the 
maximum amount that may be treated as branch interest under that 
paragraph. This paragraph (b)(6) shall apply whether or not a reduction 
in the amount of branch interest occurs as a result of adjustments made 
during the examination of the foreign corporation's income tax return, 
such as a reduction in the amount of interest allocated or apportioned 
to ECI of the foreign corporation under Sec.  1.882-5.
    (ii) Reduction of branch interest beginning with most-recently 
incurred liability. Except as provided in paragraph (b)(6)(iii) of this 
section (relating to an election to specify liabilities that do not give 
rise to branch interest), the

[[Page 545]]

amount of the excess in paragraph (b)(6)(i) of this section shall first 
reduce branch interest attributable to liabilities described in 
paragraph (b)(1)(ii) of this section (relating to liabilities identified 
as giving rise to branch interest) and then, if such excess has not been 
reduced to zero, branch interest attributable to the group of 
liabilities described in paragraph (b)(1)(i) of this section. The 
reduction of branch interest attributable to each group of liabilities 
(i.e., liabilities described in paragraph (b)(1)(ii) of this section and 
liabilities described in paragraph (b)(1)(i) of this section) shall be 
made beginning with interest attributable to the latest-incurred 
liability and continuing, in reverse chronological order, with branch 
interest attributable to the next-latest incurred liability. The branch 
interest attributable to a liability must be reduced to zero before a 
reduction is made with respect to branch interest attributable to the 
next-latest incurred liability. Where only a portion of the branch 
interest attributable to a liability is reduced by reason of this 
paragraph (b)(6)(ii), the reduction shall be made beginning with the 
last interest payment made with respect to the liability during the 
taxable year and continuing, in reverse chronological order, with the 
next-latest payment until the amount of branch interest has been reduced 
by the amount specified in paragraph (b)(6)(i) of this section. The 
amount of interest that is not treated as branch interest by reason of 
this paragraph (b)(6)(ii) shall not be treated as paid by a domestic 
corporation and thus shall not be subject to tax under section 871(a) or 
881(a).
    (iii) Election to specify liabilities that do not give rise to 
branch interest. For purposes of reducing the amount of branch interest 
under paragraph (b)(6)(i) of this section, a foreign corporation may, 
instead of using the method described in paragraph (b)(6)(ii) of this 
section, elect for any taxable year to specify which liabilities will 
not be treated as giving rise to branch interest or will be treated as 
giving rise only in part to branch interest. Branch interest paid during 
the taxable year with respect to a liability specified under this 
paragraph (b)(6)(iii) must be reduced to zero before a reduction is made 
with respect to branch interest attributable to the next-specified 
liability. If all interest payments with respect to a specified 
liability, when added to all interest payments with respect to other 
liabilities specified under this paragraph (b)(6)(iii), would exceed the 
amount of the reduction under paragraph (b)(6)(i) of this section, then 
only a portion of the branch interest attributable to that specified 
liability shall be reduced under this paragraph (b)(6)(iii), and the 
reduction shall be made beginning with the last interest payment made 
with respect to the liability during the taxable year and continuing, in 
reverse chronological order, with the next-latest payment until the 
amount of branch interest has been reduced by the amount of the 
reduction under paragraph (b)(6)(i) of this section. A foreign 
corporation that elects to have this paragraph (b)(6)(iii) apply shall 
note on its books and records maintained in the United States that the 
liability is not to be treated as giving rise to branch interest, or is 
to be treated as giving rise to branch interest only in part. Such 
notation must be made after the close of the taxable year in which the 
foreign corporation pays the interest and prior to the due date (with 
extensions) of the foreign corporation's income tax return for the 
taxable year. However, if the excess interest in paragraph (b)(6)(i) of 
this section occurs as a result of adjustments made during the 
examination of the foreign corporation's income tax return, the election 
and notation may be made at the time of examination. The amount of 
interest that is not treated as branch interest by reason of this 
paragraph (b)(6)(iii) shall not be treated as paid by a domestic 
corporation and thus shall not be subject to tax under section 871 (a) 
or 881 (a).

    (iv) Examples. The application of this paragraph (b)(6) is 
illustrated by the following examples.

    Example 1. Branch interest exceeds interest apportioned to ECI with 
no election in effect. Foreign corporation A, a calendar year, accrual 
method taxpayer, has interest expense apportioned to ECI under Sec.  
1.882-5 of $230 for 1997. A's branch interest for 1997 is as follows:

[[Page 546]]

    (i) $130 paid to B, a domestic corporation, with respect to a note 
issued on March 10, 1997, and secured by real property located in the 
United States;
    (ii) $60 paid to C, an individual resident of country X who is 
entitled to a 10 percent rate of withholding on interest payments under 
the income tax treaty between the United States and X, with respect to a 
note issued on October 15, 1996, which gives rise to interest subject to 
tax under section 871(a);
    (iii) $80 paid to D, an individual resident of country Y who is 
entitled to a 15 percent rate of withholding on interest payments under 
the income tax treaty between the United States and Y, with respect to a 
note issued on February 15, 1997, which gives rise to interest subject 
to tax under section 871(a); and
    (iv) $70 of portfolio interest (as defined in section 871(h) (2)) 
paid to E, a nonresident alien, with respect to a bond issued on March 
1, 1997.


A's branch interest accrues during 1997 for purposes of calculating the 
amount of A's interest apportioned to ECI under Sec.  1.882-5. A has 
identified under paragraph (b)(1)(ii) of this section the liabilities 
described in paragraphs (ii), (iii) and (iv) of this example. A has not 
made an election under paragraph (b)(6)(iii) of this section to specify 
liabilities that do not give rise to branch interest. The amount of A's 
branch interest in 1997 is limited under paragraph (b)(6)(i) of this 
section to $230, the amount of the interest apportioned to A's ECI for 
1997. The amount of A's branch interest must thus be reduced by $110 
($340-$230) under paragraph (b)(6)(ii) of this section. The reduction is 
first made with respect to interest attributable to liabilities 
described in paragraph (b)(1)(ii) of this section (i.e., liabilities 
identified as giving rise to branch interest) and, within the group of 
liabilities described in paragraph (b)(1)(ii) of this section, is first 
made with respect to the latest-incurred liability. Thus, the $70 of 
interest paid to E with respect to the bond issued on March 1, 1997, and 
$40 of the $80 of interest paid to D with respect to the note issued on 
February 15, 1997, are not treated as branch interest. The interest paid 
to D is no longer subject to tax under section 871(a), and D may claim a 
refund of amounts withheld with respect to the interest payments. There 
is no change in the tax consequences to E because the interest received 
by E was portfolio interest and was not subject to tax when it was 
treated as branch interest.
    Example 2. Effect of election to specify liabilities. Assume the 
same facts as in Example 1 except that A makes an election under 
paragraph (b)(6)(iii) of this section to specify which liabilities are 
not to be treated as giving rise to branch interest. A specifies the 
liability to D, who would be taxable at a rate of 15 percent on interest 
paid with respect to the liability, as a liability that does not give 
rise to branch interest, and D is therefore not subject to tax under 
section 871 (a) and is entitled to a refund of amounts withheld with 
respect to the interest payments. A also specifies the liability to C as 
a liability that gives rise to branch interest only in part. As a 
result, $30 of the $60 of interest paid to C is not treated as branch 
interest, and C is entitled to a refund with respect to the $30 of 
interest that is not treated as branch interest.

    (7) Effect of election under paragraph (c)(1) of this section to 
treat interest as if paid in year of accrual. If a foreign corporation 
accrues an interest expense in a taxable year earlier than the taxable 
year of payment and elects under paragraph (c)(1) of this section to 
compute its excess interest as if the interest expense were branch 
interest paid in the year of accrual, the interest expense shall be 
treated as branch interest that is paid at the close of such year (and 
not in the actual year of payment) for all purposes of this section. 
Such interest shall thus be subject to tax under section 871(a) or 
881(a) and withholding under section 1441 or section 1442, as if paid on 
the last day of the taxable year of accrual. Interest that is treated 
under paragraph (c)(1) of this section as paid in a later year for 
purposes of computing excess interest shall be treated as paid only in 
the actual year of payment for all purposes of this section other than 
paragraphs (a)(2) and (c)(1) of this section (relating to excess 
interest).
    (8) Effect of treaties--(i) Payor's treaty. In the case of a foreign 
corporation's branch interest, relief shall be available under an 
article of an income tax treaty between the United States and the 
foreign corporation's country of residence relating to interest paid by 
the foreign corporation only if, for the taxable year in which the 
branch interest is paid (or if the branch interest is treated as paid in 
an earlier taxable year under paragraph (b)(7) of this section, for the 
earlier taxable year)--
    (A) The foreign corporation meets the requirements of the limitation 
on benefits provision, if any, in the treaty, and either--
    (1) The corporation is a qualified resident (as defined in Sec.  
1.884-5(a)) of that foreign country in such year; or

[[Page 547]]

    (2) The corporation meets the requirements of paragraph (b)(8)(iii) 
of this section in such year; or
    (B) The limitation on benefits provision, or an amendment to that 
provision, entered into force after December 31, 1986.
    (ii) Recipient's treaty. A foreign person (other than a foreign 
corporation) that derives branch interest is entitled to claim benefits 
under provisions of an income tax treaty between the United States and 
its country of residence relating to interest derived by the foreign 
person. A foreign corporation may claim such benefits if it meets, with 
respect to the branch interest, the requirements of the limitation on 
benefits provision, if any, in the treaty and--
    (A) The foreign corporation meets the requirements of paragraphs 
(b)(8)(i)(A) or (B) of this section; and
    (B) In the case of interest paid in a taxable year beginning after 
December 31, 1988, with respect to an obligation with a maturity not 
exceeding one year, each foreign corporation that beneficially owned the 
obligation prior to maturity was a qualified resident (for the period 
specified in paragraph (b)(8)(i) of this section) of a foreign country 
with which the United States has an income tax treaty or met the 
requirements of the limitation on benefits provision in a treaty with 
respect to the interest payment and such provision entered into force 
after December 31, 1986.
    (iii) Presumption that a foreign corporation continues to be a 
qualified resident. For purposes of this paragraph (b)(8), a foreign 
corporation that was a qualified resident for the prior taxable year 
because it fulfills the requirements of Sec.  1.884-5 shall be 
considered a qualified resident with respect to branch interest that is 
paid or received during the current taxable year if--
    (A) In the case of a foreign corporation that met the stock 
ownership and base erosion tests in Sec.  1.884-5(b) and (c) for the 
preceding taxable year, the foreign corporation does not know, or have 
reason to know, that either 50 percent of its stock (by value) is not 
beneficially owned (or treated as beneficially owned by reason of Sec.  
1.884-5(b)(2)) by qualifying shareholders at any time during the portion 
of the taxable year that ends with the date on which the interest is 
paid, or that the base erosion test is not met during the portion of the 
taxable year that ends with the date on which the interest is paid;
    (B) In the case of a foreign corporation that met the requirements 
of Sec.  1.884-5(d) (relating to publicly-traded corporations) for the 
preceding taxable year, the foreign corporation is listed on an 
established securities exchange in the United States or its country of 
residence at all times during the portion of the taxable year that ends 
with the date on which the interest is paid and does not fail the 
requirements of Sec.  1.884-5(d)(4)(iii) (relating to certain closely-
held corporations) at any time during such period; or
    (C) In the case of a foreign corporation that met the requirements 
of Sec.  1.884-5(e) (relating to the active trade or business test) for 
the preceding taxable year, the foreign corporation continues to operate 
(other than in a nominal degree), at all times during the portion of the 
taxable year that ends with the date on which the interest is paid, the 
same business in the U.S. and its country of residence that caused it to 
meet such requirements for the preceding taxable year.
    (iv) Treaties other than income tax treaties. A treaty that is not 
an income tax treaty does not provide any benefits with respect to 
branch interest.
    (v) Effect of income tax treaties on interest paid by a partnership. 
If a foreign corporation is a partner (directly or indirectly) in a 
partnership that is engaged in a trade or business in the United States 
and owns an interest of 10 percent or more (as determined under the 
attribution rules of section 318) in the capital, profits, or losses of 
the partnership at any time during the partner's taxable year, the 
relief that may be claimed under an income tax treaty with respect to 
the foreign corporation distributive share of interest paid or treated 
as paid by the partnership shall not exceed the relief that would be 
available under paragraphs (b)(8) (i) and (ii) of this section if such 
interest were branch interest of the foreign corporation. See paragraph 
(c)(2) of this section for the effect on a

[[Page 548]]

foreign corporation's excess interest of interest paid by a partnership 
of which the foreign corporation is a partner.
    (vi) Examples. The following examples illustrate the application of 
this paragraph (b)(8).

    Example 1. Payor's treaty. The income tax treaty between the United 
States and country X provides that the United States may not impose a 
tax on interest paid by a corporation that is a resident of that country 
(and that is not a domestic corporation) if the recipient of the 
interest is a nonresident alien or a foreign corporation. Corp A is a 
qualified resident of country X and meets the limitation on benefits 
provision in the treaty. A's branch interest is not subject to tax under 
section 871(a) or 881(a) regardless of whether the recipient is entitled 
to benefits under an income tax treaty.
    Example 2. Recipient's treaty and interest received from a 
partnership. A, a foreign corporation, and B, a nonresident alien, are 
partners in a partnership that owns and operates U.S. real estate and 
each has a distributive share of partnership interest deductions equal 
to 50 percent of the interest deductions of the partnership. There is no 
income tax treaty between the United States and the countries of 
residence of A and B. The partnership pays $1,000 of interest to a bank 
that is a resident of a foreign country, Y, and that qualifies under an 
income tax treaty in effect with the United States for a 5 percent rate 
of tax on U.S. source interest paid to a resident of country Y. However, 
the bank is not a qualified resident of country Y and the limitation on 
benefits provision of the treaty has not been amended since December 31, 
1986. The partnership is required to withhold at a rate of 30 percent on 
$500 of the interest paid to the bank (i.e., A's 50 percent distributive 
share of interest paid by the partnership) because the bank cannot, 
under paragraph (b)(8)(iv) of this section, claim greater treaty 
benefits by lending money to the partnership than it could claim, if it 
lent money to A directly and the $500 were branch interest of A.

    (c) Rules relating to excess interest--(1) Election to compute 
excess interest by treating branch interest that is paid and accrued in 
different years as if paid in year of accrual--(i) General rule. If 
branch interest is paid in one or more taxable years before or after the 
year in which the interest accrues, a foreign corporation may elect to 
compute its excess interest as if such branch interest were paid on the 
last day of the taxable year in which it accrues, and not in the taxable 
year in which it is actually paid. The interest expense will thus reduce 
the amount of the foreign corporation's excess interest in the year of 
accrual rather than in the year of actual payment. Except as provided in 
paragraph (c)(1)(ii) of this section, if an election is made for a 
taxable year, this paragraph (c)(1)(i) shall apply to all branch 
interest that is paid or accrued during that year. See paragraph (b)(7) 
of this section for the effect of an election under this paragraph 
(c)(1) on branch interest that accrues in a taxable year after the year 
of payment.
    (ii) Election not to apply in certain cases. An election under this 
paragraph (c)(1) shall not apply to an interest expense that accrued in 
a taxable year beginning before January 1, 1987, and shall not apply to 
an interest expense that was paid in a taxable year beginning before 
such date unless the interest was income from sources within the United 
States. An election under this paragraph (c)(1) shall not apply to 
branch interest that accrues during the taxable year and is paid in an 
earlier taxable year if the branch interest reduced excess interest in 
such earlier year. However, a foreign corporation may amend its income 
tax return for such earlier taxable year so that the branch interest 
does not reduce excess interest in such year.
    (iii) Requirements for election. A foreign corporation that elects 
to apply this paragraph (c)(1) shall attach to its income tax return (or 
to an amended income tax return) a statement that it elects to have the 
provisions of this paragraph (c)(1) apply, or shall provide written 
notice to the Commissioner during an examination that it elects to apply 
this paragraph (c)(1). The election shall be effective for the taxable 
year to which the return relates and for all subsequent taxable years 
unless the Commissioner consents to revocation of the election.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(1).

    Example 1. Interest accrued before paid. Foreign corporation A, a 
calendar year, accrual method taxpayer, has $100 of interest allocated 
or apportioned to ECI under Sec.  1.882-5 for 1997. A has $60 of branch 
interest in 1997 before application of this paragraph (c)(1). A has an 
interest expense of $20 that properly accrues for tax purposes in 1997 
but is not paid until 1998. When the interest is paid in

[[Page 549]]

1998 it will meet the requirements for branch interest under paragraph 
(b)(1) of this section. A makes a timely election under this paragraph 
(c)(1) to treat the accrued interest as if it were paid in 1997. A will 
be treated as having branch interest of $80 for 1997 and excess interest 
of $20 in 1997. The $20 of interest treated as branch interest of A in 
1997 will not again be treated as branch interest in 1998.
    Example 2. Interest paid before accrued. Foreign corporation A, a 
calendar year, accrual method taxpayer, has $60 of branch interest in 
1997. The interest expense does not accrue until 1994 and the amount of 
interest allocated or apportioned to A's ECI under Sec.  1.882-5 is zero 
for 1997 and $60 for 1998. A makes an election under this paragraph 
(c)(1) with respect to 1997. As a result of the election, A's $60 of 
branch interest in 1997 reduces the amount of A's excess interest for 
1994 rather than in 1998.

    (2) Interest paid by a partnership--(i) General rule. Except as 
otherwise provided in paragraphs (c)(2) (i) and (ii) of this section, if 
a foreign corporation is a partner in a partnership that is engaged in 
trade or business in the United States, the amount of the foreign 
corporation's distributive share of interest paid or accrued by the 
partnership shall reduce (but not below zero) the amount of the foreign 
corporation's excess interest for the year to the extent such interest 
is taken into account by the foreign corporation in that year for 
purposes of calculating the interest allocated or apportioned to the ECI 
of the foreign corporation under Sec.  1.882-5. A foreign corporation's 
excess interest shall not be reduced by its distributive share of 
partnership interest that is attributable to a liability described in 
paragraph (b)(3)(iii) of this section (relating to interest on 
liabilities incurred in the ordinary course of a foreign business or 
secured predominantly by assets that are not U.S. assets) or would be 
described in paragraph (b)(3)(iii) of this section if entered on the 
partner's books. See paragraph (b)(8)(v) of this section for the effect 
of income tax treaties on interest paid by a partnership.
    (ii) Special rule for interest that is paid and accrued in different 
years. Paragraph (c)(2)(i) of this section shall not apply to any 
portion of a foreign corporation's distributive share of partnership 
interest that is paid and accrued in different taxable years unless the 
foreign corporation has an election in effect under paragraph (c)(1) of 
this section that is effective with respect to such interest and any tax 
due under section 871(a) or 881(a) with respect to such interest has 
been deducted and withheld at source in the earlier of the taxable year 
of payment or accrual.
    (3) Effect of treaties--(i) General rule. The rate of tax imposed on 
the excess interest of a foreign corporation that is a resident of a 
country with which the United States has an income tax treaty shall not 
exceed the rate provided under such treaty that would apply with respect 
to interest paid by a domestic corporation to that foreign corporation 
if the foreign corporation meets, with respect to the excess interest, 
the requirements of the limitation on benefits provision, if any, in the 
treaty and either--
    (A) The corporation is a qualified resident (as defined in Sec.  
1.884-5(a)) of that foreign country for the taxable year in which the 
excess interest is subject to tax; or
    (B) The limitation on benefits provision, or an amendment to that 
provision, entered into force after December 31, 1986.
    (ii) Provisions relating to interest paid by a foreign corporation. 
Any provision in an income tax treaty that exempts or reduces the rate 
of tax on interest paid by a foreign corporation does not prevent 
imposition of the tax on excess interest or reduce the rate of such tax.
    (4) Example. The application of paragraphs (c)(2) and (3) of this 
section is illustrated by the following example.

    Example. Interest paid by a partnership. Foreign corporation A, a 
calendar year taxpayer, is not a resident of a foreign country with 
which the United States has an income tax treaty. A is engaged in the 
conduct of a trade or business both in the United States and in foreign 
countries, and owns a 50 percent interest in X, a calendar year 
partnership engaged in the conduct of a trade or business in the United 
States. For 1997, all of X's liabilities are of a type described in 
paragraph (b)(1) of this section (relating to liabilities on U.S. books) 
and none are described in paragraph (b)(3)(iii) of this section 
(relating to liabilities that may not give rise to branch interest). A's 
distributive share of interest paid by X in 1997 is $20. For 1997, A has 
$150 of interest allocated or apportioned to its ECI under Sec.  1.882-
5, $120 of which is attributable to branch interest. Thus, the amount

[[Page 550]]

of A's excess interest for 1997, before application of paragraph 
(c)(2)(i) of this section, is $30. Under paragraph (c)(2)(i) of this 
section, A's $30 of excess interest is reduced by $20, representing A's 
share of interest paid by X. Thus, the amount of A's excess interest for 
1997 is reduced to $10. A is subject to a tax of 30 percent on its $10 
of excess interest.

    (d) Stapled entities. A foreign corporation that is treated as a 
domestic corporation by reason of section 269B (relating to stapled 
entities) shall continue to be treated as a foreign corporation for 
purposes of section 884 (f) and this section, notwithstanding section 
269B and the regulations thereunder. Interest paid by such foreign 
corporation shall be treated as paid by a domestic corporation and shall 
be subject to the tax imposed by section 871 (a) or 881 (a), and to 
withholding under section 1441 and 1442, as applicable, to the extent 
such interest is not subject to tax by reason of section 884(f) and this 
section.
    (e) Effective dates--(1) General rule. Except as provided in 
paragraph (e)(2) of this section, this section is effective for taxable 
years beginning October 13, 1992, and for payments of interest described 
in section 884(f)(1)(A) made (or treated as made under paragraph (b)(7) 
of this section) during taxable years of the payor beginning after such 
date. With respect to taxable years beginning before October 13, 1992, 
and after December 31, 1986, a foreign corporation may elect to apply 
this section in lieu of Sec.  1.884-4T of the temporary regulations (as 
contained in the CFR edition revised as of April 1, 1992) as they 
applied to the foreign corporation after issuance of Notice 89-80, 1989-
2 C.B. 394, but only if the foreign corporation has made an election 
under Sec.  1.884-1 (i) to apply Sec.  1.884-1 in lieu of Sec.  1.884-1T 
(as contained in the CFR edition revised as of April 1, 1992) for that 
year, and the statute of limitations for assessment of a deficiency has 
not expired for that taxable year. Once an election has been made, an 
election under this section shall apply to all subsequent taxable years.
    (2) Special rule. Paragraphs (a)(1), (a)(2)(i)(A), (a)(2)(iii), 
(b)(1), (b)(3), (b)(5)(i), (b)(6)(i), (b)(6)(ii), and (c)(2)(i) of this 
section are effective for taxable years beginning on or after June 6, 
1996.
    (f) Transition rules--(1) Election under paragraph (c)(1) of this 
section. If a foreign corporation has made an election described in 
Sec.  1.884-4T(b)(7) (as contained in the CFR edition revised as of 
April 1, 1992) with respect to interest that has accrued and been paid 
in different taxable years, such election shall be effective for 
purposes of paragraph (c)(1) of this section as if the corporation had 
made the election under paragraph (c)(1) of this section of these 
regulations.
    (2) Waiver of notification requirement for non-banks under Notice 
89-80. If a foreign corporation that is not a bank has made an election 
under Notice 89-80 to apply the rules in part 2 of section I of the 
Notice in lieu of the rules in Sec.  1.884-4T(b) (as contained in the 
CFR edition revised as of April 1, 1992) to determine the amount of its 
interest paid and excess interest in taxable years beginning prior to 
1990, the requirement that the foreign corporation satisfy the 
notification requirements described in paragraph (b)(3)(ii) of this 
section is waived with respect to interest paid in taxable years ending 
on or before the date the Notice was issued.
    (3) Waiver of legending requirement for certain debt issued prior to 
January 3, 1989. For purposes of sections 871(h), 881(c), and this 
section, branch interest of a foreign corporation that would be treated 
as portfolio interest under section 871(h) or 881(c) but for the fact 
that it fails to meet the requirements of section 163(f)(2)(B)(ii)(II) 
(relating to the legend requirement), shall nevertheless be treated as 
portfolio interest provided the interest arises with respect to a 
liability incurred by the foreign corporation before January 3, 1989, 
and interest with respect to the liability was treated as branch 
interest in a taxable year beginning before January 1, 1990.

[T.D. 8432, 57 FR 41660, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1992; 57 
FR 60126, Dec. 18, 1992, as amended by T.D. 8657, 61 FR 9341, Mar. 8, 
1996]



Sec.  1.884-5  Qualified resident.

    (a) Definition of qualified resident. A foreign corporation is a 
qualified resident of a foreign country with which the United States has 
an income tax treaty in effect if, for the taxable year,

[[Page 551]]

the foreign corporation is a resident of that country (within the 
meaning of such treaty) and either--
    (1) Meets the requirements of paragraphs (b) and (c) of this section 
(relating to stock ownership and base erosion);
    (2) Meets the requirements of paragraph (d) of this section 
(relating to publicly-traded corporations);
    (3) Meets the requirements of paragraph (e) of this section 
(relating to the conduct of an active trade or business); or
    (4) Obtains a ruling as provided in paragraph (f) of this section 
that it shall be treated as a qualified resident of its country of 
residence.
    (b) Stock ownership requirement--(1) General rule--(i) Ownership by 
qualifying shareholders. A foreign corporation satisfies the stock 
ownership requirement of this paragraph (b) for the taxable year if more 
than 50 percent of its stock (by value) is beneficially owned (or is 
treated as beneficially owned by reason of paragraph (b)(2) of this 
section) during at least half of the number of days in the foreign 
corporation's taxable year by one or more qualifying shareholders. A 
person shall be treated as a qualifying shareholder only if such person 
meets the requirements of paragraph (b)(3) of this section and is 
either--
    (A) An individual who is either a resident of the foreign country of 
which the foreign corporation is a resident or a citizen or resident of 
the United States;
    (B) The government of the country of which the foreign corporation 
is a resident (or a political subdivision or local authority of such 
country), or the United States, a State, the District of Columbia, or a 
political subdivision or local authority of a State;
    (C) A corporation that is a resident of the foreign country of which 
the foreign corporation is a resident and whose stock is primarily and 
regularly traded on an established securities market (within the meaning 
of paragraph (d) of this section) in that country or the United States 
or a domestic corporation whose stock is primarily and regularly traded 
on an established securities market (within the meaning of paragraph (d) 
of this section) in the United States;
    (D) A not-for profit organization described in paragraph (b)(1)(iv) 
of this section that is not a pension fund as defined in paragraph 
(b)(8)(i)(A) of this section and that is organized under the laws of the 
foreign country of which the foreign corporation is a resident or the 
United States; or
    (E) A beneficiary of certain pension funds (as defined in paragraph 
(b)(8)(i)(A) of this section) administered in or by the country in which 
the foreign corporation is a resident to the extent provided in 
paragraph (b)(8) of this section.


Beneficial owners of an association taxable as a corporation shall be 
treated as shareholders of such association for purposes of this 
paragraph (b)(1). If stock of a foreign corporation is owned by a 
corporation that is treated as a qualifying shareholder under paragraph 
(b)(1)(i)(C) of this section, such stock shall not also be treated as 
owned, directly or indirectly, by any qualifying shareholders of such 
corporation for purposes of this paragraph (b). Notwithstanding the 
above, a foreign corporation will not be treated as a qualified resident 
unless it obtains the documentation described in paragraph (b)(3) of 
this section to show that the requirements of this paragraph (b)(1)(i) 
have been met and maintains the documentation as provided in paragraph 
(b)(9) of this section. See also paragraph (b)(1)(iii) of this section, 
which treats certain publicly-traded classes of stock as owned by 
qualifying shareholders.
    (ii) Special rules relating to qualifying shareholders. For purposes 
of applying paragraph (b)(1)(i) of this section--
    (A) Stock owned on any day shall be taken into account only if the 
beneficial owner is a qualifying shareholder on that day or, in the case 
of a corporation or not-for-profit organization that is a qualifying 
shareholder under paragraph (b)(1)(i) (C) or (D) of this section, for a 
one-year period that includes such day; and
    (B) An individual, corporation or not-for-profit organization is a 
resident of a foreign country if it is a resident of

[[Page 552]]

that country for purposes of the income tax treaty between the United 
States and that country.
    (iii) Publicly-traded class of stock treated as owned by qualifying 
shareholders. A class of stock of a foreign corporation shall be treated 
as owned by qualifying shareholders if--
    (A) The class of stock is listed on an established securities market 
in the United States or in the country of residence of the foreign 
corporation seeking qualified resident status; and
    (B) The class of stock is primarily and regularly traded on such 
market (within the meaning of paragraphs (d) (3) and (4) of this 
section, applied as if the class of stock were the sole class of stock 
relied on to meet the requirements of paragraph (d)(4)(i)(A)).


For purposes of this paragraph (b), stock in such class shall not also 
be treated as owned by any qualifying shareholders who own such stock, 
either directly or indirectly.
    (iv) Special rule for not-for-profit organizations. A not-for-profit 
organization is described in paragraph (b)(1)(iv) of this section if it 
meets the following requirements--
    (A) It is a corporation, association taxable as a corporation, 
trust, fund, foundation, league or other entity operated exclusively for 
religious, charitable, educational, or recreational purposes, and it is 
not organized for profit;
    (B) It is generally exempt from tax in its country of organization 
by virtue of its not-for-profit status; and
    (C) Either--
    (1) More than 50 percent of its annual support is expended on behalf 
of persons described in paragraphs (b)(1)(i)(A) through (E) of this 
section or on qualified residents of the country in which the 
organization is organized; or
    (2) More than 50 percent of its annual support is derived from 
persons described in paragraphs (b)(1)(i) (A) through (E) of this 
section or from persons who are qualified residents of the country in 
which the organization is organized.


For purposes of meeting the requirements of paragraph (b)(1)(iv)(C) of 
this section, a not-for-profit organization may rely on the addresses of 
record of its individual beneficiaries and supporters to determine if 
such persons are resident in the country in which the not-for-profit 
organization is organized, provided that the addresses of record are not 
nonresidential addresses such as a post office box or in care of a 
financial intermediary, and the officers, directors or administrators of 
the organization do not know or have reason to know that the individual 
beneficiaries or supporters do not reside at that address.
    (2) Rules for determining constructive ownership--(i) General rules 
for attribution. For purposes of this section, stock owned by a 
corporation, partnership, trust, estate, or mutual insurance company or 
similar entity shall be treated as owned proportionately by its 
shareholders, partners, beneficiaries, grantors or other interest 
holders as provided in paragraph (b)(2)(ii) through (v) of this section. 
The proportionate interest rules of this paragraph (b)(2) shall apply 
successively upward through a chain of ownership, and a person's 
proportionate interest shall be computed for the relevant days or period 
that is taken into account in determining whether a foreign corporation 
is a qualified resident. Except as otherwise provided, stock treated as 
owned by a person by reason of this paragraph (b)(2) shall, for purposes 
of applying this paragraph (b)(2), be treated as actually owned by such 
person.
    (ii) Partnerships. A partner shall be treated as having an interest 
in stock of a foreign corporation owned by a partnership in proportion 
to the least of--
    (A) The partner's percentage distributive share of the partnership's 
dividend income from the stock;
    (B) The partner's percentage distributive share of gain from 
disposition of the stock by the partnership;
    (C) The partner's percentage distributive share of the stock (or 
proceeds from the disposition of the stock) upon liquidation of the 
partnership.


For purposes of this paragraph (b)(2)(ii), however, all qualifying 
shareholders that are partners of a partnership shall be treated as one 
partner. Thus, the percentage distributive

[[Page 553]]

shares of dividend income, gain and liquidation rights of all qualifying 
shareholders that are partners in a partnership are aggregated prior to 
determining the least of the three percentages.
    (iii) Trusts and estates--(A) Beneficiaries. In general, a person 
shall be treated as having an interest in stock of a foreign corporation 
owned by a trust or estate in proportion to the person's actuarial 
interest in the trust or estate, as provided in section 318(a)(2)(B)(i), 
except that an income beneficiary's actuarial interest in the trust will 
be determined as if the trust's only asset were the stock. The interest 
of a remainder beneficiary in stock will be equal to 100 percent minus 
the sum of the percentages of any interest in the stock held by income 
beneficiaries. The ownership of an interest in stock owned by a trust 
shall not be attributed to any beneficiary whose interest cannot be 
determined under the preceding sentence, and any such interest, to the 
extent not attributed by reason of this paragraph (b)(2)(iii)(A), shall 
not be considered owned by a beneficiary unless all potential 
beneficiaries with respect to the stock are qualifying shareholders. In 
addition, a beneficiary's actuarial interest will be treated as zero to 
extent that a grantor is treated as owning the stock under paragraph 
(b)(2)(iii)(B) of this section. A substantially separate and independent 
share of a trust, within the meaning of section 663(c), shall be treated 
as a separate trust for purposes of this paragraph (b)(2)(iii)(A), 
provided that payment of income, accumulated income or corpus of a share 
of one beneficiary (or group of beneficiaries) cannot affect the 
proportionate share of income, accumulated income or corpus of another 
beneficiary (or group of beneficiaries).
    (B) Grantor trusts. A person is treated as the owner of stock of a 
foreign corporation owned by a trust to the extent that the stock is 
included in the portion of the trust that is treated as owned by the 
person under sections 671 to 679 (relating to grantors and others 
treated as substantial owners).
    (iv) Corporations that issue stock. A shareholder of a corporation 
that issues stock shall be treated as owning stock of a foreign 
corporation that is owned by such corporation on any day in a proportion 
that equals the value of the stock owned by such shareholder to the 
value of all stock of such corporation. If there is an agreement, 
express or implied, that a shareholder of a corporation will not receive 
distributions from the earnings of stock owned by the corporation, the 
shareholder will not be treated as owning that stock owned by the 
corporation.
    (v) Mutual insurance companies and similar entities. Stock held by a 
mutual insurance company, mutual savings bank, or similar entity 
(including an association taxable as a corporation that does not issue 
stock interests) shall be considered owned proportionately by the policy 
holders, depositors, or other owners in the same proportion that such 
persons share in the surplus of such entity upon liquidation or 
dissolution.
    (vi) Pension funds. See paragraphs (b)(8) (ii) and (iii) of this 
section for the attribution of stock owned by a pension fund (as defined 
in paragraph (b)(8)(i)(A)) to beneficiaries of the fund.
    (vii) Examples. The rules of paragraph (b)(2)(ii) of this section 
are illustrated by the following examples.

    Example 1. Stock held solely by qualifying shareholders through a 
partnership. A and B, residents of country X, are qualifying 
shareholders, within the meaning of paragraphs (b)(1)(i) (A) through (E) 
of this section, and the sole partners of partnership P. P's only asset 
is the stock of foreign corporation Z, a country X corporation seeking 
qualified resident status under this section. A's distributive share of 
P's income and gain on the disposition of P's assets is 80 percent, but 
A's distributive share of P's assets (or the proceeds therefrom) on P's 
liquidation is 20 percent. B's distributive share of P's income and gain 
is 20 percent and B is entitled to 80 percent of the assets (or proceeds 
therefrom) on P's liquidation. Under the attribution rules of paragraph 
(b)(2)(ii) of this section, A and B will be treated as a single partner 
owning in the aggregate 100 percent of the stock of Z owned by P.
    Example 2. Stock held by both qualifying and non-qualifying 
shareholders through a partnership. Assume the same facts as in Example 
1 except that C, an individual who is not a qualifying shareholder, is 
also a partner in P and that C's distributive share of P's income is 60 
percent. The distributive shares of A and B are the same as in Example 1 
except that A's distributive share of income is 20

[[Page 554]]

percent. Under the attribution rules of paragraph (b)(2)(ii) of this 
section, A and B will be treated as a single partner owning in the 
aggregate 40 percent of the stock of Z owned by P (i.e., the least of A 
and B's aggregate distributive shares of dividend income (40 percent), 
gain (100 percent), and liquidation rights (100 percent) with respect to 
the Z stock).
    Example 3. Stock held through tiered partnerships. Assume the same 
facts as in Example 1, except that P does not own the stock of Z 
directly, but rather is a partner in partnership P1, which owns the 
stock of Z. Assume that P's distributive share of the dividend income, 
gain and liquidation rights with respect to the Z stock held by P1 is 40 
percent. Assume that of the remaining partners of P1 only D is a 
qualifying shareholder. D's distributive share of P1's dividend income 
and gain is 15 percent; D's distributive share of P1's assets on 
liquidation is 25 percent. Under the attribution rules of paragraph 
(b)(2)(ii) of this section, A and B, treated as a single partner, will 
own 40 percent of the Z stock owned by P1 (100 percent X 40 percent) and 
D will be treated as owning 15 percent of the Z stock owned by P1 (the 
least of D's dividend income (15 percent), gain (15 percent), and 
liquidation rights (25 percent) with respect to the Z stock). Thus, 55 
percent of the Z stock owned by P1 is treated as owned by qualifying 
shareholders under paragraph (b)(2)(ii) of this section.

    (3) Required documentation--(i) Ownership statements, certificates 
of residency and intermediary ownership statements. Except as provided 
in paragraphs (b)(3)(ii), (iii) and (iv) and paragraph (b)(8) of this 
section, a person shall only be treated as a qualifying shareholder of a 
foreign corporation if--
    (A) For the relevant period, the person completes an ownership 
statement described in paragraph (b)(4) of this section and, in the case 
of an individual who is not a U.S. citizen or resident, also obtains a 
certificate of residency described in paragraph (b)(5) of this section;
    (B) In the case of a person owning stock in the foreign corporation 
indirectly through one or more intermediaries (including mere legal 
owners or recordholders acting as nominees), each intermediary completes 
an intermediary ownership statement described in paragraph (b)(6) of 
this section; and
    (C) Such ownership statements and certificates of residency are 
received by the foreign corporation on or before the earlier of the date 
it files its income tax return for the taxable year to which the 
statements relate or the due date (including extensions) for filing such 
return or, in the case of a foreign corporation claiming treaty benefits 
under Sec.  1.884-4(b)(8) (i) or (ii) (relating to branch interest) on 
or before the date on which such interest is paid.
    (ii) Substitution of intermediary verification statement for 
ownership statements and certificates of residency. If a qualifying 
shareholder owns stock through an intermediary that is either a domestic 
corporation, a resident of the United States, or a resident (for treaty 
purposes) of a country with which the United States has an income tax 
treaty in effect, the intermediary may provide an intermediary 
verification statement (as described in paragraph (b)(7) of this 
section) in place of any relevant ownership statements and certificates 
of residency from qualifying shareholders, and in place of intermediary 
ownership statements (or, where applicable, intermediary verification 
statements) from all intermediaries standing in the chain of ownership 
between the qualifying shareholders and the intermediary issuing the 
intermediary verification statement. An intermediary verification 
statement generally certifies that the verifying intermediary holds the 
documentation described in the preceding sentence and agrees to make it 
available to the District Director on request. Such intermediary 
verification statements, along with an intermediary ownership statement 
from the verifying intermediary, must be received by the foreign 
corporation on or before the earlier of the date if files its income tax 
return for the taxable year to which the statements relate or the due 
date (including extensions) for filing such return. An indirect owner of 
a foreign corporation is thus treated as a qualifying shareholder of a 
foreign corporation if the foreign corporation receives, on or before 
the time specified above, an intermediary verification statement and an 
intermediary ownership statement from the verifying intermediary and an 
intermediary ownership statement from all intermediaries standing in the 
chain of the verifying intermediary's

[[Page 555]]

ownership of its interest in the foreign corporation.
    (iii) Special rule for registered shareholders of widely-held 
corporations. An ownership statement and a certificate of residency 
shall not be required in the case of an individual who is a shareholder 
of record of a corporation that has at least 250 shareholders if--
    (A) The individual owns less than one percent of the stock (by 
value) (applying the attribution rules of section 318) of the 
corporation at all times during the taxable year;
    (B) The individual's address of record is in the corporation's 
country of residence and is not a nonresidential address such as a post 
office box or in care of a financial intermediary or stock transfer 
agent; and
    (C) The officers and directors of the corporation do not know or 
have reason to know that the individual does not reside at that address.


The rule in this paragraph (b)(3)(iii) may also be applied with respect 
to individual owners of mutual insurance companies, mutual savings banks 
or similar entities, provided that the same conditions set forth in this 
paragraph (b)(3)(iii) are met with respect to such individuals.
    (iv) Special rule for pension funds. See paragraphs (b)(8) (ii) 
through (v) of this section for special documentation rules applicable 
to pension funds (as defined in paragraph (b)(8)(i)(A) of this section).
    (v) Reasonable cause exception. If a foreign corporation does not 
obtain the documentation described in this paragraph (b)(3) or (b)(8) of 
this section in a timely manner but is able to show prior to 
notification of an examination of the return for the taxable year that 
the failure was due to reasonable cause and not willful neglect, the 
foreign corporation may perfect the documentation after the deadlines 
specified in this paragraph (b)(3) or (b)(8) of this section. It may 
make such a showing by providing a written statement to the District 
Director having jurisdiction over the taxpayer's return or the Office of 
the Assistant Commissioner (International), as applicable, setting forth 
the reasons for the failure to obtain the documentation in a timely 
manner and describing the documentation that was received after the 
deadline had passed. Whether a failure to obtain the documentation in a 
timely manner was due to reasonable cause shall be determined by the 
District Director or the Office of the Assistant Commissioner 
(International), as applicable, under all the facts and circumstances.
    (4) Ownership statements from qualifying shareholders--(i) Ownership 
statements from individuals. An ownership statement from an individual 
is a written statement signed by the individual under penalties of 
perjury stating--
    (A) The name, permanent address, and country of residence of the 
individual and, if the individual was not a resident of the country for 
the entire taxable year of the foreign corporation seeking qualified 
resident status, the period during which it was a resident of the 
foreign corporation's country of residence;
    (B) If the individual is a direct beneficial owner of stock in the 
foreign corporation, the name of the corporation, the number of shares 
in each class of stock of the corporation that are so owned, and the 
period of time during the taxable year of the foreign corporation during 
which the individual owned the stock (or, in the case of an association 
taxable as a corporation, the amount and nature of the owner's interest 
in such association);
    (C) If the individual directly owns an interest in a corporation, 
partnership, trust, estate or other intermediary that owns (directly or 
indirectly) stock in the foreign corporation, the name of the 
intermediary, the number and class of shares or amount and nature of the 
interest of the individual in such intermediary (that is relevant for 
purposes of attributing ownership in paragraph (b)(2) of this section), 
and the period of time during the taxable year of the foreign 
corporation during which the individual held such interest; and
    (D) To the extent known by the individual, a description of the 
chain of ownership through which the individual owns stock in the 
foreign corporation, including the name and address of each intermediary 
standing between the intermediary described in paragraph (b)(4)(i)(C) of 
this section and the foreign corporation.

[[Page 556]]

    (ii) Ownership statements from governments. An ownership statement 
from a government that is a qualifying shareholder is a written 
statement signed by either--
    (A) An official of the governmental authority, agency or office that 
has supervisory authority with respect to the government's ownership 
interest who is authorized to sign such a statement on behalf of the 
authority, agency or office; or
    (B) The competent authority of the foreign country (as defined in 
the income tax treaty between the United States and the foreign 
country).


Such statement shall provide the title of the official signing the 
statement and the name and address of the government agency, and shall 
provide the information described in paragraphs (b)(4)(i) (B) through 
(D) of this section (substituting ``government'' for ``individual'') 
with respect to the government's direct or indirect ownership of stock 
in the foreign corporation seeking qualified resident status.
    (iii) Ownership statements from publicly-traded corporations. An 
ownership statement from a corporation that is a qualifying shareholder 
under paragraph (b)(1)(i)(C) of this section is a written statement 
signed by a person authorized to sign a tax return on behalf of the 
corporation under penalties of perjury stating--
    (A) The name, permanent address, and principal place of business of 
the corporation (if different from its permanent address);
    (B) The information described in paragraphs (b)(4)(i) (B) through 
(D) of this section (substituting ``corporation'' for ``individual''); 
and
    (C) That the corporation's stock is primarily and regularly traded 
on an established securities exchange (within the meaning of paragraph 
(d) of this section) in the United States or its country of residence.
    (iv) Ownership statements from not-for-profit organizations. An 
ownership statement from a not-for-profit organization (other than a 
pension fund as defined in paragraph (b)(8)(i)(A) of this section) is a 
written statement signed by a person authorized to sign a tax return on 
behalf of the organization under penalties of perjury stating--
    (A) The name, permanent address, and principal location of the 
activities of the organization (if different from its permanent 
address);
    (B) The information described in paragraphs (b)(4)(i) (B) through 
(D) of this section (substituting ``not-for-profit organization'' for 
``individual'') with respect to the not-for-profit organization's direct 
or indirect ownership of stock in the foreign corporation seeking 
qualified resident status; and
    (C) That the not-for-profit organization satisfies the requirements 
of paragraph (b)(1)(iv) of this section.
    (v) Ownership through a nominee. For purposes of this paragraph 
(b)(4) and paragraph (b)(6) of this section, a person who owns either 
stock in a foreign corporation seeking qualified resident status or an 
interest in an intermediary described in paragraph (b)(4)(i)(C) of this 
section through a nominee shall be treated as owning such stock or 
interest directly and must, therefore, provide the information described 
in paragraphs (b)(4) (i) through (iv) of this section, as applicable. 
Such person must also provide the name and address of the nominee.
    (5) Certificate of residency. A certificate of residency must be 
signed by the relevant authorities (as described below) of the country 
of residence of the individual shareholder and must state that the 
individual is a resident of that country for purposes of its income tax 
laws or, if the authorities do not customarily make such a 
determination, that the individual has filed a tax return claiming 
resident status and subjecting the individual's income to tax on a 
resident basis for the taxable year or period that ends with or within 
the taxable year for which the corporation is seeking qualified resident 
status. In the case of an individual who is not legally required to file 
a tax return in his or her country of residence or in any other country, 
a certificate of residency of a parent or guardian residing at such 
individual's address shall be considered sufficient to meet that 
individual's obligation under this paragraph (b)(5). The relevant 
authorities shall be the competent authority of the foreign country of 
which the foreign corporation is a resident, as defined in the income 
tax

[[Page 557]]

treaty between the foreign country and the United States, or such other 
governmental office of the foreign country (or political subdivision 
thereof) that customarily provides statements of residence. 
Notwithstanding the foregoing, the Commissioner may consult with the 
competent authority of a country regarding the procedures set forth in 
this paragraph (b)(5) and if necessary agree on additional or 
alternative procedures under which these certificates may be issued.
    (6) Intermediary ownership statement. An intermediary ownership 
statement is a written statement signed under penalties of perjury by 
the intermediary (if the intermediary is an individual) or a person that 
would be authorized to sign a tax return on behalf of the intermediary 
(if the intermediary is not an individual) containing the following 
information:
    (i) The name, address, country of residence, and principal place of 
business (in the case of a corporation or partnership) of the 
intermediary and, if the intermediary is a trust or estate, the name and 
permanent address of all trustees or executors (or equivalent under 
foreign law);
    (ii) The information described in paragraphs (b)(4)(i) (B) through 
(D) (substituting ``intermediary making the ownership statement'' for 
``individual'') with respect to the intermediary's direct or indirect 
ownership in the stock in the foreign corporation seeking qualified 
resident status;
    (iii) If the intermediary is a nominee for a qualifying shareholder 
or another intermediary, the name and permanent address of the 
qualifying shareholder, or the name and principal place of business of 
such other intermediary;
    (iv) If the intermediary is not a nominee for a qualifying 
shareholder or another intermediary, the proportionate interest in the 
intermediary of each direct shareholder, partner, beneficiary, grantor, 
or other interest holder (or if the direct holder is a nominee, of its 
beneficial shareholder, partner, beneficiary, grantor, or other interest 
holder) from which the intermediary received an ownership statement and 
the period of time during the taxable year for which the interest in the 
intermediary was owned by such shareholder, partner, beneficiary, 
grantor or other interest holder. For purposes of this paragraph 
(b)(6)(iv), the proportionate interest of a person in an intermediary is 
the percentage interest (by value) held by such person, determined using 
the principles for attributing ownership in paragraph (b)(2) of this 
section. If an intermediary is not required to receive an ownership 
statement from its individual registered shareholders or other interest 
holders by reason of paragraph (b)(3)(iii) of this section, then it must 
provide a list of the names and addresses of such registered 
shareholders or other interest holders and the aggregate proportionate 
interest in the intermediary of such registered shareholders or other 
interest holders.
    (7) Intermediary verification statement. An intermediary 
verification statement that may be substituted for certain documentation 
under paragraph (b)(3)(ii) of this section is a written statement signed 
under penalties of perjury by the intermediary (if the intermediary is 
an individual) or by a person that would be authorized to sign a tax 
return on behalf of the intermediary (if the verifying intermediary is 
not an individual) containing the following information--
    (i) The name, principal place of business, and country of residence 
of the verifying intermediary;
    (ii) A statement that the verifying intermediary has obtained 
either--
    (A) An ownership statement and, if applicable, a certificate of 
residency from a qualifying shareholder with respect to the foreign 
corporation seeking qualified resident status, and an intermediary 
ownership statement from each intermediary standing in the chain of 
ownership between the verifying intermediary and the qualifying 
shareholder; or
    (B) An intermediary verification statement substituting for the 
documentation described in paragraph (b)(7)(ii)(A) and an intermediary 
ownership statement from such intermediary and each intermediary 
standing in the chain of ownership between such intermediary and the 
verifying intermediary;

[[Page 558]]

    (iii) The proportionate interest (as computed using the 
documentation described in paragraph (b)(7)(ii) of this section) in the 
intermediary owned directly or indirectly by qualifying shareholders;
    (iv) An agreement to make available to the Commissioner at such time 
and place as the Commissioner may request the underlying documentation 
described in paragraph (b)(7)(ii) of this section; and
    (v) A specific and valid waiver of any right to bank secrecy or 
other secrecy under the laws of the country in which the verifying 
intermediary is located, with respect to any qualifying shareholder 
ownership statements, certificates of residency, intermediary ownership 
statements or intermediary verification statements that the verifying 
intermediary has obtained pursuant to paragraph (b)(7)(ii) of this 
section.


A foreign corporation may combine, in a single statement, the 
information in an intermediary ownership statement and the information 
in an intermediary verification statement.
    (8) Special rules for pension funds--(i) Definitions--(A) Pension 
fund. For purposes of this section, the term ``pension fund'' shall mean 
a trust, fund, foundation, or other entity that is established 
exclusively for the benefit of employees or former employees of one or 
more employers, the principal purpose of which is to provide retirement, 
disability, and death benefits to beneficiaries of such entity and 
persons designated by such beneficiaries in consideration for prior 
services rendered.
    (B) Beneficiary. For purposes of this section, the term 
``beneficiary'' of a pension fund shall mean any person who has made 
contributions to the pension fund, or on whose behalf contributions have 
been made, and who is currently receiving retirement, disability, or 
death benefits from the pension fund or can reasonably be expected to 
receive such benefits in the future, whether or not the person's right 
to receive benefits from the fund has vested.
    (ii) Government pension funds. An individual who is a beneficiary of 
a pension fund that would be a controlled entity of a foreign sovereign 
within the principles of Sec.  1.892-2T(c)(1) of the regulations 
(relating to pension funds established for the benefit of employees or 
former employees of a foreign government) shall be treated as a 
qualifying shareholder of a foreign corporation in which the pension 
fund owns a direct or indirect interest without having to meet the 
documentation requirements under paragraph (b)(3)(i)(A) of this section, 
if the foreign corporation is resident in the country of the foreign 
sovereign and the trustees, directors, or other administrators of the 
pension fund provide, with the pension fund's intermediary ownership 
statement described in paragraph (b)(6) of this section, a written 
statement that the fund is a controlled entity described in this 
paragraphs (b)(8)(ii). See paragraph (b)(4)(ii) of this section 
regarding an ownership statement from a pension fund that is an integral 
part of a foreign government.
    (iii) Non-government pension funds. For purposes of this section, an 
individual who is a beneficiary of a pension fund not described in 
paragraph (b)(8)(ii) of this section shall be treated as a qualifying 
shareholder of a foreign corporation owned directly or indirectly by 
such pension fund without having to meet the documentation requirements 
under paragraph (b)(3)(i)(A) of this section, if--
    (A) The pension fund is administered in the foreign corporation's 
country of residence and is subject to supervision or regulation by a 
governmental authority (or other authority delegated to perform such 
supervision or regulation by a governmental authority) in such country;
    (B) The pension fund is generally exempt from income taxation in its 
country of administration;
    (C) The pension fund has 100 or more beneficiaries;
    (D) The beneficiary's address, as it appears on the records of the 
fund, is in the foreign corporation's country of residence or the United 
States and is not a nonresidential address, such as a post office box or 
in care of a financial intermediary, and none of the trustees, directors 
or other administrators of the pension fund know, or have reason to 
know, that the beneficiary is not an individual resident of such foreign 
country or the United States;

[[Page 559]]

    (E) In the case of a pension fund that has fewer than 500 
beneficiaries, the beneficiary's employer provides (if the beneficiary 
is currently contributing to the fund) to the trustees, directors or 
other administrators a written statement that the beneficiary is 
currently employed in the country in which the fund is administered or 
is usually employed in such country but is temporarily employed by the 
company outside of the country; and
    (F) The trustees, directors or other administrators of the pension 
fund provide, with the pension fund's intermediary ownership statement 
described in paragraph (b)(6) of this section, a written statement 
signed under penalties of perjury declaring that the pension fund meets 
the requirements in paragraphs (b)(8)(iii) (A), (B), and (C) of this 
section and giving the number of beneficiaries who meet the requirements 
of paragraph (b)(8)(iii)(D) of this section, and, if applicable, 
paragraph (b)(8)(iii)(E) of this section.
    (iv) Computation of beneficial interests in non-government pension 
funds. The number of shares in a foreign corporation that are held 
indirectly by beneficiaries of a pension fund who are qualifying 
shareholders may be computed based on the ratio of the number of such 
beneficiaries to all beneficiaries of the pension fund (rather than on 
the basis of the rules in paragraph (b)(2) of this section) if--
    (A) The pension fund meets the requirements of paragraphs 
(b)(8)(iii) (A), (B), and (C) of this section;
    (B) The trustees, directors or other administrators of the pension 
fund have no knowledge, and no reason to know, that the ratio of the 
pension fund's beneficiaries who are residents of either the country in 
which the pension fund is administered or of the United States to all 
beneficiaries of the pension fund would differ significantly from the 
ratio of the sum of the actuarial interests of such residents in the 
pension fund to the actuarial interests of all beneficiaries in the 
pension fund (or, if the beneficiaries' actuarial interest in the stock 
held directly or indirectly by the pension fund differs from the 
beneficiaries' actuarial interest in the pension fund, the ratio of 
actuarial interests computed by reference to the beneficiaries' 
actuarial interest in the stock);
    (C) Either--
    (1) Any overfunding of the pension fund would be payable, pursuant 
to the governing instrument or the laws of the foreign country in which 
the pension fund is administered, only to, or for the benefit of, one or 
more corporations that are qualified residents of the country in which 
the pension fund is administered, individual beneficiaries of the 
pension fund or their designated beneficiaries, or social or charitable 
causes (the reduction of the obligation of the sponsoring company or 
companies to make future contributions to the pension fund by reason of 
overfunding shall not itself result in such overfunding being deemed to 
be payable to or for the benefit of such company or companies); or
    (2) The foreign country in which the pension fund is administered 
has laws that are designed to prevent overfunding of a pension fund and 
the funding of the pension fund is within the guidelines of such laws; 
or
    (3) The pension fund is maintained to provide benefits to employees 
in a particular industry, profession, or group of industries or 
professions and employees of at least 10 companies (other than companies 
that are owned or controlled, directly or indirectly, by the same 
interests) contribute to the pension fund or receive benefits from the 
pension fund; and
    (D) The trustees, directors or other administrators provide, with 
the pension fund's intermediary ownership statement described in 
paragraph (b)(6) of this section, a written statement signed under 
penalties of perjury certifying that the requirements in paragraphs 
(b)(8)(iv) (A), (B), and either (C)(1), (C)(2) or (C)(3) of this section 
have been met.


The statement described in paragraph (b)(8)(iv) (D) of this section may 
be combined, in a single statement, with the information required in 
paragraph (b)(8)(iv) (F) of this section.
    (v) Time for making determinations. The determinations required to 
be made under this paragraph (b)(8) shall be made using information 
shown on the records of the pension fund for a date on or after the 
beginning of the

[[Page 560]]

foreign corporation's taxable year to which the determination is 
relevant.
    (9) Availability of documents for inspection--(i) Retention of 
documents by the foreign corporation. The documentation described in 
paragraphs (b)(3) and (b)(8) of this section must be retained by the 
foreign corporation until expiration of the period of limitations for 
the taxable year to which the documentation relates and must be made 
available for inspection by the District Director at such time and place 
as the District Director may request.
    (ii) Retention of documents by an intermediary issuing an 
intermediary verification statement. The documentation upon which an 
intermediary relies to issue an intermediary verification statement 
under paragraph (b)(7) of this section must be retained by the 
intermediary for a period of six years from the date of issuance of the 
intermediary verification statement and must be made available for 
inspection by the District Director at such time and place as the 
District Director may request.
    (10) Examples. The application of this paragraph (b) is illustrated 
by the following examples.

    Example 1. Foreign corporation A is a resident of country L, which 
has an income tax treaty in effect with the United States. Foreign 
corporation A has one class of stock issued and outstanding consisting 
of 1,000 shares, which are beneficially owned by the following alien 
individuals, directly or by application of paragraph (b)(2) of this 
section:

------------------------------------------------------------------------
                                                    Shares
                                                    owned,
                                                 directly or
                                                  indirectly
                                                      by
                   Individual                    application  Percentage
                                                      of
                                                  paragraph
                                                  (b)(2) of
                                                     this
                                                   section
------------------------------------------------------------------------
T--resident of the U.S.........................         200           20
U--resident of country L.......................         400           40
V--resident of country M.......................         100           10
W--resident of country L.......................         210           21
X--resident of country N.......................          90            9
                                                ------------------------
    Total......................................       1,000          100
------------------------------------------------------------------------

    (i) T owns his 200 shares directly and is a beneficial owner.
    (ii) U and V own, respectively, an 80 percent and a 20 percent 
actuarial interest in foreign trust FT, (which interest does not differ 
from their respective interests in the stock owned by FT), which 
beneficially owns 100 percent of the stock of a foreign corporation B 
with bearer shares, which beneficially owns 500 shares of foreign 
corporation A. Foreign corporation B is incorporated in a country that 
does not have an income tax treaty with the United States. The foreign 
trust has deposited the bearer shares it owns in B with a bank in a 
foreign country that has an income tax treaty with the United States.
    (iii) W beneficially owns all the shares of foreign corporation C, 
which are registered in the name of individual Z, a nominee, who resides 
in country L; foreign corporation C beneficially owns a 70 percent 
interest in foreign corporation D, which beneficially owns 300 shares of 
A. D's shares are bearer shares that C (not a resident of a country with 
which the United States has an income tax treaty) has deposited with a 
bank in a foreign country that has an income tax treaty with the United 
States.
    (iv) X beneficially owns a 30 percent interest in foreign 
corporation D.
    (v) A is a qualified resident of country L if it obtains the 
applicable documentation described in paragraph (b)(3) of this section 
either with respect to ownership by individuals U and W or with respect 
to ownership by individuals T and U, since either combination of 
qualifying shareholders of foreign corporation A will exceed 50 percent.
    Example 2. Assume the same facts as in Example 1 and assume that 
foreign corporation A chooses to obtain documentation with respect to 
individuals T and U.
    (i) A must obtain, pursuant to paragraph (b)(3)(i) of this section, 
an ownership statement (as described in paragraph (b)(4)(i) of this 
section) signed by T. T is not required to furnish a certificate of 
residency because T is a U.S. resident.
    (ii) U must provide foreign trust FT with an ownership statement and 
certificate of residency, as described in paragraphs (b)(4) and (b)(5) 
of this section. The trustees of FT must provide the depository bank 
holding foreign corporation B's bearer shares with an intermediary 
ownership statement concerning its beneficial ownership of B's shares 
and must attach to it the documentation provided by U. The depository 
bank must provide B with an intermediary ownership statement regarding 
its holding of B shares on behalf of FT and has the choice of 
attaching--
    (A) The documentation from U and the intermediary ownership 
statement from FT; or
    (B) An intermediary verification statement described in paragraph 
(b)(7) of this section, in which case foreign corporation B would not be 
provided with U's individual documentation or FT's intermediary 
ownership statement, both of which are retained by the depository bank.

[[Page 561]]

    (iii) In either case, B must then provide foreign corporation A with 
an intermediary ownership statement regarding its direct beneficial 
ownership of shares in A and, as the case may be, either--
    (A) U's documentation and the intermediary ownership statements by 
FT and the depository bank; or
    (B) The depository bank's intermediary ownership and verification 
statements.
    (iv) Thus, with respect to U, A must obtain under paragraph 
(b)(3)(i) of this section the individual documentation regarding U and 
an intermediary ownership statement from each intermediary standing in 
the chain of U's indirect beneficial ownership of shares in A, i.e., 
from FT, the depository bank and B. In the alternative, A must obtain 
under paragraph (b)(3)(ii) of this section an intermediary verification 
statement issued by the depository bank and an intermediary ownership 
statement from the bank and from B, which, in this example, are the only 
intermediaries standing in the chain of ownership of the verifying 
intermediary (i.e., the depository bank).
    Example 3. Assume the same facts as in Example 1. In addition, 
assume that foreign corporation A chooses to obtain documentation with 
respect to individuals U and W. With respect to U, A must obtain the 
same documentation that is described in Example 2. With respect to W, A 
must obtain, under paragraph (b)(3)(i) of this section, individual 
documentation regarding W and an intermediary ownership statement from 
each intermediary standing in the chain of W's indirect beneficial 
ownership of shares in A, i.e., from individual Z, foreign corporation 
C, the depository bank in the foreign treaty country, and foreign 
corporation D. In the alternative, A must obtain, under paragraph 
(b)(3)(ii) of this section, either--
    (i) An intermediary verification statement by the depository bank in 
the foreign treaty country and an intermediary ownership statement from 
the bank and from D; or
    (ii) An intermediary verification statement from Z and an 
intermediary ownership statement from Z and from each intermediary 
standing in the chain of ownership of shares in foreign corporation A, 
i.e., from C, the depository bank in the foreign treaty country and D. C 
may not issue an intermediary verification statement because it is not a 
resident of a country with which the United States has an income tax 
treaty.

    (c) Base erosion. A foreign corporation satisfies the requirement 
relating to base erosion for a taxable year if it establishes that less 
than 50 percent of its income for the taxable year is used (directly or 
indirectly) to make deductible payments in the current taxable year to 
persons who are not residents (or, in the case of foreign corporations, 
qualified residents) of the foreign country of which the foreign 
corporation is a resident and who are not citizens or residents (or, in 
the case of domestic corporations, qualified residents) of the United 
States. Whether a domestic corporation is a qualified resident of the 
United States shall be determined under the principles of this section. 
For purposes of this paragraph (c), the term ``deductible payments'' 
includes payments that would be ordinarily deductible under U.S. income 
tax principles without regard to other provisions of the Code that may 
require the capitalization of the expense, or disallow or defer the 
deduction. Such payments include, for example, interest, rents, 
royalties and reinsurance premiums. For purposes of this paragraph (c), 
the income of a foreign corporation means the corporation's gross income 
for the taxable year (or, if the foreign corporation has no gross income 
for the taxable year, the average of its gross income for the three 
previous taxable years) under U.S. tax principles, but not excluding 
items of income otherwise excluded from gross income under U.S. tax 
principles.
    (d) Publicly-traded corporations--(1) General rule. A foreign 
corporation that is a resident of a foreign country shall be treated as 
a qualified resident of that country for any taxable year in which--
    (i) Its stock is primarily and regularly traded (as defined in 
paragraphs (d) (3) and (4) of this section) on one or more established 
securities markets (as defined in paragraph (d)(2) of this section) in 
that country, or in the United States, or both; or
    (ii) At least 90 percent of the total combined voting power of all 
classes of stock of such foreign corporation entitled to vote and at 
least 90 percent of the total value of the stock of such foreign 
corporation is owned, directly or by application of paragraph (b)(2) of 
this section, by a foreign corporation that is a resident of the same 
foreign country or a domestic corporation and the stock of such parent 
corporation is primarily and regularly traded on an established 
securities market in that foreign country or in the United States, or 
both.

[[Page 562]]

    (2) Established securities market--(i) General rule. For purposes of 
section 884, the term ``established securities market'' means, for any 
taxable year--
    (A) A foreign securities exchange that is officially recognized, 
sanctioned, or supervised by a governmental authority of the country in 
which the market is located, is the principal exchange in that country, 
and has an annual value of shares traded on the exchange exceeding $1 
billion during each of the three calendar years immediately preceding 
the beginning of the taxable year;
    (B) A national securities exchange that is registered under section 
6 of the Securities Act of 1934 (15 U.S.C. 78f); and
    (C) A domestic over-the-counter market (as defined in paragraph 
(d)(2)(iv) of this section).
    (ii) Exchanges with multiple tiers. If a principal exchange in a 
foreign country has more than one tier or market level on which stock 
may be separately listed or traded, each such tier shall be treated as a 
separate exchange.
    (iii) Computation of dollar value of stock traded. For purposes of 
paragraph (d)(2)(i)(A) of this section, the value in U.S. dollars of 
shares traded during a calendar year shall be determined on the basis of 
the dollar value of such shares traded as reported by the International 
Federation of Stock Exchanges, located in Paris, or, if not so reported, 
then by converting into U.S. dollars the aggregate value in local 
currency of the shares traded using an exchange rate equal to the 
average of the spot rates on the last day of each month of the calendar 
year.
    (iv) Definition of over-the-counter market. An over-the-counter 
market is any market reflected by the existence of an interdealer 
quotation system. An interdealer quotation system is any system of 
general circulation to brokers and dealers that regularly disseminates 
quotations of stocks and securities by identified brokers or dealers, 
other than by quotation sheets that are prepared and distributed by a 
broker or dealer in the regular course of business and that contain only 
quotations of such broker or dealer.
    (v) Discretion to determine that an exchange qualifies as an 
established securities market. The Commissioner may, in his sole 
discretion, determine in a published document that a securities exchange 
that does not meet the requirements of paragraph (d)(2)(i)(A) of this 
section qualifies as an established securities market. Such a 
determination will be made only if it is established that--
    (A) The exchange, in substance, has the attributes of an established 
securities market (including adequate trading volume, and comparable 
listing and financial disclosure requirements);
    (B) The rules of the exchange ensure active trading of listed 
stocks; and
    (C) The exchange is a member of the International Federation of 
Stock Exchanges.
    (vi) Discretion to determine that an exchange does not qualify as an 
established securities market. The Commissioner may, in his sole 
discretion, determine in a published document that a securities exchange 
that meets the requirements of paragraph (d)(2)(i) of this section does 
not qualify as an established securities market. Such determination 
shall be made if, in the view of the Commissioner--
    (A) The exchange does not have adequate listing, financial 
disclosure, or trading requirements (or does not adequately enforce such 
requirements); or
    (B) There is not clear and convincing evidence that the exchange 
ensures the active trading of listed stocks.
    (3) Primarily traded. For purposes of this section, stock of a 
corporation is ``primarily traded'' on one or more established 
securities markets in the corporation's country of residence or in the 
United States in any taxable year if, with respect to each class 
described in paragraph (d)(4)(l)(i)(A) of this section (relating to 
classes of stock relied on to meet the regularly traded test)--
    (i) The number of shares in each class that are traded during the 
taxable year on all established securities markets in the corporation's 
country of residence or in the United States during the taxable year 
exceeds
    (ii) The number of shares in each such class that are traded during 
that year on established securities markets in any other single foreign 
country.
    (4) Regularly traded--(i) General rule. For purposes of this 
section, stock of a

[[Page 563]]

corporation is ``regularly traded'' on one or more established 
securities markets in the foreign corporation's country of residence or 
in the United States for the taxable year if--
    (A) One or more classes of stock of the corporation that, in the 
aggregate, represent 80 percent or more of the total combined voting 
power of all classes of stock of such corporation entitled to vote and 
of the total value of the stock of such corporation are listed on such 
market or markets during the taxable year;
    (B) With respect to each class relied on to meet the 80 percent 
requirement of paragraph (d)(4)(i)(A) of this section--
    (1) Trades in each such class are effected, other than in de minimis 
quantities, on such market or markets on at least 60 days during the 
taxable year (or \1/6\ of the number of days in a short taxable year); 
and
    (2) The aggregate number of shares in each such class that is traded 
on such market or markets during the taxable year is at least 10 percent 
of the average number of shares outstanding in that class during the 
taxable year (or, in the case of a short taxable year, a percentage that 
equals at least 10 percent of the number of days in the short taxable 
year divided by 365).


If stock of a foreign corporation fails the 80 percent requirement of 
paragraph (d)(4)(i)(A) of this section, but a class of such stock meets 
the trading requirements of paragraph (d)(4)(i)(B) of this section, such 
class of stock may be taken into account under paragraph (b)(1)(iii) of 
this section as owned by qualifying shareholders for purposes of meeting 
the ownership test of paragraph (b)(1) of this section.
    (ii) Classes of stock traded on a domestic established securities 
market treated as meeting trading requirements. A class of stock that is 
traded during the taxable year on an established securities market 
located in the United States shall be treated as meeting the trading 
requirements of paragraph (d)(4)(i)(B) of this section if the stock is 
regularly quoted by brokers or dealers making a market in the stock. A 
broker or dealer makes a market in a stock only if the broker or dealer 
holds himself out to buy or sell the stock at the quoted price.
    (iii) Closely-held classes of stock not treated as meeting trading 
requirement--(A) General rule. A class of stock shall not be treated as 
meeting the trading requirements of paragraph (d)(4)(i)(B) of this 
section (or the requirements of paragraph (d)(4)(ii) of this section) 
for a taxable year if, at any time during the taxable year, one or more 
persons who are not qualifying shareholders (as defined in paragraph 
(b)(1) of this section) and who each beneficially own 5 percent or more 
of the value of the outstanding shares of the class of stock own, in the 
aggregate, 50 percent or more of the outstanding shares of the class of 
stock for more than 30 days during the taxable year. For purposes of the 
preceding sentence, shares shall not be treated as owned by a qualifying 
shareholder unless such shareholder provides to the foreign corporation, 
by the time prescribed in paragraph (b)(3) of this section, the 
documentation described in paragraph (b)(3) of this section necessary to 
establish that it is a qualifying shareholder. For purposes of this 
paragraph (d)(4)(iii)(A), shares of stock owned by a pension fund, as 
defined in paragraph (b)(8)(i)(A) of this section, shall be treated as 
beneficially owned by the beneficiaries of such fund, as defined in 
paragraph (b)(8)(i)(B) of this section.
    (B) Treatment of related persons. Persons related within the meaning 
of section 267(b) shall be treated as one person for purposes of this 
paragraph (d)(4)(iii). 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). Further, in determining 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) Anti-abuse rule. Trades between persons described in section 
267(b) (as modified in paragraph (d)(4)(iii)(B) of

[[Page 564]]

this section) and trades conducted in order to meet the requirements of 
paragraph (d)(4)(i)(B) of this section shall be disregarded. A class of 
stock shall not be treated as meeting the trading requirements of 
paragraph (d)(4)(i)(B) of this section if there is a pattern of trades 
conducted to meet the requirements of that paragraph. For example, 
trades between two persons that occur several times during the taxable 
year my be treated as an arrangement or a pattern of trades conducted to 
meet the trading requirements of paragraph (d)(4)(i)(B) of this section.
    (5) Burden of proof for publicly-traded corporations. A foreign 
corporation that relies on this paragraph (d) to establish that it is a 
qualified resident of a country with which the United States has an 
income tax treaty shall have the burden of proving all the facts 
necessary for the corporation to be treated as a qualified resident, 
except that with respect to paragraphs (d)(4) (iii) and (iv) of this 
section, a foreign corporation, with either registered or bearer shares, 
will meet the burden of proof if it has no reason to know and no actual 
knowledge of facts that would cause the corporation's stock not to be 
treated as regularly traded under such paragraphs. A foreign corporation 
that has shareholders of record must also maintain a list of such 
shareholders and, on request, make available to the District Director 
such list and any other relevant information known to the foreign 
corporation.
    (e) Active trade or business--(1) General rule. A foreign 
corporation that is a resident of a foreign country shall be treated as 
a qualified resident of that country with respect to any U.S. trade or 
business if, during the taxable year--
    (i) It is engaged in the active conduct of a trade or business (as 
defined in paragraph (e)(2) of this section) in its country of 
residence;
    (ii) It has a substantial presence (within the meaning of paragraph 
(e)(3) of this section) in its country of residence; and
    (iii) Either--
    (A) Such U.S. trade or business is an integral part (as defined in 
paragraph (e)(4) of this section) of an active trade or business 
conducted by the foreign corporation in its country of residence; or
    (B) In the case of interest received by the foreign corporation for 
which a treaty exemption or rate reduction is claimed pursuant to Sec.  
1.884-4(b)(8)(ii), the interest is derived in connection with, or is 
incidental to, a trade or business described in paragraph (e)(1)(i) of 
this section.


A foreign corporation may determine whether it is a qualified resident 
under this paragraph (e) by applying the rules of this paragraph (e) to 
the entire affiliated group (as defined in section 1504 (a) without 
regard to section 1504(b) (2) or (3)) of which the foreign corporation 
is a member rather than to the foreign corporation separately. If a 
foreign corporation chooses to apply the rules of this paragraph (e) to 
its entire affiliated group as provided in the preceding sentence, then 
it must apply such rules consistently to all of its U.S. trades or 
businesses conducted during the taxable year.
    (2) Active conduct of a trade or business. A foreign corporation is 
engaged in the active conduct of a trade or business only if either--
    (i) It is engaged in the active conduct of a trade or business 
within the meaning of section 367(a)(3) and the regulations thereunder; 
or
    (ii) It qualifies as a banking or financing institution under the 
laws of the foreign country of which it is a resident, it is licensed to 
do business with residents of its country of residence, and it is 
engaged in the active conduct of a banking, financing, or similar 
business within the meaning of Sec.  1.864-4(c)(5)(i) in its country of 
residence.


A foreign corporation that is an insurance company within the meaning of 
Sec.  1.801-3 (a) or (b) is engaged in the active conduct of a trade or 
business only if it is predominantly engaged in the active conduct of an 
insurance business within the meaning of section 952(c)(1)(B)(v) and the 
regulations thereunder.
    (3) Substantial presence test--(i) General rule. Except as provided 
in paragraph (e)(3)(ii) of this section, a foreign

[[Page 565]]

corporation that is engaged in the active conduct of a trade or business 
in its country of residence has a substantial presence in that country 
if, for the taxable year, the average of the following three ratios 
exceeds 25 percent and each ratio is at least equal to 20 percent--
    (A) The ratio of the value of the assets of the foreign corporation 
used or held for use in the active conduct of a trade or business in its 
country of residence at the close of the taxable year to the value of 
all assets of the foreign corporation at the close of the taxable year;
    (B) The ratio of gross income from the active conduct of the foreign 
corporation's trade or business in its country of residence that is 
derived from sources within such country for the taxable year to the 
worldwide gross income of the foreign corporation for the taxable year; 
and
    (C) The ratio of the payroll expenses in the foreign corporation's 
country of residence for the taxable year to the foreign corporation's 
worldwide payroll expenses for the taxable year.
    (ii) Special rules--(A) Asset ratio. For purposes of paragraph 
(e)(3)(i)(A) of this section, the value of an asset shall be determined 
using the method used by the taxpayer in keeping its books for purposes 
of financial reporting in its country of residence. An asset shall be 
treated as used or held for use in a foreign corporation's trade or 
business if it meets the requirements of Sec.  1.367(a)-2(d)(5). Stock 
held by a foreign corporation shall not be treated as an asset of the 
foreign corporation for purposes of paragraph (e)(3)i)(A) of this 
section if the foreign corporation owns 10 percent or more of the total 
combined voting power of all classes of stock of such corporation 
entitled to vote. The rules of Sec.  1.954-2T(b)(3) (other than Sec.  
1.954-2T(b)(3)(x)) shall apply to determine the location of assets used 
or held for use in a trade or business. Loans originated or acquired in 
the course of the normal customer loan activities of a banking, 
financing or similar institution, and securities and derivative 
financial instruments held by dealers, traders and insurance companies 
for use in a trade or business shall be treated as located in the 
country in which an office or other fixed place of business is primarily 
responsible for the acquisition of the asset and the realization of 
income, gain or loss with respect to the asset.
    (B) Gross income ratio--(1) General rule. For purposes of paragraph 
(e)(3)(i)(B) of this section, the term ``gross income'' means the gross 
income of a foreign corporation for purposes of financial reporting in 
its country of residence. Gross income shall not include, however, 
dividends, interest, rent, or royalties unless such corporation derives 
such dividends, interest, rents, or royalties in the active conduct of 
its trade or business. Gross income shall also not include gain from the 
disposition of stock if the foreign corporation owns 10 percent or more 
of the total combined voting power of all classes of stock of such 
corporation entitled to vote. Except as provided in this paragraph 
(e)(3)(ii)(B), the principles of sections 861 through 865 shall apply to 
determine the amount of gross income of a foreign corporation derived 
within its country of residence.
    (2) Banks, dealers and traders. Dividend income and gain from the 
sale of securities, or from entering into or disposing of derivative 
financial instruments by dealers and traders in such securities or 
derivative financial instruments shall be treated as derived within the 
country where the assets are located under paragraph (e)(3)(ii)(A) of 
this section. Other income, including interest and fees, earned in the 
active conduct of a banking, financing or similar business shall be 
treated as derived within the country where the payor of such interest 
or other income resides. For purposes of the preceding sentence, if a 
branch or similar establishment outside the country in which the payor 
resides makes a payment of interest or other income, such amounts shall 
be treated as derived within the country in which the branch or similar 
establishment is located.
    (3) Insurance companies. The gross income of a foreign insurance 
company shall include only gross premiums received by the country.
    (4) Other corporations. Gross income from the performance of 
services, including transportation services, shall

[[Page 566]]

be treated as derived within the country of residence of the person for 
whom the services are performed. Gross income from the sale of property 
by a foreign corporation shall be treated as derived within the country 
in which the purchaser resides.
    (5) Anti-abuse rule. The Commissioner may disregard the source of 
income from a transaction determined under this paragraph (e)(3)(ii)(B) 
if it is determined that one of the principal purposes of the 
transaction was to increase the source of income derived within the 
country of residence of the foreign corporation for purposes of this 
section.
    (C) Payroll ratio. For purposes of paragraph (e)(3)(i)(C) of this 
section, the payroll expenses of a foreign corporation shall include 
expenses for ``leased employees'' (within the meaning of section 
414(n)(2) but without regard to subdivision (B) of that section) and 
commission expenses paid to employees and agents for services performed 
for or on behalf of the corporation. Payroll expense for an employee, 
agent or a ``leased employee'' shall be treated as incurred where the 
employee, agent or ``leased employee'' performs services on behalf of 
the corporation.
    (iii) Exception to gross income test for foreign corporations 
engaged in certain trades or businesses. In determining whether a 
foreign corporation engaged primarily in selling tangible property or in 
manufacturing, producing, growing, or extracting tangible property has a 
substantial presence in its country of residence for purposes of 
paragraph (e)(3)(i) of this section, the foreign corporation may apply 
the ratio provided in this paragraph (e)(3)(iii) instead of the ratio 
described in paragraph (e)(3)(i)(B) of this section (relating to the 
ratio of gross income derived from its country of residence). This ratio 
shall be the ratio of the direct material costs of the foreign 
corporation with respect to tangible property manufactured, produced, 
grown, or extracted in the foreign corporation's country of residence to 
the total direct material costs of the foreign corporation.
    (4) Integral part of an active trade or business in a foreign 
corporation's country of residence--(i) In general. A U.S. trade or 
business of a foreign corporation is an integral part of an active trade 
or business conducted by a foreign corporation in its country of 
residence if the active trade or business conducted by the foreign 
corporation in both its country of residence and in the United States 
comprise, in principal part, complementary and mutually interdependent 
steps in the United States and its country of residence in the 
production and sale or lease of goods or in the provision of services. 
Subject to the presumption and de minimis rule in paragraphs (e)(4) 
(iii) and (iv) of this section, if a U.S. trade or business of a foreign 
corporation sells goods that are not, in principal part, manufactured, 
produced, grown, or extracted by the foreign corporation in its country 
of residence, such business shall not be treated as an integral part of 
an active trade or business conducted in the foreign corporation's 
country of residence unless the foreign corporation takes physical 
possession of the goods in a warehouse or other storage facility that is 
located in its country of residence and in which goods of such type are 
normally stored prior to sale to customers in such country.
    (ii) Presumption for banks. A U.S. trade or business of a foreign 
corporation that is described in Sec.  1.884-4(a)(2)(iii) shall be 
presumed to be an integral part of an active banking business conducted 
by the foreign corporation in its country of residence provided that a 
substantial part of the business of the foreign corporation in both its 
country of residence and the United States consists of receiving 
deposits and making loans and discounts. This paragraph shall be 
effective for taxable years beginning on or after June 6, 1996.
    (iii) Presumption if business principally conducted in country of 
residence. A U.S. trade or business of a foreign corporation shall be 
treated as an integral part of an active trade or business of a foreign 
corporation in its country or residence with respect to the sale or 
lease of property (or the performance of services) if at least 50 
percent of the foreign corporation's worldwide gross income from the 
sale or lease of property of

[[Page 567]]

the type sold in the United States (or from the performance of services 
of the type performed in the United States) is derived from the sale or 
lease of such property for consumption, use, or disposition in the 
foreign corporation's country of residence (or from the performance of 
such services in the foreign corporation's country of residence). In 
determining whether property or services are of the same type, a foreign 
corporation shall follow recognized industry or trade usage or the 
three-digit major groups (or any narrower classification) of the 
Standard Industrial Classification as prepared by the Statistical Policy 
Division of the Office of Management and Budget, Executive Office of the 
President. The determination of whether income is of the same kind must 
be made in a consistent manner from year to year.
    (iv) De minimis rule. If a foreign corporation is engaged in more 
than one U.S. trade or business and if at least 80 percent of the sum of 
the ECEP from the current year and the preceding two years is 
attributable to one or more trades or businesses that meet the integral 
part test of this paragraph (e)(4), all of the U.S. trades or businesses 
of the foreign corporation shall be treated as an integral part of an 
active or business conducted by the foreign corporation. If a foreign 
corporation has more than one U.S. trade or business and does not meet 
the requirements of the preceding sentence but otherwise meets the 
requirements of this paragraph (e)(4) with regard to one or more trade 
or business, see Sec.  1.884-1(g)(1) to determine the extent to which 
treaty benefits apply to such corporation.
    (f) Qualified resident ruling--(1) Basis for ruling. In his or her 
sole discretion, the Commissioner may rule that a foreign corporation is 
a qualified resident of its country or residence if the Commissioner 
determines that individuals who are not residents of the foreign country 
of which the foreign corporation is a resident do not use the treaty 
between that country and the United States in a manner inconsistent with 
the purposes of section 884. The purposes of section 884 include, but 
are not limited to, the prevention of treaty shopping by an individual 
with respect to any article of an income tax treaty between the country 
of residence of the foreign corporation and the United States.
    (2) Factors. In order to make this determination, the Commissioner 
may take into account the following factors, including, but not limited 
to:
    (i) The business reasons for establishing and maintaining the 
foreign corporation in its country of residence;
    (ii) The date of incorporation of the foreign corporation in 
relation to the date that an income tax treaty between the United States 
and the foreign corporation's country of residence entered into force;
    (iii) The continuity of the historical business and ownership of the 
foreign corporation;
    (iv) The extent to which the foreign corporation meets the 
requirements of one or more of the tests described in paragraphs (b) 
through (e) of this section;
    (v) The extent to which the U.S. trade or business is dependent on 
capital, assets, or personnel of the foreign trade or business;
    (vi) The extent to which the foreign corporation receives special 
tax benefits in its country of residence;
    (vii) Whether the foreign corporation is a member of an affiliated 
group (as defined in section 1504(a) without regard to section 1504(b) 
(2) or (3)), that has no members resident outside the country of 
residence of the foreign corporation; and
    (viii) The extent to which the foreign corporation would be entitled 
to comparable treaty benefits with respect to all articles of an income 
tax treaty that would apply to that corporation if it had been 
incorporated in the country or countries of residence of the majority of 
its shareholders. For purposes of the preceding sentence, shareholders 
taken into account shall generally be limited to persons described in 
paragraph (b)(1)(i) of this section but for the fact that they are not 
residents of the foreign corporation's country of residence.
    (3) Procedural requirements. A request for a ruling under this 
paragraph (f) must be submitted on or before the due date (including 
extensions) of the foreign corporation's income tax return

[[Page 568]]

for the taxable year for which the ruling is requested. A foreign 
corporation receiving a ruling will be treated as a qualified resident 
of its country of residence for the taxable year for which the ruling is 
requested and for the succeeding two taxable years. If there is a 
material change in any fact that formed the basis of the ruling, such as 
the ownership or the nature of the trade or business of the foreign 
corporation, the foreign corporation must notify the Secretary within 90 
days of such change and submit a new private letter ruling request. The 
Commissioner will then rule whether the change affects the foreign 
corporation's status as a qualified resident, and such ruling will be 
valid for the taxable year in which the material change occurred and the 
two succeeding taxable years, subject to the requirement in the 
preceding sentence to notify the Commissioner of a material change.
    (g) Effective dates. Except as provided in paragraph (e)(4)(ii) of 
this section, this section is effective for taxable years beginning on 
or after October 13, 1992. With respect to a taxable year beginning 
before October 13, 1992, and after December 31, 1986, a foreign 
corporation may elect to apply this section in lieu of the temporary 
regulations under 1.884-5T (as contained in the CFR edition revised as 
of April 1, 1992), but only if the statute of limitations for assessment 
of a deficiency has not expired for that taxable year. Once an election 
has been made, an election shall apply to all subsequent taxable years.
    (h) Transition rule. If a foreign corporation elects to apply this 
section in lieu of Sec.  1.884-5T (as contained in the CFR edition 
revised as of April 1, 1992) as provided in paragraph (g) of this 
section, and the application of paragraph (b) of this section results in 
additional documentation requirements in order for the foreign 
corporation to be treated as a qualified resident, the foreign 
corporation must obtain the documentation required under that paragraph 
on or before March 11, 1993.

[T.D. 8432, 57 FR 41666, Sept. 11, 1992; 57 FR 49117, Oct. 29, 1992; 57 
FR 60126, Dec. 18, 1992, as amended by T.D. 8657, 61 FR 9343, Mar. 8, 
1996; 61 FR 14248, Apr. 1, 1996; T.D. 9803, 81 FR 91030, Dec. 16, 2016]

                        miscellaneous provisions



Sec.  1.891  Statutory provisions; doubling of rates of tax on citizens 
and corporations of certain foreign countries.

    Sec. 891. Doubling of rates of tax on citizens and corporations of 
certain foreign countries. Whenever the President finds that, under the 
laws of any foreign country, citizens or corporations of the United 
States are being subjected to discriminatory or extraterritorial taxes, 
the President shall so proclaim and the rates of tax imposed by sections 
1, 3, 11, 802, 821, 831, 852, 871, and 881 shall, for the taxable year 
during which such proclamation is made and for each taxable year 
thereafter, be doubled in the case of each citizen and corporation of 
such foreign country; but the tax at such doubled rate shall be 
considered as imposed by such sections as the case may be. In no case 
shall this section operate to increase the taxes imposed by such 
sections (computed without regard to this section) to an amount in 
excess of 80 percent of the taxable income of the taxpayer (computed 
without regard to the deductions allowable under section 151 and under 
part VIII of subchapter B). Whenever the President finds that the laws 
of any foreign country with respect to which the President has made a 
proclamation under the preceding provisions of this section have been 
modified so that discriminatory and extraterritorial taxes applicable to 
citizens and corporations of the United States have been removed, he 
shall so proclaim, and the provisions of this section providing for 
doubled rates of tax shall not apply to any citizen or corporation of 
such foreign country with respect to any taxable year beginning after 
such proclamation is made.

(Sec. 891 as amended by sec. 5(6), Life Insurance Company Tax Act 1955 
(70 Stat. 49); sec. 3(f)(1), Life Insurance Company Income Tax Act 1959 
(73 Stat. 140))

[T.D. 6610, 27 FR 8723, Aug. 31, 1962]



Sec.  1.892-1T  Purpose and scope of regulations (temporary regulations).

    (a) In general. These regulations provide guidance with respect to 
the taxation of income derived by foreign governments and international 
organizations from sources within the United

[[Page 569]]

States. Under section 892, certain specific types of income received by 
foreign governments are excluded from gross income and are exempt, 
unless derived from the conduct of a commercial activity or received 
from or by a controlled commercial entity. This section sets forth the 
effective date of the regulations. Section 1.892-2T defines a foreign 
government. In particular it describes the extent to which either an 
integral part of a foreign sovereign or an entity which is not an 
integral part of a foreign sovereign will be treated as a foreign 
government for purposes of section 892. Section 1.892-3T describes the 
types of income that generally qualify for exemption and certain 
limitations on the exemption. Section 1.892-4T provides rules concerning 
the characterization of activities as commercial activities. Section 
1.892-5T defines a controlled commercial entity. Section 1.892-6T sets 
forth the extent to which income of international organizations from 
sources within the United States is excluded from gross income and is 
exempt from taxation. Section 1.892-7T sets forth the relationship of 
section 892 to other Internal Revenue Code sections.
    (b) Effective date. The regulations set forth in Sec. Sec.  1.892-1T 
through 1.892-7T apply to income received by a foreign government on or 
after July 1, 1986. No amount of income shall be required to be deducted 
and withheld, by reason of the amendment of section 892 by section 1247 
of the Tax Reform Act of 1986 (Pub. L. 99-514, 100 Stat. 2085, 2583) 
from any payment made before October 22, 1986.

[T.D. 8211, 53 FR 24061, June 27, 1988; 53 FR 27595, July 21, 1988]



Sec.  1.892-2T  Foreign government defined (temporary regulations).

    (a) Foreign government--(1) Definition. The term ``foreign 
government'' means only the integral parts or controlled entities of a 
foreign sovereign.
    (2) Integral part. An ``integral part'' of a foreign sovereign is 
any person, body of persons, organization, agency, bureau, fund, 
instrumentality, or other body, however designated, that constitutes a 
governing authority of a foreign country. The net earnings of the 
governing authority must be credited to its own account or to other 
accounts of the foreign sovereign, with no portion inuring to the 
benefit of any private person. An integral part does not include any 
individual who is a sovereign, official, or administrator acting in a 
private or personal capacity. Consideration of all the facts and 
circumstances will determine whether an individual is acting in a 
private or personal capacity.
    (3) Controlled entity. The term ``controlled entity'' means an 
entity that is separate in form from a foreign sovereign or otherwise 
constitute a separate juridical entity if it satisfies the following 
requirements:
    (i) It is wholly owned and controlled by a foreign sovereign 
directly or indirectly through one or more controlled entities;
    (ii) It is organized under the laws of the foreign sovereign by 
which owned;
    (iii) Its net earnings are credited to its own account or to other 
accounts of the foreign sovereign, with no portion of its income inuring 
to the benefit of any private person; and
    (iv) Its assets vest in the foreign sovereign upon dissolution.


A controlled entity does not include partnerships or any other entity 
owned and controlled by more than one foreign sovereign. Thus, a foreign 
financial organization organized and wholly owned and controlled by 
several foreign sovereigns to foster economic, financial, and technical 
cooperation between various foreign nations is not a controlled entity 
for purposes of this section.
    (b) Inurement to the benefit of private persons. For purposes of 
this section, income will be presumed not to inure to the benefit of 
private persons if such persons (within the meaning of section 
7701(a)(1)) are the intended beneficiaries of a governmental program 
which is carried on by the foreign sovereign and the activities of which 
constitute governmental functions (within the meaning of Sec.  1.892-
4T(c)(4)). Income will be considered to inure to the benefit of private 
persons if such income benefits:
    (1) Private persons through the use of a governmental entity as a 
conduit for personal investment; or

[[Page 570]]

    (2) Private persons who divert such income from its intended use by 
the exertion of influence or control through means explicitly or 
implicitly approved of by the foreign sovereign.
    (c) Pension trusts--(1) In general. A controlled entity includes a 
separately organized pension trust if it meets the following 
requirements:
    (i) The trust is established exclusively for the benefit of (A) 
employees or former employees of a foreign government or (B) employees 
or former employees of a foreign government and non-governmental 
employees or former employees that perform or performed governmental or 
social services;
    (ii) The funds that comprise the trust are managed by trustees who 
are employees of, or persons appointed by, the foreign government;
    (iii) The trust forming a part of the pension plan provides for 
retirement, disability, or death benefits in consideration for prior 
services rendered; and
    (iv) Income of the trust satisfies the obligations of the foreign 
government to participants under the plan, rather than inuring to the 
benefit of a private person.


Income of a pension trust is subject to the rules of Sec.  1.892-
5T(b)(3) regarding the application of the rules for controlled 
commercial entities to pension trusts. Income of a superannuation or 
similar pension fund of an integral part or controlled entity (which is 
not a separate pension trust as defined in this paragraph (c)(1)) is 
subject to the rules that generally apply to a foreign sovereign. Such a 
pension fund may also benefit non-governmental employees or former 
employees that perform or performed governmental or social services.
    (2) Illustrations. The following examples illustrate the application 
of paragraph (c)(1).

    Example 1. The Ministry of Welfare (MW), an integral part of foreign 
sovereign FC, instituted a retirement plan for FC's employees and former 
employees. Retirement benefits under the plan are based on a percentage 
of the final year's salary paid to an individual, times the number of 
years of government service. Pursuant to the plan, contributions are 
made by MW to a pension trust managed by persons appointed by MW to the 
extent actuarially necessary to fund accrued pension liabilities. The 
pension trust in turn invests such contributions partially in United 
States Treasury obligations. The income of the trust is credited to the 
trust's account and subsequently used to satisfy the pension plan's 
obligations to retired employees. Under these circumstances, the income 
of the trust is not deemed to inure to the benefit of private persons. 
Accordingly, the trust is considered a controlled entity of FC.
    Example 2. The facts are the same as in Example 1, except that the 
retirement plan also benefits employees performing governmental or 
social services for the following non-government institutions: (i) A 
university in a local jurisdiction; (ii) a harbor commission; and (iii) 
a library system. The retirement benefits under the plan are based on 
the total amounts credited to an individual's account over the term of 
his or her employment. MW makes annual contributions to each covered 
employee's account equal to a percentage of annual compensation. In 
addition, the income derived from investment of the annual contributions 
is credited annually to individual accounts. The annual contributions do 
not exceed an amount that is determined to be actuarially necessary to 
provide the employee with reasonable retirement benefits. 
Notwithstanding that retirement benefits vary depending upon the 
investment experience of the trust, no portion of the income of the 
trust is deemed to inure to the benefit of private persons. Accordingly, 
the trust is considered a controlled entity of FC.
    Example 3. The facts are the same as in Example 1, except that 
employees are allowed to make unlimited contributions to the trust, and 
such contributions are credited to the employee's account as well as 
interest accrued on such contributions. Retirement benefits will reflect 
the amounts credited to the individual accounts in addition to the usual 
annuity computation based on the final year's salary and years of 
service. A pension plan established under these rules is in part acting 
as an investment conduit. As a result, the income of the trust is deemed 
to inure to the benefit of private persons. Accordingly, the trust is 
not considered a controlled entity of FC.
    Example 4. (a) The facts are the same as in Example 2, except that 
MW establishes a pension fund rather than a separate pension trust. A 
pension fund is merely assets of an integral part or controlled entity 
allocated to a separate account and held and invested for purposes of 
providing retirement benefits. Under these circumstances, the income of 
the pension fund is not deemed to inure to the benefit of private 
persons. Accordingly, income earned from the United States Treasury 
obligations by the pension fund is considered to be received by a 
foreign government and is exempt from taxation under section 892.

[[Page 571]]

    (b) The facts are the same as in Example 4(a), except that MW is a 
controlled entity of foreign sovereign FC. The result is the same as in 
Example 4(a). However, should MW engage in commercial activities 
(whether within or outside the United States), the income from the 
Treasury obligations earned by the pension fund will not be exempt from 
taxation under section 892 since MW will be considered a controlled 
commercial entity within the meaning of Sec.  1.892-5T(a).

    (d) Political subdivision and transnational entity. The rules that 
apply to a foreign sovereign apply to political subdivisions of a 
foreign country and to transnational entities. A transnational entity is 
an organization created by more than one foreign sovereign that has 
broad powers over external and domestic affairs of all participating 
foreign countries stretching beyond economic subjects to those 
concerning legal relations and transcending state or political 
boundaries.

[T.D. 8211, 53 FR 24061, June 27, 1988; 53 FR 27595, July 21, 1988]



Sec.  1.892-3  Income of foreign governments.

    (a)(1) through (a)(5) [Reserved] For further information, see Sec.  
1.892-3T(a)(1) through (a)(5).
    (6) Dividend equivalents. Income from investments in stocks includes 
the payment of a dividend equivalent described in section 871(m) and the 
regulations thereunder.
    (b) [Reserved] For further information, see Sec.  1.892-3T(b).
    (c) Effective/applicability date. Paragraph (a)(6) of this section 
applies to payments made on or after December 5, 2013.

[T.D. 9648, 78 FR 73080, Dec. 5, 2013]



Sec.  1.892-3T  Income of foreign governments (temporary regulations).

    (a) Types of income exempt--(1) In general. Subject to the 
exceptions contained in Sec. Sec.  1.892-4T and 1.892-5T for income 
derived from the conduct of a commercial activity or received from or by 
a controlled commercial entity, the following types of income derived by 
a foreign government (as defined in Sec.  1.892-2T) are not included in 
gross income and are exempt:
    (i) Income from investments in the United States in stocks, bonds, 
or other securities;
    (ii) Income from investments in the United States in financial 
instruments held in the execution of governmental financial or monetary 
policy; and
    (iii) Interest on deposits in banks in the United States of moneys 
belonging to such foreign government.


Income derived from sources other than described in this paragraph (such 
as income earned from a U.S. real property interest described in section 
897(c)(1)(A)(i)) is not exempt from taxation under section 892. 
Furthermore, any gain derived from the disposition a U.S. real property 
interest defined in section 897(c)(1)(A)(i) shall in no event qualify 
for exemption under section 892.
    (2) Income from investments. For purposes of paragraph (a) of this 
section, income from investments in stocks, bonds or other securities 
includes gain from their disposition and income earned from engaging in 
section 1058 securities lending transactions. Gain on the disposition of 
an interest in a partnership or a trust is not exempt from taxation 
under section 892.
    (3) Securities. For purposes of paragraph (a) of this section, the 
term ``other securities'' includes any note or other evidence of 
indebtedness. Thus, an annuity contract, a mortgage, a banker's 
acceptance or a loan are securities for purposes of this section.
    However, the term ``other securities'' does not include partnership 
interests (with the exception of publicly traded partnerships within the 
meaning of section 7704) or trust interests. The term also does not 
include commodity forward or futures contracts and commodity options 
unless they constitute securities for purposes of section 864(b)(2)(A).
    (4) Financial instrument. For purposes of paragraph (a) of this 
section, the term ``financial instrument'' includes any forward, 
futures, options contract, swap agreement or similar instrument in a 
functional or nonfunctional currency (see section 985(b) for the 
definition of functional currency) or in precious metals when held by a 
foreign government or central bank of issue (as defined in Sec.  1.895-
1(b)). Nonfunctional

[[Page 572]]

currency or gold shall be considered a ``financial instrument'' also 
when physically held by a central bank of issue.
    (5) Execution of financial or monetary policy--(i) Rule. A financial 
instrument shall be deemed held in the execution of governmental 
financial or monetary policy if the primary purpose for holding the 
instrument is to implement or effectuate such policy.
    (ii) Illustration. The following example illustrates the application 
of this paragraph (a)(5).

    Example. In order to ensure sufficient currency reserves, the 
monetary authority of foreign country FC issues short-term government 
obligations. The amount received from the obligations is invested in 
U.S. financial instruments. Since the primary purpose for obtaining the 
U.S. financial instruments is to implement FC's monetary policy, the 
income received from the financial instruments is exempt from taxation 
under section 892.

    (b) Illustrations. The principles of paragraph (a) of this section 
may be illustrated by the following examples.

    Example 1. X, a foreign corporation not engaged in commercial 
activity anywhere in the world, is a controlled entity of a foreign 
sovereign within the meaning of Sec.  1.892-2T(a)(3). X is not a Central 
bank of issue as defined in Sec.  1.895-1(b). In 1987, X received the 
following items of income from investments in the United States: (i) 
Dividends from a portfolio of publicly traded stocks in U.S. 
corporations in which X owns less than 50 percent of the stock; (ii) 
dividends from BTB Corporation, an automobile manufacturer, in which X 
owns 50 percent of the stock; (iii) interest from bonds issued by 
noncontrolled entities and from interest-bearing bank deposits in 
noncontrolled entities; (iv) rents from a net lease on real property; 
(v) gains from silver futures contracts; (vi) gains from wheat futures 
contracts; (vii) gains from spot sales of nonfunctional foreign currency 
in X's possession; (viii) gains from the disposition of a publicly 
traded partnership interest, and (ix) gains from the disposition of the 
stock of Z Corporation, a United States real property holding company as 
defined in section 897, of which X owns 12 percent of the stock. Only 
income derived from sources described in paragraph (a)(1) of this 
section is treated as income of a foreign government eligible for 
exemption from taxation. Accordingly, only income received by X from 
items (i), (iii), (v) provided that the silver futures contracts are 
held in the execution of governmental financial or monetary policy, and 
(ix) is exempt from taxation under section 892.
    Example 2. The facts are the same as in Example 1, except that X is 
also a central bank of issue within the meaning of section 895. Since 
physical possession of nonfunctional foreign currency when held by a 
central bank of issue is considered a financial instrument, the item 
(vii) gains from spot sales of nonfunctional foreign currency are exempt 
from taxation under paragraph (a)(1) of this section, if physical 
possession of the currency was an essential part of X's reserve policy 
in the execution of its governmental financial or monetary policy.
    Example 3. State Concert Bureau, an integral part of a foreign 
sovereign within the meaning of Sec.  1.892-2T(a)(2), entered into an 
agreement with a U.S. corporation engaged in the business of promoting 
international cultural programs. Under the agreement the State Concert 
Bureau agreed to send a ballet troupe on tour for 5 weeks in the United 
States. The Bureau received approximately $60,000 from the performances. 
Regardless of whether the performances themselves constitute commercial 
activities under Sec.  1.892-4T, the income received by the Bureau is 
not exempt from taxation under section 892 since the income is from 
sources other than described in paragraph (a)(1) of this section.

[T.D. 8211, 53 FR 24062, June 27, 1988]



Sec.  1.892-4T  Commercial activities (temporary regulations).

    (a) Purpose. The exemption generally applicable to a foreign 
government (as defined in Sec.  1.892-2T) for income described in Sec.  
1.892-3T does not apply to income derived from the conduct of a 
commercial activity or income received by a controlled commercial entity 
or received (directly or indirectly) from a controlled commercial 
entity. This section provides rules for determining whether income is 
derived from the conduct of a commercial activity. These rules also 
apply in determining under Sec.  1.892-5T whether an entity is a 
controlled commercial entity.
    (b) In general. Except as provided in paragraph (c) of this section, 
all activities (whether conducted within or outside the United States) 
which are ordinarily conducted by the taxpayer or by other persons with 
a view towards the current or future production of income or gain are 
commercial activities. An activity may be considered a commercial 
activity even if such activity does not constitute the conduct of a 
trade

[[Page 573]]

or business in the United States under section 864(b).
    (c) Activities that are not commercial--(1) Investments--(i) In 
general. Subject to the provisions of paragraphs (ii) and (iii) of this 
paragraph (c)(1), the following are not commercial activities: 
Investments in stocks, bonds, and other securities; loans; investments 
in financial instruments held in the execution of governmental financial 
or monetary policy; the holding of net leases on real property or land 
which is not producing income (other than on its sale or from an 
investment in net leases on real property); and the holding of bank 
deposits in banks. Transferring securities under a loan agreement which 
meets the requirements of section 1058 is an investment for purposes of 
this paragraph (c)(1)(i). An activity will not cease to be an investment 
solely because of the volume of transactions of that activity or because 
of other unrelated activities.
    (ii) Trading. Effecting transactions in stocks, securities, or 
commodities for a foreign government's own account does not constitute a 
commercial activity regardless of whether such activities constitute a 
trade or business for purposes of section 162 or a U.S. trade or 
business for purposes of section 864. Such transactions are not 
commercial activities regardless of whether they are effected by the 
foreign government through its employees or through a broker, commission 
agent, custodian, or other independent agent and regardless of whether 
or not any such employee or agent has discretionary authority to make 
decisions in effecting the transactions. An activity undertaken as a 
dealer, however, as defined in Sec.  1.864-2(c)(2)(iv)(a) will not be an 
investment for purposes of this paragraph (c)(1)(i). For purposes of 
this paragraph (c)(1)(ii), the term ``commodities'' means commodities of 
a kind customarily dealt in on an organized commodity exchange but only 
if the transaction is of a kind customarily consummated at such place.
    (iii) Banking, financing, etc. Investments (including loans) made by 
a banking, financing, or similar business constitute commercial 
activities, even if the income derived from such investments is not 
considered to be income effectively connected to the active conduct of a 
banking, financing, or similar business in the U.S. by reason of the 
application of Sec.  1.864-4(c)(5).
    (2) Cultural events. Performances and exhibitions within or outside 
the United States of amateur athletic events and events devoted to the 
promotion of the arts by cultural organizations are not commercial 
activities.
    (3) Non-profit activities. Activities that are not customarily 
attributable to or carried on by private enterprise for profit are not 
commercial activities. The fact that in some instances Federal, State, 
or local governments of the United States also are engaged in the same 
or similar activity does not mean necessarily that it is a non-profit 
activity. For example, even though the United States Government may be 
engaged in the activity of operating a railroad, operating a railroad is 
not a non-profit activity.
    (4) Governmental functions. Governmental functions are not 
commercial activities. The term ``governmental functions'' shall be 
determined under U.S. standards. In general, activities performed for 
the general public with respect to the common welfare or which relate to 
the administration of some phase of government will be considered 
governmental functions. For example, the operation of libraries, toll 
bridges, or local transportation services and activities substantially 
equivalent to the Federal Aviation Authority, Interstate Commerce 
Commission, or United States Postal Service will all be considered 
governmental functions for purposes of this section.
    (5) Purchasing. The mere purchasing of goods for the use of a 
foreign government is not a commercial activity.

[T.D. 8211, 53 FR 24063, June 27, 1988]



Sec.  1.892-5  Controlled commercial entity.

    (a)-(a)(2) [Reserved]. For further information, see Sec.  1.892-
5T(a) through (a)(2).
    (3) For purposes of section 892(a)(2)(B), the term entity means and 
includes a corporation, a partnership, a trust (including a pension 
trust described in Sec.  1.892-2T(c)) and an estate.
    (4) Effective date. This section applies on or after January 14, 
2002. See Sec.  1.892-

[[Page 574]]

5T(a) for the rules that apply before January 14, 2002.
    (b)-(d) [Reserved]. For further information, see Sec. Sec.  1.892-
5T(b) through (d).

[T.D. 9012, 67 FR 49864, Aug. 1, 2002]



Sec.  1.892-5T  Controlled commercial entity (temporary regulations).

    (a) In general. The exemption generally applicable to a foreign 
government (as defined in Sec.  1.892-2T) for income described in Sec.  
1.892-3T does not apply to income received by a controlled commercial 
entity or received (directly or indirectly) from a controlled commercial 
entity. The term ``controlled commercial entity'' means any entity 
engaged in commercial activities as defined in Sec.  1.892-4T (whether 
conducted within or outside the United States) if the government--
    (1) Holds (directly or indirectly) any interest in such entity which 
(by value or voting power) is 50 percent or more of the total of such 
interests in such entity, or
    (2) Holds (directly or indirectly) a sufficient interest (by value 
or voting power) or any other interest in such entity which provides the 
foreign government with effective practical control of such entity.
    (3) [Reserved]. For further information, see Sec.  1.892-5(a)(3).
    (b) Entities treated as engaged in commercial activity--(1) U.S. 
real property holding corporations. A United States real property 
holding corporation, as defined in section 897(c)(2) or a foreign 
corporation that would be a United States real property holding 
corporation if it was a United States corporation, shall be treated as 
engaged in commercial activity and, therefore, is a controlled 
commercial entity if the requirements of paragraph (a)(1) or (a)(2) of 
this section are satisfied.
    (2) Central banks. Notwithstanding paragraph (a) of this section, a 
central bank of issue (as defined in Sec.  1.895-1(b)) shall be treated 
as a controlled commercial entity only if it engages in commercial 
activities within the United States.
    (3) Pension trusts. A pension trust, described in Sec.  1.892-2T(c), 
which engages in commercial activities within or outside the United 
States, shall be treated as a controlled commercial entity. Income 
derived by such a pension trust is not income of a foreign government 
for purposes of the exemption from taxation provided in section 892. A 
pension trust described in Sec.  1.892-2T(c) shall not be treated as a 
controlled commercial entity if such trust solely earns income which 
would not be unrelated business taxable income (as defined in section 
512(a)(1)) if the trust were a qualified trust described in section 
401(a). However, only income derived by a pension trust that is 
described in Sec.  1.892-3T and which is not from commercial activities 
as defined in Sec.  1.892-4T is exempt from taxation under section 892.
    (c) Control--(1) Attribution--(i) Rule. In determining for purposes 
of paragraph (a) of this section the interest held by a foreign 
government, any interest in an entity (whether or not engaged in 
commercial activity) owned directly or indirectly by an integral part or 
controlled entity of a foreign sovereign shall be treated as actually 
owned by such foreign sovereign.
    (ii) Illustration. The following example illustrates the application 
of paragraph (c)(1)(i) of this section.

    Example. FX, a controlled entity of foreign sovereign FC, owns 20 
percent of the stock of Corp 1. Neither FX nor Corp 1 is engaged in 
commercial activity anywhere in the world. Corp 1 owns 60 percent of the 
stock of Corp 2, which is engaged in commercial activity. The remaining 
40 percent of Corp 2's stock is owned by Bureau, an integral part of 
foreign sovereign FC. For purposes of determining whether Corp 2 is a 
controlled commercial entity of FC, Bureau will be treated as actually 
owning the 12 percent of Corp 2's stock indirectly owned by FX. 
Therefore, since Bureau directly and indirectly owns 52 percent of the 
stock of Corp 2, Corp 2 is a controlled commercial entity of FC within 
the meaning of paragraph (a) of this section. Accordingly, dividends or 
other income received, directly or indirectly, from Corp 2 by either 
Bureau or FX will not be exempt from taxation under section 892. 
Furthermore, dividends from Corp 1 to the extent attributable to 
dividends from Corp 2 will not be exempt from taxation. Thus, a 
distribution from Corp 1 to FX shall be exempt only to the extent such 
distribution exceeds Corp 1's earnings and profits attributable to the 
Corp 2 dividend amount received by Corp 1.

    (2) Effective practical control. An entity engaged in commercial 
activity may be treated as a controlled commercial

[[Page 575]]

entity if a foreign government holds sufficient interests in such entity 
to give it ``effective practical control'' over the entity. Effective 
practical control may be achieved through a minority interest which is 
sufficiently large to achieve effective control, or through creditor, 
contractual, or regulatory relationships which, together with ownership 
interests held by the foreign government, achieve effective control. For 
example, an entity engaged in commercial activity may be treated as a 
controlled commercial entity if a foreign government, in addition to 
holding a small minority interest (by value or voting power), is also a 
substantial creditor of the entity or controls a strategic natural 
resource which such entity uses in the conduct of its trade or business, 
giving the foreign government effective practical control over the 
entity.
    (d) Related controlled entities--(1) Brother/sister entities. 
Commercial activities of a controlled entity are not attributed to such 
entity's other brother/sister related entities. Thus, investment income 
described in Sec.  1.892-2T that is derived by a controlled entity that 
is not itself engaged in commercial activity within or outside the 
United States is exempt from taxation notwithstanding the fact that such 
entity's brother/sister related entity is a controlled commercial 
entity.
    (2) Parent/subsidiary entities--(i) Subsidiary to parent 
attribution. Commercial activities of a subsidiary controlled entity are 
not attributed to its parent. Thus, investment income described in Sec.  
1.892-3T that is derived by a parent controlled entity that is not 
itself engaged in commercial activity within or outside the United 
States is exempt from taxation notwithstanding the fact that its 
subsidiary is a controlled commercial entity. Dividends or other 
payments of income received by the parent controlled entity from the 
subsidiary are not exempt under section 892, because it constitutes 
income received from a controlled commercial entity. Furthermore, 
dividends paid by the parent are not exempt to the extent attributable 
to the dividends received by the parent from the subsidiary. Thus, a 
distribution by the parent shall be exempt only to the extent such 
distribution exceeds earnings and profits attributable to the dividend 
received from its subsidiary.
    (ii) Parent to subsidiary attribution. Commercial activities of a 
parent controlled entity are attributed to its subsidiary. Thus, 
investment income described in Sec.  1.892-3T that is derived by a 
subsidiary controlled entity (not engaged in commercial activity within 
or outside the United States) is not exempt from taxation under section 
892 if its parent is a controlled commercial entity.
    (3) Partnerships. Except for partners of publicly traded 
partnerships, commercial activities of a partnership are attributable to 
its general and limited partners for purposes of section 892. For 
example, where a controlled entity is a general partner in a partnership 
engaged in commercial activities, the controlled entity's distributive 
share of partnership income (including income described in Sec.  1.892-
3T) will not be exempt from taxation under section 892.
    (4) Illustrations. The principles of this section may be illustrated 
by the following examples.

    Example 1. (a) The Ministry of Industry and Development is an 
integral part of a foreign sovereign under Sec.  1.892-2T(a)(2). The 
Ministry is engaged in commercial activity within the United States. In 
addition, the Ministry receives income from various publicly traded 
stocks and bonds, soybean futures contracts and net leases on U.S. real 
property. Since the Ministry is an integral part, and not a controlled 
entity, of a foreign sovereign, it is not a controlled commercial entity 
within the meaning of paragraph (a) of this section. Therefore, income 
described in Sec.  1.892-3T is ineligible for exemption under section 
892 only to the extent derived from the conduct of commercial 
activities. Accordingly, the Ministry's income from the stocks and bonds 
is exempt from U.S. tax.
    (b) The facts are the same as in Example (1)(a), except that the 
Ministry also owns 75 percent of the stock of R, a U.S. holding company 
that owns all the stock of S, a U.S. operating company engaged in 
commercial activity. Ministry's dividend income from R is income 
received indirectly from a controlled commercial entity. The Ministry's 
income from the stocks and bonds, with the exception of dividend income 
from R, is exempt from U.S. tax.
    (c) The facts are the same as in Example (1)(a), except that the 
Ministry is a controlled entity of a foreign sovereign. Since

[[Page 576]]

the Ministry is a controlled entity and is engaged in commercial 
activity, it is a controlled commercial entity within the meaning of 
paragraph (a) of this section, and none of its income is eligible for 
exemption.
    Example 2. (a) Z, a controlled entity of a foreign sovereign, has 
established a pension trust as part of a pension plan for the benefit of 
its employees and former employees. The pension trust (T), which meets 
the requirements of Sec.  1.892-2T(c), has investments in the U.S. in 
various stocks, bonds, annuity contracts, and a shopping center which is 
leased and managed by an independent real estate management firm. T also 
makes securities loans in transactions that qualify under section 1058. 
T's investment in the shopping center is not considered an unrelated 
trade or business within the meaning of section 513(b). Accordingly, T 
will not be treated as engaged in commercial activity. Since T is not a 
controlled commercial entity, its investment income described in Sec.  
1.892-3T, with the exception of income received from the operations of 
the shopping center, is exempt from taxation under section 892.
    (b) The facts are the same as Example (2)(a), except that T has an 
interest in a limited partnership which owns the shopping center. The 
shopping center is leased and managed by the partnership rather than by 
an independent management firm. Managing a shopping center, directly or 
indirectly through a partnership of which a trust is a member, would be 
considered an unrelated trade or business within the meaning of section 
513(b) giving rise to unrelated business taxable income. Since the 
commercial activities of a partnership are attributable to its partners, 
T will be treated as engaged in commercial activity and thus will be 
considered a controlled commercial entity. Accordingly, none of T's 
income will be exempt from taxation under section 892.
    (c) The facts are the same as Example (2)(a), except that Z is a 
controlled commercial entity. The result is the same as in Example 
(2)(a).
    Example 3. (a) The Department of Interior, an integral part of 
foreign sovereign FC, wholly owns corporations G and H. G, in turn, 
wholly owns S. G, H and S are each controlled entities. G, which is not 
engaged in commercial activity anywhere in the world, receives interest 
income from deposits in banks in the United States. Both H and S do not 
have any investments in the U.S. but are both engaged in commercial 
activities. However, only S is engaged in commercial activities within 
the United States. Because neither the commercial activities of H nor 
the commercial activities of S are attributable to the Department of 
Interior or G, G's interest income is exempt from taxation under section 
892.
    (b) The facts are the same as Example (3)(a), except that G rather 
than S is engaged in commercial activities and S rather than G receives 
the interest income from the United States. Since the commercial 
activities of G are attributable to S, S's interest income is not exempt 
from taxation.
    Example 4. (a) K, a controlled entity of a foreign sovereign, is a 
general partner in the Daj partnership. The Daj partnership has 
investments in the U.S. in various stocks and bonds and also owns and 
manages an office building in New York. K will be deemed to be engaged 
in commercial activity by being a general partner in Daj even if K does 
not actually make management decisions with regard to the partnership's 
commercial activity, the operation of the office building. Accordingly 
K's distributive share of partnership income (including income derived 
from stocks and bonds) will not be exempt from taxation under section 
892.
    (b) The facts are the same as in Example (4)(a), except that the Daj 
partnership has hired a real estate management firm to lease offices and 
manage the building. Notwithstanding the fact that an independent 
contractor is performing the activities, the partnership shall still be 
deemed to be engaged in commercial activity. Accordingly, K's 
distributive share of partnership income (including income derived from 
stocks and bonds) will not be exempt from taxation under section 892.
    (c) The facts are the same as in Example (4)(a), except that K is a 
partner whose partnership interest is considered a publicly traded 
partnership interest within the meaning of section 7704. Under paragraph 
(d)(3) of this section, the partnership's commercial activity will not 
be attributed to K. Since K will not be deemed to be engaged in 
commercial activity, K's distributive share of partnership income 
derived from stocks and bonds will be exempt from taxation under section 
892.

[T.D. 8211, 53 FR 24064, June 27, 1988, as amended by T.D. 9012, 67 FR 
49864, Aug. 1, 2002]



Sec.  1.892-6T  Income of international organizations (temporary regulations).

    (a) Exempt from tax. Subject to the provisions of section 1 of the 
International Organizations Immunities Act (22 U.S.C. 288) (the 
provisions of which are set forth in paragraph (b)(3) of Sec.  1.893-1), 
the income of an international organization (as defined in section 
7701(a)(18)) received from investments in the United States in stocks, 
bonds, or other domestic securities, owned by such international 
organization, or from interest on deposits

[[Page 577]]

in banks in the United States of moneys belonging to such international 
organization, or from any other source within the United States, is 
exempt from Federal income tax.
    (b) Income received prior to Presidential designation. An 
organization designated by the President through appropriate Executive 
order as entitled to enjoy the privileges, exemptions, and immunities 
provided in the International Organizations Immunities Act may enjoy the 
benefits of the exemption with respect to income of the prescribed 
character received by such organization prior to the date of the 
issuance of such Executive order, if (i) the Executive order does not 
provide otherwise and (ii) the organization is a public international 
organization in which the United States participates, pursuant to a 
treaty or under the authority of an act of Congress authorizing such 
participation or making an appropriation for such participation, at the 
time such income is received.

[T.D. 8211, 53 FR 24065, June 27, 1988]



Sec.  1.892-7T  Relationship to other Internal Revenue Code sections 
(temporary regulations).

    (a) Section 893. The term ``foreign government'' referred to in 
section 893 (relating to the exemption for compensation of employees of 
foreign governments) has the same meaning as given such term in Sec.  
1.892-2T.
    (b) Section 895. A foreign central bank of issue (as defined in 
Sec.  1.895-1(b)) that fails to qualify for the exemption from tax 
provided by this section (for example, it is not wholly owned by a 
foreign sovereign) may nevertheless be exempt from tax on the items of 
income described in section 895.
    (c) Section 883(b). Nothing in section 892 or these regulations 
shall limit the exemption provided under section 883(b) relating 
generally to the exemption of earnings derived by foreign participants 
from the ownership or operation of communications satellite systems.
    (d) Section 884. Earnings and profits attributable to income of a 
controlled entity of a foreign sovereign which is exempt from taxation 
under section 892 shall not be subject to the tax imposed by section 
884(a).
    (e) Sections 1441 and 1442. No withholding is required under 
sections 1441 and 1442 in the case of income exempt from taxation under 
section 892.

[T.D. 8211, 53 FR 24066, June 27, 1988]



Sec.  1.893-1  Compensation of employees of foreign governments 
or international organizations.

    (a) Employees of foreign governments--(1) Exempt from tax. Except to 
the extent that the exemption is limited by the execution and filing of 
the waiver provided for in section 247(b) of the Immigration and 
Nationality Act (8 U.S.C. 1257(b)), all employees of a foreign 
government (including consular or other officers, or nondiplomatic 
representatives) who are not citizens of the United States, or are 
citizens of the Republic of the Philippines (whether or not citizens of 
the United States), are exempt from Federal income tax with respect to 
wages, fees, or salaries received by them as compensation for official 
services rendered to such foreign government, provided (i) the services 
are of a character similar to those performed by employees of the 
Government of the United States in that foreign country and (ii) the 
foreign government whose employees are claiming exemption grants an 
equivalent exemption to employees of the Government of the United States 
performing similar services in that foreign country.
    (2) Certificate by Secretary of State. Section 893(b) provides that 
the Secretary of State shall certify to the Secretary of the Treasury 
the names of the foreign countries which grant an equivalent exemption 
to the employees of the Government of the United States performing 
services in such foreign countries, and the character of the services 
performed by employees of the Government of the United States in foreign 
countries.
    (3) Items not exempt. The income received by employees of foreign 
governments from sources other than their salaries, fees, or wages, 
referred to in subparagraph (1) of this paragraph, is subject to Federal 
income tax.
    (4) Immigration and Nationality Act. Section 247(b) of the 
Immigration and Nationality Act provides as follows:

    Sec. 247. Adjustment of status of certain resident aliens.* * *

[[Page 578]]

    (b) The adjustment of status required by subsection (a) [of section 
247 of the Immigration and Nationality Act] shall not be applicable in 
the case of any alien who requests that he be permitted to retain his 
status as an immigrant and who, in such form as the Attorney General may 
require, executes and files with the Attorney General a written waiver 
of all rights, privileges, exemptions, and immunities under any law or 
any executive order which would otherwise accrue to him because of the 
acquisition of an occupational status entitling him to a nonimmigrant 
status under paragraph (15)(A), (15)(E), or (15)(G) of section 101(a).

    (5) Effect of waiver. An employee of a foreign government who 
executes and files with the Attorney General the waiver provided for in 
section 247(b) of the Immigration and Nationality Act thereby waives the 
exemption conferred by section 893 of the Code. As a consequence, that 
exemption does not apply to income received by that alien after the date 
of filing of the waiver.
    (6) Citizens of the United States. The compensation of citizens of 
the United States (other than those who are also citizens of the 
Republic of the Philippines) who are officers or employees of a foreign 
government is not exempt from income tax pursuant to this paragraph. But 
see section 911 and the regulations thereunder.
    (b) Employees of international organizations--(1) Exempt from tax. 
Except to the extent that the exemption is limited by the execution and 
filing of the waiver provided for in section 247(b) of the Immigration 
and Nationality Act and subject to the provisions of sections 1, 8, and 
9 of the International Organizations Immunities Act (22 U.S.C. 288, 
288e, 288f), wages, fees, or salary of any officer or employee of an 
international organization (as defined in section 7701(a)(18)) received 
as compensation for official services to that international organization 
is exempt from Federal income tax, if that officer or employee (i) is 
not a citizen of the United States or (ii) is a citizen of the Republic 
of the Philippines (whether or not a citizen of the United States).
    (2) Income earned prior to executive action. An individual of the 
prescribed class who receives wages, fees, or salary as compensation for 
official services to an organization designated by the President through 
appropriate Executive order as entitled to enjoy the privileges, 
exemptions, and immunities provided in the International Organizations 
Immunities Act and who has been duly notified to, and accepted by, the 
Secretary of State as an officer or employee of that organization, or 
who has been designated by the Secretary of State, prior to formal 
notification and acceptance, as a prospective officer or employee of 
that organization, may enjoy the benefits of the exemption with respect 
to compensation of the prescribed character earned by that individual, 
either prior to the date of the Issuance of the Executive order, or 
prior to the date of the acceptance or designation by the Secretary of 
State, for official services to that organization, if (i) the Executive 
order does not provide otherwise, (ii) the organization is a public 
international organization in which the United States participates, 
pursuant to a treaty or under the authority of an act of Congress 
authorizing such participation or making an appropriation for such 
participation, at the time the compensation is earned, and (iii) the 
individual is an officer or employee of that organization at that time.
    (3) International Organizations Immunities Act. Sections 1, 8, and 9 
of the International Organizations Immunities Act (22 U.S.C. 288, 288e, 
288f) provide in part as follows:

    Section 1. For the purposes of this title [International 
Organizations Immunities Act], the term ``international organization'' 
means a public international organization in which the United States 
participates pursuant to any treaty or under the authority of any Act of 
Congress authorizing such participation or making an appropriation for 
such participation, and which shall have been designated by the 
President through appropriate Executive order as being entitled to enjoy 
the privileges, exemptions, and immunities herein provided. The 
President shall be authorized, in the light of the functions performed 
by any such international organization, by appropriate Executive order 
to withhold or withdraw from any such organization or its officers or 
employees any of the privileges, exemptions, and immunities provided for 
in this title (including the amendments made by this title) or to 
condition or limit the enjoyment by any such organization or its 
officers or employees of any such privilege, exemption, or immunity. The

[[Page 579]]

President shall be authorized, if in his judgment such action should be 
justified by reason of the abuse by an international organization or its 
officers and employees of the privileges, exemptions, and immunities 
herein provided or for any other reason, at any time to revoke the 
designation of any international organization under this section, 
whereupon the international organization in question shall cease to be 
classed as an international organization for the purposes of this title.

                                * * * * *

    Sec. 8. (a) No person shall be entitled to the benefits of this 
title [International Organizations Immunities Act] unless he (1) shall 
have been duly notified to and accepted by the Secretary of State as a * 
* * officer, or employee; or (2) shall have been designated by the 
Secretary of State, prior to formal notification and acceptance, as a 
prospective * * * officer, or employee; * * *.
    (b) Should the Secretary of State determine that the continued 
presence in the United States of any person entitled to the benefits of 
this title is not desirable, he shall so inform the * * * international 
organization concerned * * *, and after such person shall have had a 
reasonable length of time, to be determined by the Secretary of State, 
to depart from the United States, he shall cease to be entitled to such 
benefits.
    (c) No person shall, by reason of the provisions of this title, be 
considered as receiving diplomatic status or as receiving any of the 
privileges incident thereto other than such as are specifically set 
forth herein.
    Sec. 9. The privileges, exemptions, and immunities of international 
organizations and of their officers and employees * * * provided for in 
this title [International Organizations Immunities Act], shall be 
granted notwithstanding the fact that the similar privileges, 
exemptions, and immunities granted to a foreign government, its 
officers, or employees, may be conditioned upon the existence of 
reciprocity by that foreign government: Provided, That nothing contained 
in this title shall be construed as precluding the Secretary of State 
from withdrawing the privileges, exemptions, and immunities herein 
provided from persons who are nationals of any foreign country on the 
ground that such country is failing to accord corresponding privileges, 
exemptions, and immunities to citizens of the United States.

    (4) Effect of waiver. An officer or employee of an international 
organization who executes and files with the Attorney General the waiver 
provided for in section 247(b) of the Immigration and Nationality Act (8 
U.S.C. 1257(b)) thereby waives the exemption conferred by section 893 of 
the Code. As a consequence, that exemption does not apply to income 
received by that individual after the date of filing of the waiver.
    (5) Citizens of the United States. The compensation of citizens of 
the United States (other than those who are also citizens of the 
Republic of the Philippines) who are officers or employees of an 
international organization is not exempt from income tax pursuant to 
this paragraph. But see section 911 and the regulations thereunder.
    (c) Tax conventions, consular conventions, and international 
agreements--(1) Exemption dependent upon internal revenue laws. A tax 
convention or consular convention between the United States and a 
foreign country, which provides that the United States may include in 
the tax base of its residents all income taxable under the internal 
revenue laws, and which makes no specific exception for the income of 
the employees of that foreign government, does not provide any exemption 
(with respect to residents of the United States) beyond that which is 
provided by the internal revenue laws. Accordingly, the effect of the 
execution and filing of a waiver under section 247(b) of the Immigration 
and Nationality Act by an employee of a foreign government which is a 
party to such a convention is to subject the employee to tax to the same 
extent as provided in paragraph (a)(5) of this section with respect to 
the waiver of exemption under section 893.
    (2) Exemption not dependent upon internal revenue laws. If a tax 
convention, consular convention, or international agreement provides 
that compensation paid by the foreign government or international 
organization to its employees is exempt from Federal income tax, and the 
application of this exemption is not dependent upon the provisions of 
the internal revenue laws, the exemption so conferred is not affected by 
the execution and filing of a waiver under section 247(b) of the 
Immigration and Nationality Act. For examples of exemptions which are 
not affected by the Immigration and Nationality Act, see article X of 
the income tax convention between the United States and the United 
Kingdom (60 Stat. 1383); article IX, section 9(b), of the Articles of

[[Page 580]]

Agreement of the International Monetary Fund (60 Stat. 1414); and 
article VII, section 9(b), of the Articles of Agreement of the 
International Bank for Reconstruction and Development (60 Stat. 1458).



Sec.  1.894-1  Income affected by treaty.

    (a) Income exempt under treaty. Income of any kind is not included 
in gross income and is exempt from tax under Subtitle A (relating to 
income taxes), to the extent required by any income tax convention to 
which the United States is a party. However, unless otherwise provided 
by an income tax convention, the exclusion from gross income under 
section 894(a) and this paragraph does not apply in determining the 
accumulated taxable income of a foreign corporation under section 535 
and the regulations thereunder or the undistributed personal holding 
company income of a foreign corporation under section 545 and the 
regulations thereunder. Moreover, the distributable net income of a 
foreign trust is determined without regard to section 894 and this 
paragraph, to the extent provided by section 643(a)(6)(B). Further, the 
compensating tax adjustment required by section 819(a)(3) in the case of 
a foreign life insurance company is to be determined without regard to 
section 894 and this paragraph, to the extent required by section 
819(a)(3)(A). See Sec.  1.871-12 for the manner of determining the tax 
liability of a nonresident alien individual or foreign corporation whose 
gross income includes income on which the tax is reduced under a tax 
convention.
    (b) Taxpayer treated as having no permanent establishment in the 
United States--(1) In general. A nonresident alien individual or a 
foreign corporation, that is engaged in trade or business in the United 
States through a permanent establishment located therein at any time 
during a taxable year beginning after December 31, 1966, shall be deemed 
not to have a permanent establishment in the United States at any time 
during that year for purposes of applying any exemption from, or 
reduction in the rate of, any tax under Subtitle A of the Code which is 
provided by any income tax convention with respect to income which is 
not effectively connected for that year with the conduct of a trade or 
business in the United States by the taxpayer. This paragraph applies to 
all treaties or conventions entered into by the United States, whether 
entered into before, on, or after November 13, 1966, the date of 
enactment of the Foreign Investors Tax Act of 1966 (80 Stat. 1539). This 
paragraph is not considered to be contrary to any obligation of the 
United States under an income tax convention to which it is a party. The 
benefit granted under section 894(b) and this paragraph applies only to 
those items of income derived from sources within the United States 
which are subject to the tax imposed by section 871(a) or 881(a), and 
section 1441, 1442, or 1451, on the noneffectively connected income 
received from sources within the United States by a nonresident alien 
individual or a foreign corporation. The benefit does not apply to any 
income from real property in respect of which an election is in effect 
for the taxable year under Sec.  1.871-10 or in determining under 
section 877(b) the tax of a nonresident alien individual who has lost 
United States citizenship at any time after March 8, 1965. The benefit 
granted by section 894(b) and this paragraph is not elective.
    (2) Illustrations. The application of this paragraph may be 
illustrated by the following examples:

    Example 1. M, a corporation organized in foreign country X, uses the 
calendar year as the taxable year. The United States and country X are 
parties to an income tax convention which provides in part that 
dividends received from sources within the United States by a 
corporation of country X not having a permanent establishment in the 
United States are subject to tax under Chapter 1 of the Code at a rate 
not to exceed 15 percent. During 1967, M is engaged in business in the 
United States through a permanent establishment located therein and 
receives $100,000 in dividends from domestic corporation B, which under 
section 861(a)(2)(A) constitute income from sources within the United 
States. Under section 864(c)(2) and Sec.  1.864-4(c), the dividends 
received from B are not effectively connected for 1967 with the conduct 
of a trade or business in the United States by M. Although M has a 
permanent establishment in the United States during 1967, it is deemed, 
under section 894(b) and this paragraph, not to have a permanent 
establishment in the United States during that year with respect to the

[[Page 581]]

dividends. Accordingly, in accordance with paragraph (c)(3) of Sec.  
1.871-12 the tax on the dividends is $15,000, that is, 15 percent of 
$100,000, determined without the allowance of any deductions.
    Example 2. T, a corporation organized in foreign country X, uses the 
calendar year as the taxable year. The United States and country X are 
parties to an income tax convention which provides in part that an 
enterprise of country X is not subject to tax under chapter 1 of the 
Code in respect of its industrial or commercial profits unless it is 
engaged in trade or business in the United States during the taxable 
year through a permanent establishment located therein and that, if it 
is so engaged, the tax may be imposed upon the entire income of that 
enterprise from sources within the United States. The convention also 
provides that the tax imposed by Chapter 1 of the Code on dividends 
received from sources within the United States by a corporation of X 
which is not engaged in trade or business in the United States through a 
permanent establishment located therein shall not exceed 15 percent of 
the dividend. During 1967, T is engaged in a business (business A) in 
the United States which is carried on through a permanent establishment 
in the United States; in addition, T is engaged in a business (business 
B) in the United States which is not carried on through a permanent 
establishment. During 1967, T receives from sources within the United 
States $60,000 in service fees through the operation of business A and 
$10,000 in dividends through the operation of business B, both of which 
amounts are, under section 864(c)(2)(B) and Sec.  1.864-4(c)(3), 
effectively connected for that year with the conduct of a trade or 
business in the United States by that corporation. The service fees are 
considered to be industrial or commercial profits under the tax 
convention with country X. Since T has no income for 1967 which is not 
effectively connected for that year with the conduct of a trade or 
business in the United States by that corporation, section 894(b), this 
paragraph, and Sec.  1.871-12 do not apply. Accordingly, for 1967 T's 
entire income of $70,000 from sources within the United States is 
subject to tax, after allowance of deductions, in accordance with 
section 882(a)(1) and paragraph (b)(2) of Sec.  1.882-1.
    Example 3. S, a corporation organized in foreign country W, uses the 
calendar year as the taxable year. The United States and country W are 
parties to an income tax convention which provides in part that a 
corporation of country W is not subject to tax under Chapter 1 of the 
Code in respect of its industrial or commercial profits unless it is 
engaged in trade or business in the United States during the taxable 
year through a permanent establishment located therein and that, if it 
is so engaged, the tax may be imposed upon the entire income of that 
corporation from sources within the United States. The convention also 
provides that the tax imposed by Chapter 1 of the Code on dividends 
received from sources within the United States by a corporation of 
country W which is not engaged in trade or business in the United States 
through a permanent establishment located therein shall not exceed 15 
percent of the dividend. During 1967, S is engaged in business in the 
United States through a permanent establishment located therein and 
derives from sources within the United States $100,000 in service fees 
which, under section 864(c)(2)(B) and Sec.  1.864-4(c)(3), are 
effectively connected for that year with the conduct of a trade or 
business in the United States by S and which are considered to be 
industrial or commercial profits under the tax convention with country 
W. During 1967, S also derives from sources within the United States, 
through another business it carries on in foreign country X, $10,000 in 
sales income which, under section 864(c)(3) and Sec.  1.864-4(b), is 
effectively connected for that year with the conduct of a trade or 
business in the United States by S and $5,000 in dividends which, under 
section 864(c)(2)(A) and Sec.  1.864-4(c)(2), are not effectively 
connected for that year with the conduct of a trade or business in the 
United States by S. The sales income is considered to be industrial or 
commercial profits under the tax convention with country W. Although S 
is engaged in a trade or business in the United States during 1967 
through a permanent establishment located therein, it is deemed, under 
section 894(b) and this paragraph, not to have a permanent establishment 
therein with respect to the $5,000 in dividends. Accordingly, in 
accordance with paragraph (c) of Sec.  1.871-12, for 1967 S is subject 
to a tax of $750 on the dividends ($5,000 x .15) and a tax, determined 
under section 882(a) and Sec.  1.882-1, on its $110,000 industrial or 
commercial profits.
    Example 4. (a) N, a corporation organized in foreign country Z, uses 
the calendar year as the taxable year. The United States and country Z 
are parties to an income tax convention which provides in part that the 
tax imposed by Chapter 1 of the Code on dividends received from sources 
within the United States by a corporation of country Z shall not exceed 
15 percent of the amount distributed if the recipient does not have a 
permanent establishment in the United States or, where the recipient 
does have a permanent establishment in the United States, if the shares 
giving rise to the dividends are not effectively connected with the 
permanent establishment. The tax convention also provides that if a 
corporation of country Z is engaged in industrial or commercial activity 
in the United States through a permanent establishment in the United 
States, income tax may be imposed

[[Page 582]]

by the United States on so much of the industrial or commercial profits 
of such corporation as are attributable to the permanent establishment 
in the United States.
    (b) During 1967, N is engaged in a business (business A) in the 
United States which is not carried on through a permanent establishment 
in the United States. In addition, N has a permanent establishment in 
the United States through which it carries on another business (business 
B) in the United States. During 1967, N holds shares of stock in 
domestic corporation D which are not effectively connected with N's 
permanent establishment in the United States. During 1967, N receives 
$100,000 in dividends from D which, pursuant to section 864(c)(2)(A) and 
Sec.  1.864-4(c)(2), are effectively connected for that year with the 
conduct of business A. Under section 861(a)(2)(A) these dividends are 
treated as income from sources within the United States. In addition, 
during 1967, N receives from sources within the United States $150,000 
in sales income which, pursuant to section 864(c)(3) and Sec.  1.864-
4(b), is effectively connected with the conduct of a trade or business 
in the United States and which is considered to be industrial or 
commercial profits under the tax convention with country Z. Of these 
total profits, $70,000 is from business A and $80,000 is from business 
B. Only the $80,000 of industrial or commercial profits is attributable 
to N's permanent establishment in the United States.
    (c) Since N has no income for 1967 which is not effectively 
connected for that year with the conduct of a trade or business in the 
United States by that corporation, section 894(b) and this paragraph do 
not apply. However, N is entitled to the reduced rate of tax under the 
tax convention with country Z with respect to the dividends because the 
shares of stock are not effectively connected with N's permanent 
establishment in the United States. Accordingly, assuming that there are 
no deductions connected with N's industrial or commercial profits, the 
tax for 1967, determined as provided in paragraph (c) of Sec.  1.871-12, 
is $46,900 as follows:

Tax on nontreaty income:
  $80,000 x .48...............................................   $38,400
  Less $25,000 x .26..........................................     6,500
                                                               ---------
                                                                  31,900
Tax on treaty income:
  $100,000 (gross dividends) x .15............................    15,000
                                                               =========
   Total tax..................................................    46,900
 

    Example 5. M, a corporation organized in foreign country Z, uses the 
calendar year as the taxable year. The United States and country Z are 
parties to an income tax convention which provides in part that a 
corporation of country Z is not subject to tax under Chapter 1 of the 
Code in respect of its commercial and industrial profits except such 
profits as are allocable to its permanent establishment in the United 
States. The regulations in this chapter under the tax convention with 
country Z provide that a corporation of country Z having a permanent 
establishment in the United States is subject to U.S. tax upon its 
industrial and commercial profits from sources within the United States 
and that its industrial and commercial profits from such sources are 
deemed to be allocable to the permanent establishment in the United 
States. During 1967, M is engaged in a business (business A) in the 
United States which is carried on through a permanent establishment in 
the United States; in addition, M is engaged in a business (business B) 
in foreign country X and none of such business is carried on in the 
United States. During 1967, M receives from sources within the United 
States $40,000 in sales income through the operation of business A and 
$10,000 in sales income through the operation of business B, both of 
which amounts are, under section 864(c)(3) and Sec.  1.864-4(b), 
effectively connected for that year with the conduct of a trade or 
business in the United States by that corporation. The sales income is 
considered to be industrial and commercial profits under the tax 
convention with country Z. Since M has no income for 1967 which is not 
effectively connected for that year with the conduct of a trade or 
business in the United States by that corporation, section 894(b) and 
this paragraph do not apply. Accordingly, for 1967 M's entire income of 
$50,000 from sources within the United States is subject to tax, after 
allowance of deductions, in accordance with section 882(a)(1) and 
paragraph (b)(2) of Sec.  1.882-1.

    (c)(1) Substitute interest and dividend payments. The provisions of 
an income tax convention dealing with interest or dividends paid to or 
derived by a foreign person include substitute interest or dividend 
payments that have the same character as interest or dividends under 
Sec.  1.864-5(b)92)(ii), 1.871-7(b)(2) or 1.881-2(b)(2). The provisions 
of this paragraph (c) shall apply for purposes of securities lending 
transactions or sale-repurchase transactions as defined in Sec.  1.861-
2(a)(7) and Sec.  1.861-3(a)(6).
    (2) Dividend equivalents. The provisions of an income tax convention 
relating to dividends paid to or derived by a foreign person apply to 
the payment of a dividend equivalent described in section 871(m) and the 
regulations thereunder.
    (d) Special rule for items of income received by entities--(1) In 
general. The tax imposed by sections 871(a), 881(a), 1443, 1461, and 
4948(a) on an item of income

[[Page 583]]

received by an entity, wherever organized, that is fiscally transparent 
under the laws of the United States and/or any other jurisdiction with 
respect to an item of income shall be eligible for reduction under the 
terms of an income tax treaty to which the United States is a party only 
if the item of income is derived by a resident of the applicable treaty 
jurisdiction. For this purpose, an item of income may be derived by 
either the entity receiving the item of income or by the interest 
holders in the entity or, in certain circumstances, both. An item of 
income paid to an entity shall be considered to be derived by the entity 
only if the entity is not fiscally transparent under the laws of the 
entity's jurisdiction, as defined in paragraph (d)(3)(ii) of this 
section, with respect to the item of income. An item of income paid to 
an entity shall be considered to be derived by the interest holder in 
the entity only if the interest holder is not fiscally transparent in 
its jurisdiction with respect to the item of income and if the entity is 
considered to be fiscally transparent under the laws of the interest 
holder's jurisdiction with respect to the item of income, as defined in 
paragraph (d)(3)(iii) of this section. Notwithstanding the preceding two 
sentences, an item of income paid directly to a type of entity 
specifically identified in a treaty as a resident of a treaty 
jurisdiction shall be treated as derived by a resident of that treaty 
jurisdiction.
    (2) Application to domestic reverse hybrid entities--(i) In general. 
An income tax treaty may not apply to reduce the amount of federal 
income tax on U.S. source payments received by a domestic reverse hybrid 
entity. Further, notwithstanding paragraph (d)(1) of this section, the 
foreign interest holders of a domestic reverse hybrid entity are not 
entitled to the benefits of a reduction of U.S. income tax under an 
income tax treaty on items of income received from U.S. sources by such 
entity. A domestic reverse hybrid entity is a domestic entity that is 
treated as not fiscally transparent for U.S. tax purposes and as 
fiscally transparent under the laws of the interest holder's 
jurisdiction, with respect to the item of income received by the 
domestic entity.
    (ii) Payments by domestic reverse hybrid entities--(A) General rule. 
Except as otherwise provided in paragraph (d)(2)(ii)(B) of this section, 
an item of income paid by a domestic reverse hybrid entity to an 
interest holder in such entity shall have the character of such item of 
income under U.S. law and shall be considered to be derived by the 
interest holder, provided the interest holder is not fiscally 
transparent in its jurisdiction, as defined in paragraph (d)(3)(iii) of 
this section, with respect to the item of income. In determining whether 
the interest holder is fiscally transparent with respect to the item of 
income under this paragraph (d)(2)(ii)(A), the determination under 
paragraph (d)(3)(ii) of this section shall be made based on the 
treatment that would have resulted had the item of income been paid by 
an entity that is not fiscally transparent under the laws of the 
interest holder's jurisdiction with respect to any item of income.
    (B) Payment made to related foreign interest holder--(1) General 
rule. If--
    (i) A domestic entity makes a payment to a related domestic reverse 
hybrid entity that is treated as a dividend under either the laws of the 
United States or the laws of the jurisdiction of a related foreign 
interest holder in the domestic reverse hybrid entity, and under the 
laws of the jurisdiction of the related foreign interest holder in the 
domestic reverse hybrid entity, the related foreign interest holder is 
treated as deriving its proportionate share of the payment under the 
principles of paragraph (d)(1) of this section; and
    (ii) The domestic reverse hybrid entity makes a payment of a type 
that is deductible for U.S. tax purposes to the related foreign interest 
holder or to a person, wherever organized, the income and losses of 
which are available, under the laws of the jurisdiction of the related 
foreign interest holder, to offset the income and losses of the related 
foreign interest holder, and for which a reduction in U.S. withholding 
tax would be allowed under an applicable income tax treaty; then
    (iii) To the extent the amount of the payment described in paragraph 
(d)(2)(ii)(B)(1)(ii) of this section does not exceed the sum of the 
portion of the payment described in paragraph

[[Page 584]]

(d)(2)(ii)(B)(1)(i) of this section treated as derived by the related 
foreign interest holder and the portion of any other prior payments 
described in paragraph (d)(2)(ii)(B)(1)(i) of this section treated as 
derived by the related foreign interest holder, the amount of the 
payment described in (d)(2)(ii)(B)(1)(ii) of this section will be 
treated for all purposes of the Internal Revenue Code and any applicable 
income tax treaty as a distribution within the meaning of section 301(a) 
of the Internal Revenue Code, and the tax to be withheld from the 
payment described in paragraph (d)(2)(ii)(B)(1)(ii) of this section 
(assuming the payment is a dividend under section 301(c)(1) of the 
Internal Revenue Code) shall be determined based on the appropriate rate 
of withholding that would be applicable to dividends paid from the 
domestic reverse hybrid entity to the related foreign interest holder in 
accordance with the principles of paragraph (d)(2)(ii)(A) of this 
section.
    (2) Determining amount to be recharacterized under paragraph 
(d)(2)(ii)(B)(1)(iii). For purposes of determining the amount to be 
recharacterized under paragraph (d)(2)(ii)(B)(1)(iii) of this section, 
the portion of the payment described in paragraph (d)(2)(ii)(B)(1)(i) of 
this section treated as derived by the related foreign interest holder 
shall be increased by the portion of the payment derived by any other 
person described in paragraph (d)(2)(ii)(B)(1)(ii), and shall be reduced 
by the amount of any prior section 301(c) distributions made by the 
domestic reverse hybrid entity to the related foreign interest holder or 
any other person described in paragraph (d)(2)(ii)(B)(1)(ii) and by the 
amount of any payments from the domestic reverse hybrid entity 
previously recharacterized under paragraph (d)(2)(ii)(B)(1)(iii) of this 
section.
    (3) Tiered entities. The principles of this paragraph (d)(2)(ii)(B) 
also shall apply to payments referred to in this paragraph (d)(2)(ii)(B) 
made among related entities when there is more than one domestic reverse 
hybrid entity or other fiscally transparent entity involved.
    (4) Definition of related. For purposes of this section, a person 
shall be treated as related to a domestic reverse hybrid entity if it is 
related by reason of the ownership requirements of section 267(b) or 
707(b)(1), except that the language ``at least 80 percent'' applies 
instead of ``more than 50 percent,'' where applicable. For purposes of 
determining whether a person is related by reason of the ownership 
requirements of section 267(b) or 707(b)(1), the constructive ownership 
rules of section 318 shall apply, and the attribution rules of section 
267(c) also shall apply to the extent they attribute ownership to 
persons to whom section 318 does not attribute ownership.
    (C) Payments to persons not described in paragraph 
(d)(2)(ii)(B)(1)(ii)--(1) Related persons. The Commissioner may treat a 
payment by a domestic reverse hybrid entity to a related person (who is 
neither the related foreign interest holder nor otherwise described in 
paragraph (d)(2)(ii)(B)(1)(ii) of this section), in whole or in part, as 
being made to a related foreign interest holder for purposes of applying 
paragraph (d)(2)(ii)(B) of this section, if--
    (i) The payment to the related person is of a type that is 
deductible by the domestic reverse hybrid entity; and
    (ii) The payment is made in connection with one or more transactions 
the effect of which is to avoid the application of paragraph 
(d)(2)(ii)(B) of this section.
    (2) Unrelated persons. The Commissioner may treat a payment by a 
domestic reverse hybrid entity to an unrelated person, in whole or in 
part, as being made to a related foreign interest holder for purposes of 
applying paragraph (d)(2)(ii)(B) of this section, if--
    (i) The payment to the unrelated person is of a type that is 
deductible by the domestic reverse hybrid entity;
    (ii) The unrelated person (or other person (whether related or not) 
which receives a payment in a series of transactions that includes a 
transaction involving such unrelated person) makes a payment to the 
related foreign interest holder (or other person described in paragraph 
(d)(2)(ii)(B)(1)(ii));
    (iii) The foregoing payments are made in connection with a series of

[[Page 585]]

transactions which constitute a financing arrangement, as defined in 
Sec.  1.881-3(a)(2)(i); and
    (iv) The transactions have the effect of avoiding the application of 
paragraph (d)(2)(ii)(B) of this section.
    (iii) Examples. The rules of this paragraph (d)(2) are illustrated 
by the following examples:

    Example 1. Dividend paid by unrelated entity to domestic reverse 
hybrid entity. (i) Facts. Entity A is a domestic reverse hybrid entity, 
as defined in paragraph (d)(2)(i) of this section, with respect to the 
U.S. source dividends it receives from B, a domestic corporation to 
which A is not related within the meaning of paragraph (d)(2)(ii)(B)(4) 
of this section. A's 85-percent shareholder, FC, is a corporation 
organized under the laws of Country X, which has an income tax treaty in 
effect with the United States. A's remaining 15-percent shareholder is 
an unrelated domestic corporation. Under Country X law, FC is not 
fiscally transparent with respect to the dividend, as defined in 
paragraph (d)(3)(ii) of this section. In year 1, A receives $100 of 
dividend income from B. Under Country X law, FC is treated as deriving 
$85 of the $100 dividend payment received by A. The applicable rate of 
tax on dividends under the U.S.-Country X income tax treaty is 5 percent 
with respect to a 10-percent or more corporate shareholder.
    (ii) Analysis. Under paragraph (d)(2)(i) of this section, the U.S.-
Country X income tax treaty does not apply to the dividend income 
received by A because the payment is made by B, a domestic corporation, 
to A, another domestic corporation. A remains fully taxable under the 
U.S. tax laws as a domestic corporation with regard to that item of 
income. Further, pursuant to paragraph (d)(2)(i) of this section, 
notwithstanding the fact that A is treated as fiscally transparent with 
respect to the dividend income under the laws of Country X, FC may not 
claim a reduced rate of taxation on its share of the U.S. source 
dividend income received by A.
    Example 2. Interest paid by domestic reverse hybrid entity to 
related foreign interest holder where dividend is paid by unrelated 
entity. (i) Facts. The facts are the same as in Example 1. Both the 
United States and Country X characterize the payment by B in year 1 as a 
dividend. In addition, in year 2, A makes a payment of $25 to FC that is 
characterized under the Internal Revenue Code as interest on a loan from 
FC to A. Under the U.S.-Country X income tax treaty, the rate of tax on 
interest is zero. Under Country X laws, had the interest been paid by an 
entity that is not fiscally transparent under Country X's laws with 
respect to any item of income, FC would not be fiscally transparent as 
defined in paragraph (d)(2)(ii) of this section with respect to the 
interest.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 payment from B to A. With respect to the $25 payment from A 
to FC, paragraph (d)(2)(ii)(B) of this section will not apply because, 
although FC is a related foreign interest holder in A, A is not related 
to B, the payor of the dividend income it received. Under paragraph 
(d)(2)(ii)(A) of this section, the $25 of interest paid by A to FC in 
year 2 is characterized under U.S. law as interest. Accordingly, in year 
2, A is entitled to an interest deduction with respect to the $25 
interest payment from A to FC, and FC is entitled to the reduced rate of 
withholding applicable to interest under the U.S.-Country X income tax 
treaty, assuming all other requirements for claiming treaty benefits are 
met.
    Example 3. Interest paid by domestic reverse hybrid entity to 
related foreign interest holder where dividend is paid by a related 
entity. (i) Facts. The facts are the same as in Example 2, except the 
$100 dividend income received by A in year 1 is from A's wholly-owned 
subsidiary, S.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. However, the $25 interest 
payment in year 2 by A to FC will be treated as a dividend for all 
purposes of the Internal Revenue Code and the U.S.-Country X income tax 
treaty because $25 does not exceed FC's share of the $100 dividend 
payment made by S to A ($85). Since FC is not fiscally transparent with 
respect to the payment as determined under paragraph (d)(2)(ii)(A) of 
this section, FC is entitled to the reduced rate applicable to dividends 
under the U.S.-Country X income tax treaty with respect to the $25 
payment. Because the $25 payment in year 2 is recharacterized as a 
dividend for all purposes of the Internal Revenue Code and the U.S.-
Country X income tax treaty, A is not entitled to an interest deduction 
with respect to that payment and FC is not entitled to claim the reduced 
rate of withholding applicable to interest.
    Example 4. Definition of related foreign interest holder. (i) Facts. 
The facts are the same as in Example 3, except that A has two 50-percent 
shareholders, FC1 and FC2. In year 2, A makes an interest payment of $25 
to both FC1 and FC2. FC1 is a corporation organized under the laws of 
Country X, which has an income tax treaty in effect with the United 
States. FC2 is a corporation organized under the laws of Country Y, 
which also has an income tax treaty in effect with the United States. FP 
owns 100-percent of both FC1 and FC2, and is organized under the laws of 
Country X. Under Country X law, FC1 is not fiscally transparent with 
respect to the dividend, as defined in paragraph (d)(3)(ii) of this 
section. Under Country X law, FC1 is treated as deriving $50 of the $100 
dividend payment

[[Page 586]]

received by A because A is fiscally transparent under the laws of 
Country X, as determined under paragraph (d)(3)(iii) of this section. 
The applicable rate of tax on dividends under the U.S.-Country X income 
tax treaty is 5-percent with respect to a 10-percent or more corporate 
shareholder. Under Country Y law, FC2 is not treated as deriving any of 
the $100 dividend payment received by A because, under the laws of 
Country Y, A is not a fiscally transparent entity.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. With respect to the $25 
payment in year 2 by A to FC1, the payment will be treated as a dividend 
for all purposes of the Internal Revenue Code and the U.S.-Country X 
income tax treaty because FC1 is a related foreign interest holder as 
determined under paragraph (d)(2)(ii)(B)(4) of this section, and because 
$25 does not exceed FC1's share of the dividend payment made by S to A 
($50). FC1 is a related foreign interest holder because FC1 is treated 
as owning the stock of A owned by FC2 under section 267(b)(3). Since FC1 
is not fiscally transparent with respect to the payment as determined 
under paragraph (d)(2)(ii)(A) of this section, FC1 is entitled to the 5-
percent reduced rate applicable to dividends under the U.S.-Country X 
income tax treaty with respect to the $25 payment. Because the $25 
payment in year 2 is recharacterized as a dividend for all purposes of 
the Internal Revenue Code and the U.S.-Country X income tax treaty, A is 
not entitled to an interest deduction with respect to that payment. Even 
though FC2 is also a related foreign interest holder, the $25 interest 
payment by A to FC2 in year 2 is not recharacterized because A is not 
fiscally transparent under the laws of Country Y, and FC2 is not treated 
as deriving any of the $100 dividend payment received by A. Thus, the 
U.S.-Country Y income tax treaty is not implicated.
    Example 5. Higher treaty withholding rate on dividends. (i) Facts. 
The facts are the same as in Example 3, except that under the U.S.-
Country X income tax treaty, the rate of tax on interest is 10-percent 
and the rate of tax on dividends is 5-percent.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. The analysis is the same as in 
Example 3 with respect to the $25 interest payment in year 2 from A to 
FC.
    Example 6. Foreign sister corporation the income and losses of which 
may offset the income and losses of related foreign interest holder. (i) 
Facts. The facts are the same as Example 3, except that in year 2, A 
makes the interest payment of $25 to FS, a subsidiary of FC also 
organized in Country X. Under the laws of Country X, FS is not fiscally 
transparent with respect to the interest payment, and the income and 
losses of FS may be used to offset the income and losses of FC.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. With respect to the $25 
interest payment from A to FS in year 2, FS is a person described in 
paragraph (d)(2)(ii)(B)(1)(ii) of this section because the income and 
losses of FS may be used under the laws of Country X to offset the 
income and losses of FC, the related foreign interest holder that 
derived its proportionate share of the payment from S to A. Therefore, 
paragraph (d)(2)(ii)(B) of this section applies, and the $25 interest 
payment in year 2 by A to FS is treated as a dividend for all purposes 
of the Internal Revenue Code and the U.S.-Country X income tax treaty 
because the $25 payment does not exceed FC's share of the $100 dividend 
payment made by S to A ($85). Since FS is not fiscally transparent with 
respect to the payment as determined under paragraph (d)(2)(ii)(A) of 
this section, FS is entitled to obtain the rate applicable to dividends 
under the U.S.-Country X income tax treaty with respect to the $25 
payment. Because the $25 payment in year 2 is recharacterized as a 
dividend for all purposes of the Internal Revenue Code and the U.S.-
Country X income tax treaty, A is not entitled to an interest deduction 
with respect to the payment and FS is not entitled to claim the reduced 
rate of withholding applicable to interest under the U.S.-Country X 
income tax treaty.
    Example 7. Interest paid by domestic reverse hybrid entity to 
unrelated foreign bank. (i) Facts. The facts are the same as in Example 
3, except that in year 2, A makes the interest payment of $25 to FB, a 
Country Y unrelated foreign bank, on a loan from FB to A.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. With respect to the payment 
from A to FB, paragraph (d)(2)(ii)(B) of this section will not apply 
because, although A is related to S, the payor of the dividend income it 
received, A is not related to FB under paragraph (d)(2)(ii)(B)(4) of 
this section. Under paragraph (d)(2)(ii)(A) of this section, the $25 
interest payment made from A to FB in year 2 is characterized as 
interest under the Internal Revenue Code.
    Example 8. Interest paid by domestic reverse hybrid to an unrelated 
entity pursuant to a financing arrangement. (i) Facts. The facts are the 
same as in Example 7, except that in year 3, FB makes an interest 
payment of $25 to FC on a deposit made by FC with FB.
    (ii) Analysis. The analysis is the same as in Example 1 with respect 
to the $100 dividend payment from S to A. With respect to the $25 
payment from A to FB in year 2, because the payment is made in 
connection with a transaction that consititutes a financing arrangement 
within the meaning of paragraph (d)(2)(ii)(C)(2) of this section, the 
payment may be treated by the Commissioner as

[[Page 587]]

being made directly to FC. If the Commissioner disregards FB, then the 
analysis is the same as in Example 3 with respect to the $25 interest 
payment in year 2 from A to FC.
    Example 9. Royalty paid by related entity to domestic reverse hybrid 
entity. (i) Facts. The facts are the same as in Example 3, except the 
$100 income received by A from S in year 1 is a royalty payment under 
both the laws of the United States and the laws of Country X. The 
royalty rate under the treaty is 10 percent and the interest rate is 0 
percent.
    (ii) Analysis. The analysis as to the royalty payment from S to A is 
the same as in Example 1 with respect to the $100 dividend payment from 
S to A. With respect to the $25 payment from A to FC, paragraph 
(d)(2)(ii)(B) of this section will not apply because the payment from S 
to A is not treated as a dividend under the Internal Revenue Code or the 
laws of Country X. Under paragraph (d)(2)(ii)(A) of this section, the 
$25 of interest paid by A to FC in year 2 is characterized as interest 
under the Internal Revenue Code. Accordingly, in year 2, FC may obtain 
the reduced rate of withholding applicable to interest under the U.S.-
Country X income tax treaty, assuming all other requirements for 
claiming treaty benefits are met.

    (3) Definitions--(i) Entity. For purposes of this paragraph (d), the 
term entity shall mean any person that is treated by the United States 
or the applicable treaty jurisdiction as other than an individual. The 
term entity includes disregarded entities, including single member 
disregarded entities with individual owners.
    (ii) Fiscally transparent under the law of the entity's 
jurisdiction--(A) General rule. For purposes of this paragraph (d), an 
entity is fiscally transparent under the laws of the entity's 
jurisdiction with respect to an item of income to the extent that the 
laws of that jurisdiction require the interest holder in the entity, 
wherever resident, to separately take into account on a current basis 
the interest holder's respective share of the item of income paid to the 
entity, whether or not distributed to the interest holder, and the 
character and source of the item in the hands of the interest holder are 
determined as if such item were realized directly from the source from 
which realized by the entity. However, the entity will be fiscally 
transparent with respect to the item of income even if the item of 
income is not separately taken into account by the interest holder, 
provided the item of income, if separately taken into account by the 
interest holder, would not result in an income tax liability for that 
interest holder different from that which would result if the interest 
holder did not take the item into account separately, and provided the 
interest holder is required to take into account on a current basis the 
interest holder's share of all such nonseparately stated items of income 
paid to the entity, whether or not distributed to the interest holder. 
In determining whether an entity is fiscally transparent with respect to 
an item of income in the entity's jurisdiction, it is irrelevant that, 
under the laws of the entity's jurisdiction, the entity is permitted to 
exclude such item from gross income or that the entity is required to 
include such item in gross income but is entitled to a deduction for 
distributions to its interest holders.
    (B) Special definitions. For purposes of this paragraph (d)(3)(ii), 
an entity's jurisdiction is the jurisdiction where the entity is 
organized or incorporated or may otherwise be considered a resident 
under the laws of that jurisdiction. An interest holder will be treated 
as taking into account that person's share of income paid to an entity 
on a current basis even if such amount is taken into account by the 
interest holder in a taxable year other than the taxable year of the 
entity if the difference is due solely to differing taxable years.
    (iii) Fiscally transparent under the law of an interest holder's 
jurisdiction--(A) General rule. For purposes of this paragraph (d), an 
entity is treated as fiscally transparent under the law of an interest 
holder's jurisdiction with respect to an item of income to the extent 
that the laws of the interest holder's jurisdiction require the interest 
holder resident in that jurisdiction to separately take into account on 
a current basis the interest holder's respective share of the item of 
income paid to the entity, whether or not distributed to the interest 
holder, and the character and source of the item in the hands of the 
interest holder are determined as if such item were realized directly 
from the source from which realized by the entity. However, an entity 
will be fiscally transparent with respect to the item of income even if 
the

[[Page 588]]

item of income is not separately taken into account by the interest 
holder, provided the item of income, if separately taken into account by 
the interest holder, would not result in an income tax liability for 
that interest holder different from that which would result if the 
interest holder did not take the item into account separately, and 
provided the interest holder is required to take into account on a 
current basis the interest holder's share of all such nonseparately 
stated items of income paid to the entity, whether or not distributed to 
the interest holder. An entity will not be treated as fiscally 
transparent with respect to an item of income under the laws of the 
interest holder's jurisdiction, however, if, under the laws of the 
interest holder's jurisdiction, the interest holder in the entity is 
required to include in gross income a share of all or a part of the 
entity's income on a current basis year under any type of anti-deferral 
or comparable mechanism. In determining whether an entity is fiscally 
transparent with respect to an item of income under the laws of an 
interest holder's jurisdiction, it is irrelevant how the entity is 
treated under the laws of the entity's jurisdiction.
    (B) Special definitions. For purposes of this paragraph (d)(3)(iii), 
an interest holder's jurisdiction is the jurisdiction where the interest 
holder is organized or incorporated or may otherwise be considered a 
resident under the laws of that jurisdiction. An interest holder will be 
treated as taking into account that person's share of income paid to an 
entity on a current basis even if such amount is taken into account by 
such person in a taxable year other than the taxable year of the entity 
if the difference is due solely to differing taxable years.
    (iv) Applicable treaty jurisdiction. The term applicable treaty 
jurisdiction means the jurisdiction whose income tax treaty with the 
United States is invoked for purposes of reducing the rate of tax 
imposed under sections 871(a), 881(a), 1461, and 4948(a).
    (v) Resident. The term resident shall have the meaning assigned to 
such term in the applicable income tax treaty.
    (4) Application to all income tax treaties. Unless otherwise 
explicitly agreed upon in the text of an income tax treaty, the rules 
contained in this paragraph (d) shall apply in respect of all income tax 
treaties to which the United States is a party. Notwithstanding the 
foregoing sentence, the competent authorities may agree on a mutual 
basis to depart from the rules contained in this paragraph (d) in 
appropriate circumstances. However, a reduced rate under a tax treaty 
for an item of U.S. source income paid will not be available 
irrespective of the provisions in this paragraph (d) to the extent that 
the applicable treaty jurisdiction would not grant a reduced rate under 
the tax treaty to a U.S. resident in similar circumstances, as evidenced 
by a mutual agreement between the relevant competent authorities or by a 
public notice of the treaty jurisdiction. The Internal Revenue Service 
shall announce the terms of any such mutual agreement or public notice 
of the treaty jurisdiction. Any denial of tax treaty benefits as a 
consequence of such a mutual agreement or notice shall affect only 
payment of U.S. source items of income made after announcement of the 
terms of the agreement or of the notice.
    (5) Examples. This paragraph (d) is illustrated by the following 
examples:

    Example 1. Treatment of entity treated as partnership by U.S. and 
country of organization. (i) Facts. Entity A is a business organization 
formed under the laws of Country X that has an income tax treaty in 
effect with the United States. A is treated as a partnership for U.S. 
federal income tax purposes. A is also treated as a partnership under 
the laws of Country X, and therefore Country X requires the interest 
holders in A to separately take into account on a current basis their 
respective shares of the items of income paid to A, whether or not 
distributed to the interest holders, and the character and source of the 
items in the hands of the interest holders are determined as if such 
items were realized directly from the source from which realized by A. A 
receives royalty income from U.S. sources that is not effectively 
connected with the conduct of a trade or business in the United States.
    (ii) Analysis. A is fiscally transparent in its jurisdiction within 
the meaning of paragraph (d)(3)(ii) of this section with respect to the 
U.S. source royalty income in Country X and, thus, A does not derive 
such income for purposes of the U.S.-X income tax treaty.

[[Page 589]]

    Example 2. Treatment of interest holders in entity treated as 
partnership by U.S. and country of organization. (i) Facts. The facts 
are the same as under Example 1. A's partners are M, a corporation 
organized under the laws of Country Y that has an income tax treaty in 
effect with the United States, and T, a corporation organized under the 
laws of Country Z that has an income tax treaty in effect with the 
United States. M and T are not fiscally transparent under the laws of 
their respective countries of incorporation. Country Y requires M to 
separately take into account on a current basis M's respective share of 
the items of income paid to A, whether or not distributed to M, and the 
character and source of the items of income in M's hands are determined 
as if such items were realized directly from the source from which 
realized by A. Country Z treats A as a corporation and does not require 
T to take its share of A's income into account on a current basis 
whether or not distributed.
    (ii) Analysis. M is treated as deriving its share of the U.S. source 
royalty income for purposes of the U.S.-Y income tax treaty because A is 
fiscally transparent under paragraph (d)(3)(iii) with respect to that 
income under the laws of Country Y. Under Country Z law, however, 
because T is not required to take into account its share of the U.S. 
source royalty income received by A on a current basis whether or not 
distributed, A is not treated as fiscally transparent. Accordingly, T is 
not treated as deriving its share of the U.S. source royalty income for 
purposes of the U.S.-Z income tax treaty.
    Example 3. Dual benefits to entity and interest holder. (i) Facts. 
The facts are the same as under Example 2, except that A is taxable as a 
corporation under the laws of Country X. Article 12 of the U.S.-X income 
tax treaty provides for a source country reduced rate of taxation on 
royalties of 5-percent. Article 12 of the U.S.-Y income tax treaty 
provides that royalty income may only be taxed by the beneficial owner's 
country of residence.
    (ii) Analysis. A is treated as deriving the U.S. source royalty 
income for purposes of the U.S.-X income tax treaty because it is not 
fiscally transparent with respect to the item of income within the 
meaning of paragraph (d)(3)(ii) of this section in Country X, its 
country of organization. M is also treated as deriving its share of the 
U.S. source royalty income for purposes of the U.S.-Y income tax treaty 
because A is fiscally transparent under paragraph (d)(3)(iii) of this 
section with respect to that income under the laws of Country Y. T is 
not treated as deriving the U.S. source royalty income for purposes of 
the U.S.-Z income tax treaty because under Country Z law A is not 
fiscally transparent. Assuming all other requirements for eligibility 
for treaty benefits have been satisfied, A is entitled to the 5-percent 
treaty reduced rate on royalties under the U.S.-X income tax treaty with 
respect to the entire royalty payment. Assuming all other requirements 
for treaty benefits have been satisfied, M is also entitled to a zero 
rate under the U.S.-Y income tax treaty with respect to its share of the 
royalty income.
    Example 4. Treatment of grantor trust. (i) Facts. Entity A is a 
trust organized under the laws of Country X, which does not have an 
income tax treaty in effect with the United States. M, the grantor and 
owner of A for U.S. income tax purposes, is a resident of Country Y, 
which has an income tax treaty in effect with the United States. M is 
also treated as the grantor and owner of the trust under the laws of 
Country Y. Thus, Country Y requires M to take into account all items of 
A's income in the taxable year, whether or not distributed to M, and 
determines the character of each item in M's hands as if such item was 
realized directly from the source from which realized by A. Country X 
does not treat M as the owner of A and does not require M to account for 
A's income on a current basis whether or not distributed to M. A 
receives interest income from U.S. sources that is neither portfolio 
interest nor effectively connected with the conduct of a trade or 
business in the United States.
    (ii) Analysis. A is not fiscally transparent under the laws of 
Country X within the meaning of paragraph (d)(3)(ii) of this section 
with respect to the U.S. source interest income, but A may not claim 
treaty benefits because there is no U.S.-X income tax treaty. M, 
however, does derive the income for purposes of the U.S.-Y income tax 
treaty because under the laws of Country Y, A is fiscally transparent.
    Example 5. Treatment of complex trust. (i) Facts. The facts are the 
same as in Example 4 except that M is treated as the owner of the trust 
only under U.S. tax law, after application of section 672(f), but not 
under the law of Country Y. Although the trust document governing A does 
not require that A distribute any of its income on a current basis, some 
distributions are made currently to M. There is no requirement under 
Country Y law that M take into account A's income on a current basis 
whether or not distributed to him in that year. Under the laws of 
Country Y, with respect to current distributions, the character of the 
item of income in the hands of the interest holder is determined as if 
such item were realized directly from the source from which realized by 
A. Accordingly, upon a current distribution of interest income to M, the 
interest income retains its source as U.S. source income.
    (ii) Analysis. M does not derive the U.S. source interest income 
because A is not fiscally transparent under paragraph (d)(3)(ii) of this 
section with respect to the U.S. source interest income under the laws 
of Country Y. Although the character of the interest in the hands of M 
is determined as if

[[Page 590]]

realized directly from the source from which realized by A, under the 
laws of Country Y, M is not required to take into account his share of 
A's interest income on a current basis whether or not distributed. 
Accordingly, neither A nor M is entitled to claim treaty benefits, since 
A is a resident of a non-treaty jurisdiction and M does not derive the 
U.S. source interest income for purposes of the U.S.-Y income tax 
treaty.
    Example 6. Treatment of interest holders required to include passive 
income under anti-deferral regime. (i) Facts. The facts are the same as 
under Example 2. However, Country Z does require T, who is treated as 
owning 60-percent of the stock of A, to take into account its respective 
share of the royalty income of A under an anti-deferral regime 
applicable to certain passive income of controlled foreign corporations.
    (ii) Analysis. T is still not eligible to claim treaty benefits with 
respect to the royalty income. T is not treated as deriving the U.S. 
source royalty income for purposes of the U.S.-Z income tax treaty under 
paragraph (d)(3)(iii) of this section because T is only required to take 
into account its pro rata share of the U.S. source royalty income by 
reason of Country Z's anti-deferral regime.
    Example 7. Treatment of contractual arrangements operating as 
collective investment vehicles. (i) Facts. A is a contractual 
arrangement without legal personality for all purposes under the laws of 
Country X providing for joint ownership of securities. Country X has an 
income tax treaty in effect with the United States. A is a collective 
investment fund which is of a type known as a Common Fund under Country 
X law. Because of the absence of legal personality in Country X of the 
arrangement, A is not liable to tax as a person at the entity level in 
Country X and is thus not a resident within the meaning of the Residence 
Article of the U.S.-X income tax treaty. A is treated as a partnership 
for U.S. income tax purposes and receives U.S. source dividend income. 
Under the laws of Country X, however, investors in A only take into 
account their respective share of A's income upon distribution from the 
Common Fund. Some of A's interest holders are residents of Country X and 
some of Country Y. Country Y has no income tax treaty in effect with the 
United States.
    (ii) Analysis. A is not fiscally transparent under paragraph 
(d)(3)(ii) of this section with respect to the U.S. source dividend 
income because the interest holders in A are not required to take into 
account their respective shares of such income in the taxable year 
whether or not distributed. Because A is an arrangement without a legal 
personality that is not considered a person in Country X and thus not a 
resident of Country X under the Residence Article of the U.S.-X income 
tax treaty, however, A does not derive the income as a resident of 
Country X for purposes of the U.S.-X income tax treaty. Further, because 
A is not fiscally transparent under paragraph (d)(3)(iii) of this 
section with respect to the U.S. source dividend income, A's interest 
holders that are residents of Country X do not derive the income as 
residents of Country X for purposes of the U.S.-X income tax treaty.
    Example 8. Treatment of person specifically listed as resident in 
applicable treaty. (i) Facts. The facts are the same as in Example 7 
except that A (the Common Fund) is organized in Country Z and the 
Residence Article of the U.S.-Z income tax treaty provides that ``the 
term 'resident of a Contracting State' includes, in the case of Country 
Z, Common Funds.* * *''
    (ii) Analysis. A is treated, for purposes of the U.S.-Z income tax 
treaty as deriving the dividend income as a resident of Country Z under 
paragraph (d)(1) of this section because the item of income is paid 
directly to A, A is a Common Fund under the laws of Country Z, and 
Common Funds are specifically identified as residents of Country Z in 
the U.S.-Z treaty. There is no need to determine whether A meets the 
definition of fiscally transparent under paragraph (d)(3)(ii) of this 
section.
    Example 9. Treatment of investment company when entity receives 
distribution deductions, and all distributions sourced by residence of 
entity. (i) Facts. Entity A is a business organization formed under the 
laws of Country X, which has an income tax treaty in effect with the 
United States. A is treated as a partnership for U.S. income tax 
purposes. Under the laws of Country X, A is an investment company 
taxable at the entity level and a resident of Country X. It is also 
entitled to a distribution deduction for amounts distributed to its 
interest holders on a current basis. A distributes all its net income on 
a current basis to its interest holders and, thus, in fact, has no 
income tax liability to Country X. A receives U.S. source dividend 
income. Under Country X law, all amounts distributed to interest holders 
of this type of business entity are treated as dividends from sources 
within Country X and Country X imposes a withholding tax on all payments 
by A to foreign persons. Under Country X laws, the interest holders in A 
do not have to separately take into account their respective shares of 
A's income on a current basis if such income is not, in fact, 
distributed.
    (ii) Analysis. A is not fiscally transparent under paragraph 
(d)(3)(ii) of this section with respect to the U.S. source dividends 
because the interest holders in A do not have to take into account their 
respective share of the U.S. source dividends on a current basis whether 
or not distributed. A is also not fiscally transparent under paragraph 
(d)(3)(ii) of this section because there is a change in source of the 
income received by A when A distributes the income to its interest 
holders

[[Page 591]]

and, thus, the character and source of the income in the hands of A's 
interest holder are not determined as if such income were realized 
directly from the source from which realized by A. Accordingly, A is 
treated as deriving the U.S. source dividends for purposes of the U.S.-
Country X treaty.
    Example 10. Item by item determination of fiscal transparency. (i) 
Facts. Entity A is a business organization formed under the laws of 
Country X, which has an income tax treaty in effect with the United 
States. A is treated as a partnership for U.S. income tax purposes. 
Under the laws of Country X, A is an investment company taxable at the 
entity level and a resident of Country X. It is also entitled to a 
distribution deduction for amounts distributed to its interest holders 
on a current basis. A receives both U.S. source dividend income and 
interest income from U.S. sources that is neither portfolio interest nor 
effectively connected with the conduct of a trade or business in the 
United States. Country X law sources all distributions attributable to 
dividend income based on the residence of the investment company. In 
contrast, Country X law sources all distributions attributable to 
interest income based on the residence of the payor of the interest. No 
withholding applies with respect to distributions attributable to U.S. 
source interest and the character of the distributions attributable to 
the interest income remains the same in the hands of A's interest 
holders as if such items were realized directly from the source from 
which realized by A. However, under Country X law the interest holders 
in A do not have to take into account their respective share of the 
interest income received by A on a current basis whether or not 
distributed.
    (ii) Analysis. An item by item analysis is required under paragraph 
(d) of this section. The analysis is the same as Example 9 with respect 
to the dividend income. A is also not fiscally transparent under 
paragraph (d)(3)(ii) of this section with respect to the interest income 
because, although the character of the distributions attributable to the 
interest income in the hands of A's interest holders is determined as if 
realized directly from the source from which realized by A, under 
Country X law the interest holders in A do not have to take into account 
their respective share of the interest income received by A on a current 
basis whether or not distributed. Accordingly, A derives the U.S. source 
interest income for purpose of the U.S.-X treaty.
    Example 11. Treatment of charitable organizations. (i) Facts. Entity 
A is a corporation organized under the laws of Country X that has an 
income tax treaty in effect with the United States. Entity A is 
established and operated exclusively for religious, charitable, 
scientific, artistic, cultural, or educational purposes. Entity A 
receives U.S. source dividend income from U.S. sources. A provision of 
Country X law generally exempts Entity A's income from Country X tax due 
to the fact that Entity A is established and operated exclusively for 
religious, charitable, scientific, artistic, cultural, or educational 
purposes. But for such provision, Entity A's income would be taxed by 
Country X.
    (ii) Analysis. Entity A is not fiscally transparent under paragraph 
(d)(3)(ii) of this section with respect to the U.S. source dividend 
income because, under Country X law, the dividend income is treated as 
an item of income of A and no other persons are required to take into 
account their respective share of the item of income on a current basis, 
whether or not distributed. Accordingly, Entity A is treated as deriving 
the U.S. source dividend income.
    Example 12. Treatment of pension trusts. (i) Facts. Entity A is a 
trust established and operated in Country X exclusively to provide 
pension or other similar benefits to employees pursuant to a plan. 
Entity A receives U.S. source dividend income. A provision of Country X 
law generally exempts Entity A's income from Country X tax due to the 
fact that Entity A is established and operated exclusively to provide 
pension or other similar benefits to employees pursuant to a plan. Under 
the laws of Country X, the beneficiaries of the trust are not required 
to take into account their respective share of A's income on a current 
basis, whether or not distributed and the character and source of the 
income in the hands of A's interest holders are not determined as if 
realized directly from the source from which realized by A.
    (ii) Analysis. A is not fiscally transparent under paragraph 
(d)(3)(ii) of this section with respect to the U.S. source dividend 
income because under the laws of Country X, the beneficiaries of A are 
not required to take into account their respective share of A's income 
on a current basis, whether or not distributed. A is also not fiscally 
transparent under paragraph (d)(3)(ii) of this section with respect to 
the U.S. source dividend income because under the laws of Country X, the 
character and source of the income in the hands of A's interest holders 
are not determined as if realized directly from the source from which 
realized by A. Accordingly, A derives the U.S. source dividend income 
for purposes of the U.S.-X income tax treaty.

    (6) Effective dates. This paragraph (d) applies to items of income 
paid on or after June 30, 2000, except paragraphs (d)(2)(ii) and 
(d)(2)(iii) of this section apply to items of income paid by a domestic 
reverse hybrid entity on or after June 12, 2002 with respect to

[[Page 592]]

amounts received by the domestic reverse hybrid entity on or after June 
12, 2002.
    (e) Effective/applicability date. Paragraphs (a) and (b) of this 
section apply for taxable years beginning after December 31, 1966. For 
corresponding rules applicable to taxable years beginning before January 
1, 1967, (see 26 CFR part 1 revised April 1, 1971). Paragraph (c)(1) of 
this section applies to payments made after November 13, 1997. Paragraph 
(c)(2) of this section applies to payments made on or after December 5, 
2013. See paragraph (d)(6) of this section for applicability dates for 
paragraph (d) of this section.

[T.D. 7293, 38 FR 32800, Nov. 28, 1973, as amended by T.D. 8735, 62 FR 
53502, Oct. 14, 1997; T.D. 8889, 65 FR 40997, July 3, 2000; 65 FR 76932, 
Dec. 8, 2000; T.D. 8999, 67 FR 40160, June 12, 2002; T.D. 9648, 78 FR 
73080, Dec. 5, 2013]



Sec.  1.895-1  Income derived by a foreign central bank of issue, 
or by Bank for International Settlements, from obligations 
of the United States or from bank deposits.

    (a) In general. Income derived by a foreign central bank of issue 
from obligations of the United States or of any agency or 
instrumentality thereof, or from interest on deposits with persons 
carrying on the banking business, is excluded from the gross income of 
such bank and is exempt from income tax if the bank is the owner of the 
obligations or deposits and does not hold the obligations or deposits 
for, or use them in connection with, the conduct of a commercial banking 
function or other commercial activity by such bank. For purposes of this 
section and paragraph (i) of Sec.  1.1441-4, obligations of the United 
States or of any agency or instrumentality thereof include beneficial 
interests, participations, and other instruments issued under section 
302(c) of the Federal National Mortgage Association Charter Act (12 
U.S.C. 1717). See 24 CFR part 1600 et seq.
    (b) Foreign central bank of issue. (1) A foreign central bank of 
issue is a bank which is by law or government sanction the principal 
authority, other than the government itself, issuing instruments 
intended to circulate as currency. Such a bank is generally the 
custodian of the banking reserves of the country under whose law it is 
organized. See also paragraph (b)(5) of Sec.  1.861-2.
    (2) The exclusion granted by section 895 applies to an 
instrumentality that is separate from a foreign government, whether or 
not owned in whole or in part by a foreign government. For example, 
foreign banks organized along the lines of, and performing functions 
similar to, the Federal Reserve System qualify as foreign central banks 
of issue for purposes of this section.
    (3) The Bank for International Settlements shall be treated as 
though it were a foreign central bank of issue for purposes of obtaining 
the exclusion granted by section 895.
    (c) Ownership of United States obligations or bank deposits. The 
exclusion does not apply if the obligations or bank deposits from which 
the income is derived are not owned by the foreign central bank of 
issue. Obligations held, or deposits made, by a foreign central bank of 
issue as agent, custodian, trustee, or in any other fiduciary capacity, 
shall be considered as not owned by such bank for purposes of this 
section.
    (d) Commercial banking function or other commercial activity. The 
exclusion applies only to obligations of the United States or of any 
agency or instrumentality thereof, or to bank deposits, held for, or 
used in connection with, the conduct of a central banking function and 
not to obligations or deposits held for, or used in connection with, the 
conduct of commercial banking functions or other commercial activities 
by the foreign central bank.
    (e) Other exclusions. See section 861(a)(1) (A) and (E) and Sec.  
1.861-2(b) (1) and (4), for special rules relating to interest paid or 
credited before January 1, 1977, on deposits and on similar amounts and 
for rules on interest derived from bankers' acceptances. For exemption 
from withholding under Sec.  1.1441-1 on income derived by a foreign 
central bank of issue, or by the Bank of International Settlements, from 
obligations of the United States or of any agency or instrumentality 
thereof, or from bank deposits, see Sec.  1.1441-4(i).
    (f) Effective date. This section shall apply with respect to taxable 
years beginning after December 31, 1966. For

[[Page 593]]

corresponding rules applicable to taxable years beginning before January 
1, 1967, see 26 CFR 1.85-1 (Revised as of January 1, 1972).

[T.D. 7378, 40 FR 45435, Oct. 2, 1975; 40 FR 48508, Oct. 16, 1975]



Sec.  1.897-1  Taxation of foreign investment in United States 
real property interests, definition of terms.

    (a) In general--(1) Purpose and scope of regulations. These 
regulations provide guidance with respect to the taxation of foreign 
investments in U.S. real property interests and related matters. This 
section defines various terms for purposes of sections 897, 1445, and 
6039C and the regulations thereunder. Section 1.897-2 provides rules 
regarding the definition of, and consequences of, U.S. real property 
holding corporation status. Section 1.897-3 sets forth rules pursuant to 
which certain foreign corporations may elect under section 897(i) to be 
treated as domestic corporations for purposes of sections 897 and 6039C. 
Finally, Sec.  1.987-4 provides rules concerning the similar election 
under section 897(k) for certain foreign corporations in the process of 
liquidation.
    (2) Effective date. The regulations set forth in Sec. Sec.  1.897-1 
through 1.897-4 are effective for transactions occurring after June 18, 
1980. However, with respect to all transactions occurring after June 18, 
1980 and before January 30, 1985, taxpayers may at their option choose 
to apply the Temporary Regulations under section 897 (in their 
entirety). The Temporary Regulations are located at 26 CFR 6a.897-1 
through 6a.897-4 (Revised as of April 1, 1983), and were originally 
published in the Federal Register for September 21, 1982 (47 FR 41532) 
and amended by T.D. 7890, published in the Federal Register on April 28, 
1983 (48 FR 19163).
    (b) Real property--(1) In general. The term ``real property'' 
includes the following three categories of property: Land and unserved 
natural products of the land, improvements, and personal property 
associated with the use of real property. The three categories of real 
property are defined in subparagraphs (2), (3), and (4) of this 
paragraph (b). Local law definitions will not be controlling for 
purposes of determining the meaning of the term ``real property'' as it 
is used in sections 897, 1445, and 6039C and the regulations thereunder.
    (2) Land and unserved natural products of the land. The term ``real 
property'' includes land, growing crops and timber, and mines, wells, 
and other natural deposits. Crops and timber cease to be real property 
at the time that they are served from the land. Ores, minerals, and 
other natural deposits cease to be real property when they are extracted 
from the ground. The storage of severed or extracted crops, timber, or 
minerals in or upon real property will not cause such property to be 
recharacterized as real property.
    (3) Improvements--(i) In general. The term ``real property'' 
includes improvements on land. An improvement is a building, any other 
inherently permanent structure, or the structural components of either, 
as defined in subdivisions (ii) through (iv) of this paragraph (b)(3).
    (ii) Building. The term ``building'' generally means any structure 
or edifice enclosing a space within its walls, and usually covered by a 
roof, the purpose of which is, for example, to provide shelter or 
housing or to provide working, office, parking, display, or sales space. 
The term includes, for example, structures such as apartment houses, 
factory and office buildings, warehouses, barns, garages, railway or bus 
stations, and stores. Any structure that is classified as a building for 
purposes of section 48(a)(1)(B) and Sec.  1.48-1 shall be treated as 
such for purposes of this section.
    (iii) Inherently permanent structure--(A) In general. The term 
``inherently permanent structure'' means any property not otherwise 
described in this paragraph (b)(3) that is affixed to real property and 
that will ordinarily remain affixed for an indefinite period of time. 
Property that is not classified as a building for purposes of section 
48(a)(1)(B) and Sec.  1.48-1 may nevertheless constitute an inherently 
permanent structure. For purposes of this section, affixation to real 
property may be accomplished by weight alone.
    (B) Use of precedents under section 48. Any property not otherwise 
described

[[Page 594]]

in this paragraph (b)(3) that constitutes ``other tangible property'' 
under the principles of section 48(a)(1)(B) and Sec.  1.48-1 (c) and (d) 
shall be treated for purposes of this section as an inherently permanent 
structure. Thus, for example, the term includes swimming pools, paved 
parking areas and other pavements, special foundations for heavy 
equipment, wharves and docks, bridges, fences, inherently permanent 
advertising displays, inherently permanent outdoor lighting facilities, 
railroad tracks and signals, telephone poles, permanently installed 
telephone and television cables, broadcasting towers, oil derricks, oil 
and gas pipelines, oil and gas storage tanks, grain storage bins, and 
silos. However, property that is determined to be either property in the 
nature of machinery under Sec.  1.48-1(c) or property which is 
essentially an item of machinery or equipment under Sec.  1.48-
1(e)(1)(i) shall not be treated as an inherently permanent structure.
    (C) Absence of precedents under section 48. Where precedents 
developed under the principles of section 48 fail to provide adequate 
guidance with respect to the classification of particular property, the 
determination of whether such property constitutes an inherently 
permanent structure shall be made in view of all the facts and 
circumstances. In particular, the following factors must be taken into 
account:
    (1) The manner in which the property is affixed to real property;
    (2) Whether the property was designed to be easily removable or to 
remain in place indefinitely;
    (3) Whether the property has been moved since its initial 
installation;
    (4) Any circumstances that suggest the expected period of affixation 
(e.g., a lease that requires removal of the property upon its 
expiration);
    (5) The amount of damage that removal of the property would cause to 
the property itself or to the real property to which it is affixed; and
    (6) The extent of the effort that would be required to remove the 
property, in terms of time and expense.
    (iv) Structural components of buildings and other inherently 
permanent structures. Structural components of buildings and other 
inherently permanent structures, as defined in Sec.  1.48-1 (e)(2), 
themselves constitute improvements. Structural components include walls, 
partitions, floors, ceilings, windows, doors, wiring, plumbing, central 
heating and central air conditioning systems, lighting fixtures, pipes, 
ducts, elevators, escalators, sprinkler systems, fire escapes and other 
components relating to the operation or maintenance of a building. 
However, the term ``structural components'' does not include machinery 
the sole justification for the installation of which is the fact that 
such machinery is required to meet temperature or humidity requirements 
which are essential for the operation of other machinery or the 
processing of materials or foodstuffs. Machinery may meet the ``sole 
justification'' test provided by the preceding sentence even though it 
incidentally provides for the comfort of employees or serves to an 
insubstantial degree areas where such temperature or humidity 
requirements are not essential.
    (4) Personal property associated with the use of the real property--
(i) In general. The term ``real property'' includes movable walls, 
furnishings, and other personal property associated with the use of the 
real property. Personal property is associated with the use of real 
property only if it is described in one of the categories set forth in 
subdivisions (A) through (D) of this paragraph (b)(4)(i). ``Personal 
property'' for purposes of this section means any property that 
constitutes ``tangible personal property'' under the principles of Sec.  
1.48-1(c), without regard to whether such property qualifies as section 
38 property. Such property will be associated with the use of the real 
property only where both the personal property and the United States 
real property interest with which it is associated are held by the same 
person or by related persons within the meaning of Sec.  1.897-1(i). For 
purposes of this paragraph (b)(4)(i), property is used ``predominantly'' 
in a named activity if it is devoted to that activity during at least 
half of the time in which it is in use during a calendar year.

[[Page 595]]

    (A) Property used in mining, farming, and forestry. Personal 
property is associated with the use of real property if it is 
predominantly used to exploit unsevered natural products in or upon the 
land. Such property includes mining equipment used to extract ores, 
minerals, and other natural deposits from the ground. It also includes 
any property used to cultivate the soil and harvest its products, such 
as farm machinery, draft animals, and equipment used in the growing and 
cutting of timber. However, personal property used to process or 
transport minerals, crops, or timber after they are severed from the 
land is not associated personal property.
    (B) Property used in the improvement of real property. Personal 
property is associated with the use of real property if it is 
predominantly used to construct or otherwise carry out improvements to 
real property. Such property includes equipment used to alter the 
natural contours of the land, equipment used to clear and prepare raw 
land for construction, and equipment used to carry out the construction 
of improvements.
    (C) Property used in the operation of a lodging facility. Personal 
property is associated with the use of real property if it is 
predominantly used in connection with the operation of a lodging 
facility. Property that is used in connection with the operation of a 
lodging facility includes property used in the living quarters of such 
facility, such as beds and other furniture, refrigerators, ranges and 
other equipment, as well as property used in the common areas of such 
facility, such as lobby furniture and laundry equipment. Such property 
constitutes personal property associated with the use of real property 
in the hands of the owner or operator of the facility, not of the tenant 
or guest. A lodging facility is an apartment house or apartment, hotel, 
motel, dormitory, residence, or any other facility (or part of a 
facility) predominantly used to provide, at a charge, living and/or 
sleeping accommodations, whether on daily, weekly, monthly, annual, or 
other basis. The term ``lodging facility'' does not include a personal 
residence occupied solely by its owner, or a facility used primarily as 
a means of transportation (such as an aircraft, vessel, or a railroad 
car) or used primarily to provide medical or convalescent services, even 
though sleeping accommodations are provided. Nor does the term include 
temporary living quarters provided by an employer due to the 
unavailability of lodgings within a reasonable distance of a work-site 
(such as a mine or construction project). The term ``lodging facility'' 
does not include any portion of a facility that constitutes a nonlodging 
commercial facility and that is available to persons not using the 
lodging facility on the same basis that it is available to tenants of 
the lodging facility. Examples of nonlodging commercial facilities 
include restaurants, drug stores, and grocery stores located in a 
lodging facility.
    (D) Property used in the rental of furnished office and other work 
space. Personal property is associated with the use of real property if 
it is predominantly used by a lessor to provide furnished office or 
other work space to lessees. Property that is so used includes office 
furniture and equipment included in the rental of furnished space. Such 
property constitutes personal property associated with the use of real 
property in the hands of the lessor, not of the lessee.
    (ii) Dispositions of associated personal property--(A) In general. 
Personal property that has become associated with the use of a real 
property interest shall itself be treated as a real property interest 
upon its disposition, unless either:
    (1) The personal property is disposed of more than one year before 
the disposition of any present right to use or occupy the real property 
with which it was associated (and subject to the provisions of 
subdivision (B) of this paragraph (b)(4)(ii));
    (2) The personal property is disposed of more than one year after 
the disposition of all present rights to use or occupy the real property 
with which it was associated (and subject to the provisions of 
subdivision (C) of this paragraph (b)(4)(ii)); or
    (3) The personal property and the real property with which it was 
associated are separately sold to persons that are related neither to 
the transferor

[[Page 596]]

nor to one another (and subject to the provisions of subdivision (D) of 
this paragraph (b)(4)(ii)).
    (B) Personalty property disposed of one year before realty. A 
transferor of personal property associated with the use of real property 
need not treat such property as a real property interest upon 
disposition if on the date of disposition the transferor does not expect 
or intend to dispose of the real property until more than one year 
later.


However, if the real property is in fact disposed of within the 
following year, the transferor must treat the personal property as 
having been a real property interest as of the date on which the 
personalty was disposed of. If the transferor had not previously filed 
an income tax return, a return must be filed and tax paid, together with 
any interest due thereon, by the later of the date on which a tax return 
or payment is actually due (with extensions), or the 60th day following 
the date of disposition. If the transferor had previously filed an 
income tax return, an amended return must be filed and tax paid, 
together with any interest due thereon, by the later of the dates 
specified above. Such a transferor may be liable to penalties for 
failure to file, for late payment of tax, or for understatement of 
liability, but only if the transferor knew or had reason to anticipate 
that the real property would be disposed of within one year of the 
disposition of the associated personal property.
    (C) Personalty disposed of one year after realty. A disposition of 
real property shall be disregarded for purposes of subdivision (A)(2) of 
this paragraph (b) (4)(ii) if any right to use or occupy the real 
property is reacquired within the one-year period referred to in that 
subdivision. However, the disposition shall not be disregarded if such 
reacquisition is made in foreclosure of a mortgage or other security 
interest, in the exercise of a contractual remedy, or in the enforcement 
of a judgment. If, however, the reacquisition of the porperty is made 
pursuant to a plan the principal purpose of which is the avoidance of 
the provisions of section 897, 1445, or 6039C and the regulations 
thereunder, then the initial disposition shall be disregarded for 
purposes of subdivision (A)(2) of this paragraph (b)(4)(ii).
    (D) Separate dispositions of personalty and realty. A transferor of 
personal property associated with the use of real property need not 
treat such property as a real property interest upon disposition if 
within 90 days before or after such disposition the transferor 
separately disposes of the real property interest to persons that are 
related neither to the transferor nor to the purchaser of the personal 
property. A transferor may rely upon this rule unless the transferor 
knows or has reason to know that the purchasers of the real property and 
the personal property--
    (1) Are related persons; or
    (2) Intend to reassociate the personal property with the use of the 
real property within one year of the date of disposition of the personal 
property.
    (E) Status of property in hands of transferee. Personal property 
that has been associated with the use of real property and that is sold 
to an unrelated party will be treated as real property in the hands of 
the transferee only if the personal property becomes associated with the 
use of real property held or acquired by the transferee, in the manner 
described in paragraph (b)(4)(i) of this section.
    (iii) Determination dates. The determination of whether personal 
property is personal property associated with the use of real property 
as defined in this paragraph (b)(4) is to be made on the date the 
personal property is disposed of and on each applicable determination 
date. See Sec.  1.897-2(c).
    (c) United States real property interest--(1) In general. The term 
``United States real property interest'' means any interest, other than 
an interest solely as a creditor, in either:
    (i) Real property located in the United States or the Virgin 
Islands, or
    (ii) A domestic corporation unless it is established that the 
corporation was not a U.S. real property holding corporation within the 
period described in section 897(c)(1)(A)(ii).
    In addition, for the limited purpose of determining whether any 
corporation is a U.S. real property holding corporation, the term 
``United States real property interest'' means an interest,

[[Page 597]]

other than an interest solely as a creditor, in a foreign corporation 
unless it is established that the foreign corporation is not a U.S. real 
property holding corporation within the period prescribed in section 
897(c)(1)(A)(ii). See Sec.  1.897-2 for rules regarding the manner of 
establishing that a corporation is not a United States real property 
holding corporation.
    (2) Exceptions and special rules--(i) Domestically-controlled REIT. 
An interest in a domestically-controlled real estate investment trust 
(REIT) is not a U.S. real property interest. A domestically-controlled 
REIT is one in which less than 50 percent of the fair market value of 
the outstanding stock was directly or indirectly held by foreign persons 
during the five-year period ending on the applicable determination date 
(or the period since June 18, 1980, if shorter). For purposes of this 
determination the actual owners of stock, as determined under Sec.  
1.857-8, must be taken into account.
    (ii) Corporation that has disposed of all U.S. real property 
interests. The term ``United States real property interest'' does not 
include an interest in a corporation which has disposed of all its U.S. 
real property interests in transactions in which the full amount of 
gain, if any, was recognized, as provided by section 897(c)(1)(B). See 
Sec.  1.897-2(f) for rules regarding the requirements of section 
897(c)(1)(B).
    (iii) Publicly-traded corporations. If, at any time during the 
calendar year, any class of stock of a domestic corporation is regularly 
traded on an established securities market, an interest in such 
corporation shall be treated as a U.S. real property interest only in 
the case of:
    (A) A regularly traded interest owned by a person who beneficially 
owned more than 5 percent of the total fair market value of that class 
of interests at any time during the five-year period ending either on 
the date of disposition of such interest or other applicable 
determination date (or the period since June 18, 1980, in shorter), or
    (B) [Reserved]


Separate non-regularly traded interests that were acquired in 
transactions more than three years apart shall not be cumulated pursuant 
to this rule. In determining whether a shareholder holds 5 percent of a 
class of stock in a corporation (or any other interest of an equivalent 
fair market value), section 318(a) shall apply (except that sections 
318(a) (2)(C) and (3)(C) are applied by substituting the phrase ``5 
percent'' for ``50 percent'').
    (iv) Publicly traded partnerships and trusts. If any class of 
interests in a partnership or trust is, within the meaning of Sec.  
1.897-1(m) and (n), regularly traded on an established securities 
market, then for purposes of sections 897(g) and 1445 and Sec.  1.897-2 
(d) and (e) an interest in the entity shall not be treated as an 
interest in a partnership or trust. Instead, such an interest shall be 
subject to the rules applicable to interests in publicly traded 
corporations pursuant to paragraph (c)(2)(iii) of this section. Such 
interests can be real property interests in the hands of a person that 
holds a greater than 5 percent interest. Therefore, solely for purposes 
of determining whether greater than 5 percent interests in such an 
entity constitute U.S. real property interests the disposition of which 
is subject to tax, the entity is required to determine pursuant to the 
provisions of Sec.  1.897-2 whether the assets it holds would cause it 
to be classified as a U.S. real property holding corporation if it were 
a corporation. The treatment of dispositions of U.S. real property 
interests by publicly traded partnerships and trusts is not affected by 
the rules of this paragraph (c)(2)(iv); by reason of the operation of 
section 897(a), foreign partners or beneficiaries are subject to tax 
upon their distributive share of any gain recognized upon such 
dispositions by the partnership or trust. The rules of this paragraph 
(c)(2)(iv) are illustrated by the following example.

    Example. PTP is a partnership one class of interests in which is 
regularly traded on an established securities market. A is a nonresident 
alien individual who owns 1 percent of a class of limited partnership 
interests in PTP. B is a nonresident alien individual who owns 10 
percent of the same class of limited partnership interests in PTP. On 
July 1, 1986, A and B sell their interests in PTP. Pursuant to the rules 
of this paragraph (c)(2)(iv), neither disposition is treated as the 
disposition of a partnership interest subject to the provisions of 
section 897(g). Instead, A and B are treated as having disposed of 
interests in a

[[Page 598]]

publicly traded corporation. Therefore, pursuant to the rule of 
paragraph (c)(2)(iii) of this section, A's disposition of a 1 percent 
interest has no consequences under section 897. However, B's disposition 
of a 10 percent interest will constitute the disposition of a U.S. real 
property interest subject to tax by reason of the operation of section 
897 unless it is established pursuant to the rules of Sec.  1.897-2 that 
the interest is not a U.S. real property interest.

    (d) Interest other than an interest solely as a creditor--(1) In 
general. This paragraph defines an interest other than an interest 
solely as a creditor, with respect to real property, and with respect to 
corporations, partnerships, trusts, and estates. An interest solely as a 
creditor either in real property or in a domestic corporation does not 
constitute a United States real property interest. Similarly, where one 
corporation holds an interest solely as a creditor in a second 
corporation or in a partnership, trust, or estate, that interest will be 
disregarded for purposes of determining whether the first corporation is 
a U.S. real property holding corporation (except to the extent that such 
interest constitutes an asset used or held for use in a trade or 
business, in accordance with rules of Sec.  1.897-1(f)). In addition, 
the disposition of an interest solely as a creditor in a parnership, 
trust, or estate is not subject to sections 897, 1445, and 6039C. 
Whether an interest is considered debt under any provisions of the Code 
is not determinative of whether it constitutes an interest solely as a 
creditor for purpose of sections 897, 1445, and 6039C and the 
regulations thereunder.
    (2) Interests in real property other than solely as creditor--(i) In 
general. An interest in real property other than an interest solely as a 
creditor includes a fee ownership, co-ownership, or leasehold interest 
in real property, a time sharing interest in real property, and a life 
estate, remainder, or reversionary interest in such property. The term 
also includes any direct or indirect right to share in the appreciation 
in the value, or in the gross or net proceeds or profits generated by, 
the real property.
    A loan to an individual or entity under the terms of which a holder 
of the indebtedness has any direct or indirect right to share in the 
appreciation in value of, or the gross or net proceeds or profits 
generated by, an interest in real property of the debtor or of a related 
person is, in its entirety, an interest in real property other than 
solely as a creditor. An interest in production payments described in 
section 636 does not generally constitute an interest in real property 
other than solely as a creditor. However, a right to production payments 
shall constitute an interest in real property other than solely as a 
creditor if it conveys a right to share in the appreciation in value of 
the mineral property. A production payment that is limited to a quantum 
of mineral (including a percentage of recoverable reserves produced) or 
a period of time will be considered to convey a right to share in the 
appreciation in value of the mineral property. The rules of this 
paragraph (d)(2)(i) are illustrated by the following example.

    Example. A, a U.S. citizen, purchases a condominium unit located in 
the United States for $500,000. A makes a $100,000 down payment and 
borrows $400,000 from B, a foreign person, to pay the balance of the 
purchase price. Under the terms of the loan. A is to pay B 13 percent 
annual interest each year for 10 years and 35 percent of the 
appreciation in the fair market value of the condominum at the end of 
the 10-year period. Because B has a right to share in the appreciation 
in value of the condominium, B has an interest other than solely as a 
creditor in the condominium. B's entire interest in the obligation from 
A, therefore, is a United States real property interest.

    (ii) Special rule--(A) Installment obligations. A right to 
installment or other deferred payments from the disposition of an 
interest in real property will constitute an interest solely as a 
creditor if the transferor elects not to have the installment method of 
section 453(a) apply, any gain or loss is recognized in the year of 
disposition, and all tax due is timely paid. See section 1445 and 
regulations thereunder for further guidance concerning the availability 
of installment sale treatment under section 453. If an agreement for the 
payment of tax with respect to an installment sale is entered into with 
the Internal Revenue Service pursuant to section 1445, that agreement 
may specify whether or not the installment obligation will

[[Page 599]]

constitute an interest solely as a creditor. If an installment 
obligation constitutes an interest other than solely as a creditor then 
the receipt of each payment shall be treated as the disposition of an 
interest in real property that is subject to section 897(a) to the 
extent of any gain required to be taken into account pursuant to section 
453.
    If the original holder of an installment obligation that constitutes 
an interest other than solely as a creditor subsequently disposes of the 
obligation to an unrelated party and recognizes gain or loss pursuant to 
section 453B, the obligation will constitute an interest in real 
property solely as a creditor in the hands of the subsequent holder. 
However, if the obligation is disposed of to a related person and the 
full amount of gain realized upon the disposition of the real property 
has not been recognized upon such disposition of the installment 
obligation, then the obligation shall continue to be an interest in real 
property other than solely as a creditor in the hands of the subsequent 
holder subject to the rules of this paragraph (d)(2)(ii)(A).
    In addition, if the obligation is disposed of to any person for a 
principal purpose of avoiding the provisions of sections 897, 1445, or 
6039C, then the obligation shall continue to be an interest in real 
property other than solely as a creditor in the hands of the subsequent 
holder subject to the rules of this paragraph (d)(2)(ii)(A). However, 
rights to payments arising from dispositions that took place before June 
19, 1980, shall in no event constitute interests in real property other 
than solely as a creditor, even if such payments are received after June 
18, 1980. In addition, rights to payments arising from dispositions to 
unrelated parties that took place before January 1, 1985, and that were 
not subject to U.S. tax pursuant to the provisions of a U.S. income tax 
treaty, shall not constitute interests in real property other than 
solely as a creditor, even if such payments are received after December 
31, 1984.
    (B) Options. An option, a contract or a right of first refusal to 
acquire any interest in real property (other than an interest solely as 
a creditor) will itself constitute an interest in real property other 
than solely as a creditor.
    (C) Security interests. A right to repossess or foreclose on real 
property under a mortgage, security agreement, financing statement, or 
other collateral instrument securing a debt will not be considered a 
reversionary interest in, or a right to share in the appreciation in 
value of or gross or net proceeds or profits generated by, an interest 
in real property. Thus, no such right of repossession or foreclosure 
will of itself cause an interest in real property which is otherwise an 
interest solely as a creditor to become an interest other than solely as 
a creditor. In addition, a person acting as mortgagee in possession 
shall not be considered to hold an interest in real property other than 
solely as a creditor, if the mortgagee's interest in the property 
otherwise constitutes an interest solely as a creditor.
    (D) Indexed interest rates. An interest will not constitute a right 
to share in the appreciation in the value of, or gross or net proceeds 
or profits generated by, real property solely because it bears a rate of 
interest that is tied to an index of any kind that is intended to 
reflect general inflation or deflation of prices and interest rates 
(e.g., the Consumer Price Index). However, where an interest in real 
property bears a rate of interest that is tied to an index the principal 
purpose of which is to reflect changes in real property values, the real 
property interest will be considered an indirect right to share in the 
appreciation in value of, or gross or net proceeds or profits generated 
by, real property. Such an indirect right constitutes an interest in 
real property other than solely as a creditor.
    (E) Commissions. A right to payment of a commission, brokerage fee, 
or similar charge for professional services rendered in connection with 
the arrangement or financing of a purchase, sale, or lease of real 
property does not constitute a right to share in the appreciation in 
value of, or gross or net proceeds or profits of, real property solely 
because it is based upon a percentage of the purchase price or rent. 
Thus, a right to a commission earned

[[Page 600]]

by a real estate agent based on a percentage of the sales price does not 
constitute an interest in real property other than solely as a creditor.
    However, a right to a commission, brokerage fee, or similar charge 
will constitute an interest other than solely as a creditor if the total 
amount of the payment is contingent upon appreciation, proceeds, or 
profits of the real property occurring or arising after the date of the 
transaction with respect to which the professional services were 
rendered. For example, a commission earned in connection with the 
purchase of a real property interest that is contingent upon the amount 
of gain ultimately realized by the purchaser will constitute an interest 
in real property other than solely as a creditor.
    (F) Trustees' fees, etc. A right to payment of reasonable 
compensation for services rendered as a trustee, as an administrator of 
an estate, or in a similar capacity does not constitute a right to share 
in the appreciation in the value of, or gross or net proceeds or profits 
of, real property solely because the assets of the trust or estate 
include U.S. real property interests.
    (3) Interest in an entity other than solely as a creditor--(i) In 
general. For purposes of sections 897, 1445, and 6039C, an interest in 
an entity other than an interest solely as a creditor is--
    (A) Stock of a corporation;
    (B) An interest in a partnership as a partner within the meaning of 
section 761(b) and the regulations thereunder;
    (C) An interest in a trust or estate as a beneficiary within the 
meaning of section 643(c) and the regulations thereunder or an ownership 
interest in any portion of a trust as provided in sections 671 through 
679 and the regulations thereunder;
    (D) An interest which is, in whole or in part, a direct or indirect 
right to share in the appreciation in value of an interest in an entity 
described in subdivision (A), (B), or (C) of this paragraph (d)(3)(i) or 
a direct or indirect right to share in the appreciation in value of 
assets of, or gross or net proceeds or profits derived by, the entity; 
or
    (E) A right (whether or not presently exercisable) directly or 
indirectly to acquire, by purchase, conversion, exchange, or in any 
other manner, an interest described in subdivision (A), (B), (C), or (D) 
of this paragraph (d)(3) (i).
    (ii) Special rules--(A) Installment obligations. A right to 
installment or other deferred payments from the disposition of an 
interest in an entity will constitute an interest solely as a creditor 
if the transferor elects not to have the installment method of section 
453(a) apply, any gain or loss is recognized in the year of disposition, 
and tax due is timely paid. See section 1445 and regulations thereunder 
for further guidance concerning the availability of installment sale 
treatment under section 453. If an agreement for the payment of tax with 
respect to an installment sale is entered into with the Internal Revenue 
Service pursuant to section 1445, that agreement may specify whether or 
not the installment obligation will constitute an interest solely as a 
creditor. If an installment obligation constitutes an interest other 
than solely as a creditor then the receipt of each payment shall be 
treated as the disposition of such an interest and shall be subject to 
section 897(a) to the extent that:
    (1) It constitutes the disposition of a U.S. real property interest 
and
    (2) Gain or loss is required to be taken into account pursuant to 
section 453. Such treatment shall apply to payments arising from 
dispositions of interests in a corporation any class of the stock of 
which is regularly traded on an established securities market, but only 
in the case of a disposition of any portion of an interest described in 
paragraph (c)(2)(iii)(A) or (B) of this section. If the original holder 
of an installment obligation that constitutes an interest other than 
solely as a creditor subsequently disposes of the obligation to an 
unrelated party and recognizes gain or loss pursuant to section 453B, 
the obligation will constitute an interest in the entity solely as a 
creditor in the hands of the subsequent holder. However, if the 
obligation is disposed of to a related person and the full amount of 
gain realized upon the disposition of the interest in the entity has not 
been recognized upon such disposition of the installment obligation, 
then the obligation shall continue to be an interest in the entity other 
than

[[Page 601]]

solely as a creditor in the hands of the subsequent holder subject to 
the rules of this paragraph (d)(3)(ii)(A). In addition, if the 
obligation is disposed of to any person for a principal purpose of 
avoiding the provisions of section 897, 1445, or 6039C, then the 
obligation shall continue to be an interest in the entity other than 
solely as a creditor in the hands of the subsequent holder subject to 
the rules of this paragraph (d)(3)(ii)(A). However, rights to payments 
arising from dispositions that took place before June 19, 1980, shall in 
no event constitute interests in an entity other than solely as a 
creditor, even if such payments are received after June 18, 1980. In 
addition, such treatment shall not apply to payments arising from 
dispositions to unrelated parties that took place before January 1, 
1985, and that were not subject to U.S. tax pursuant to the provisions 
of a U.S. income tax treaty, regardless of when such payments are 
received.
    (B) Contingent interests. The interests described in subdivision (D) 
of paragraph (d)(3)(i) of this section include any right to a payment 
from an entity the amount of which is contingent on the appreciation in 
value of an interest described in subdivision (A), (B), or (C) of 
paragraph (d)(3)(i) of this section or which is contingent on the 
appreciation in value of assets of, or the general gross or net proceeds 
or profits derived by, such entity. The right to such a payment is 
itself an interest in the entity other than solely as a creditor, 
regardless of whether the holder of such right actually holds an 
interest in the entity described in subdivision (A), (B), or (C) of 
paragraph (d)(3)(i) of this section. For example, a stock appreciation 
right constitutes an interest in a corporation other than solely as a 
creditor even if the holder of such right actually holds no stock in the 
corporation. However, the interests described in subdivision (D) of 
paragraph (d)(3)(i) of this section do not include any right to a 
payment that is (1) exclusively contingent upon and exclusively paid out 
of revenues from sales of personal property (whether tangible or 
intangible) or from services, or (2) exclusively contingent upon the 
resolution of a claim asserted against the entity by a person related 
neither to the entity nor to the holder of the interest.
    (C) Security interests. A right to repossess or foreclose on an 
interest in an entity under a mortgage, security agreement, financing 
statement, or other collateral instrument securing a debt will not of 
itself cause an interest in an entity which is otherwise an interest 
solely as a creditor to become an interest other than solely as a 
creditor.
    (D) Royalties. The interests described in subdivision (D) of 
paragraph (d)(3)(i) of this section do not include rights to payments 
representing royalties, license fees, or similar charges for the use of 
patents, inventions, formulas, copyrights, literary, musical or artistic 
compositions, trademarks, trade names, franchises, licenses, or similar 
intangible property.
    (E) Commissions. The interests described in subdivision (D) of 
paragraph (d)(3)(i) of this section do not include a right to a 
commission, brokerage fee or similar charge for professional services 
rendered in connection with the purchase or sale of an interest in an 
entity. However, a right to such a payment will constitute an interest 
other than solely as a creditor if the total amount of the payment is 
contingent upon appreciation in value of assets of, or proceeds or 
profits derived by, the entity after the date of the transaction with 
respect to which the payment was earned.
    (F) Trustee's fees. The interests described in subdivision (D) of 
paragraph (d)(3)(i) of this section do not include a right to payment 
representing reasonable compensation for services rendered as a trustee, 
as an administrator of an estate, or in a similar capacity.
    (4) Aggregation of interests. If a person holds both interests 
solely as a creditor and interests other than solely as a creditor in 
real property or in an entity, those interests will generally be treated 
as separate and distinct interests. However, such interests shall be 
aggregated and treated as interests other than solely as a creditor in 
their entirety if the interest solely as a creditor has been separated 
from, or acquired separately from, the interest other than solely as a 
creditor, for a principal purpose of avoiding the provisions of section 
897, 1445, or 6039C by

[[Page 602]]

causing one or more of such interests to be an interest solely as a 
creditor. The existence of such a purpose will be determined with 
reference to all the facts and circumstances. Where an interest solely 
as a creditor has arm's-length interest and repayment terms it shall in 
no event be aggregated with and treated as an interest other than solely 
as a creditor. For purposes of this paragraph (d)(4), an interest rate 
that does not exceed 120 percent of the applicable Federal rate (as 
defined in section 1274(d)) shall be presumed to be an arm's-length 
interest rate. For purposes of applying the rules of this paragraph 
(d)(4), a person shall be treated as holding any interests held by a 
related person within the meaning of Sec.  1.897-1(i).
    (5) ``Interest'' means ``interest other than solely as a creditor.'' 
Unless otherwise stated, the term ``interest'' as used with regard to 
real property or with regard to an entity hereafter in the regulations 
under sections 897, 1445, and 6039C, means an interest in such real 
property or entity other than an interest solely as a creditor.
    (e) Proportionate share of assets held by an entity--(1) In general. 
A person that holds an interest in an entity is for certain purposes 
treated as holding a proportionate or pro rata share of the assets held 
by the entity. Such proportionate share must be calculated, in 
accordance with the rules of this paragraph, for the following purposes.
    (i) In determining whether a corporation is a U.S. real property 
holding corporation--
    (A) A person holding an interest in a partnership, trust, or estate 
is treated as holding a proportionate share of the assets held by the 
partnership, trust, or estate (see section 897-2(e)(2)), and
    (B) A corporation that holds a controlling interest in a second 
corporation is treated as holding a proportionate share of the assets 
held by the second corporation (see Sec.  1.897-2(e)(3)).
    (ii) In determining reporting obligations that may be imposed under 
section 6039C, the holder of an interest in a partnership, trust, or 
estate is treated as owning a proportionate share of the U.S. real 
property interests held by the partnership, trust, or estate.
    (2) Proportionate share of assets held by a corporation or 
partnership--(i) In general. A person's proportionate or pro rata share 
of assets held by a corporation or partnership is determined by 
multiplying--
    (A) The person's percentage ownership interest in the entity, by
    (B) The fair market value of the assets held by the entity (or the 
book value of such assets, in the case of a determination pursuant to 
Sec.  1.897-2(b)(2)).
    (ii) Percentage ownership interest. A person's percentage ownership 
interest in a corporation or partnership is the percentage equal to the 
ratio of (A) the sum of the liquidation values of all interests in the 
entity held by the person to (B) the sum of the liquidation values of 
all outstanding interest in the entity. The liquidation value of an 
interest in an entity is the amount of cash and the fair market value of 
any property that would be distributed with respect to such interest 
upon the liquidation of the entity after satisfaction of liabilities to 
persons having interests in the entity solely as creditors. With respect 
to an entity that has interests outstanding that grant a presently-
exercisable option to acquire or right to convert into or otherwise 
acquire an interest in the entity other than solely as a creditor, the 
liquidation value of all interests in such entity shall be calculated as 
though such option or right had been exercised, giving effect both to 
the payment of any consideration required to exercise the option or 
right and to the issuance of the additional interest.


The fair market value of the assets of the entity, the amount of cash 
held by the entity, and the amount of liabilities to persons having 
interests solely as creditors if determined for this purpose on the date 
with respect to which the percentage ownership interest is determined.
    (iii) Examples. The rules of this paragraph (e)(2) are illustrated 
by the following examples.

    Example 1. Corporation K's only assets are stock and securities with 
a fair market value as of the applicable determination date of 
$20,000,000 K's assets are subject to liabilities of $10,000,000. Among 
K's liabilities are a $1,000,000 loan from L, under the terms of which L 
is entitled, upon payment of the

[[Page 603]]

loan principal, to a profit share equal to 10 percent of the excess of 
the fair market value of K's assets over $18,000,000, but only if all 
other corporate liabilities have been paid. K has two classes of stock, 
common and preferred. PS1 and PS2 each own 100 of the 200 outstanding 
shares of preferred stock. CS1 and CS2 each own 500 of the 1,000 
outstanding shares of common stock. Each preferred shareholder is 
entitled to $10,000 per share of preferred stock upon liquidation, 
subject to payment of all corporate liabilities and to any amount owed 
to L, but before any common shareholder is paid. The liquidation value 
of L's interest in K, which constitutes an interest other than an 
interest solely as a creditor, is $1,200 ($1,000,000 principal of the 
loan to K plus $200,000 (10 percent of the excess of $20,000,000 over 
$18,000,000). The liquidation value of each of PS1's and PS2's blocks of 
preferred stock is $1,000,000 ($10,000 times 100 shares each). The 
liquidation value of each of CS1's and CS2's blocks of common stock is 
$3,900,000 [$20,000,000 (the total fair market value of K's assets)--
$9,000,000 (liabilities to creditors other than L)--$1,200,000 (L's 
liquidation value)--$2,000,000 (PS1's and PS2's liquidation value)) 
times 50 percent (the percentage of common stock owned by each)]. The 
sum of the liquidation values of all of the outstanding interests in K 
(i.e., interests other than solely as a creditor) is $11,000,000 
[$1,200,000 (L's liquidation value) + $2,000,000 (PS1's and PS2's 
liquidation values) + $7,800,000 (CS1's and CS2's liquidation values)]. 
Each of CS1's and CS2's percentage ownership interests in K is 35.5 
percent ($3,900,000 divided by $11,000,000). Each of PS1's and PS2's 
percentage ownership interests in K is 9 percent ($1,000,000 divided by 
$11,000,000). L's percentage ownership interest in K is 11 percent 
($1,200,000 divided by $11,000,000).
    Example 2. A, a U.S. person, and B, a foreign person are partners in 
a partnership the only asset of which is a parcel of undeveloped land 
located in the United States that was purchased by the partnership in 
1980 for $300,000. The partnership has no liabilities, and its capital 
is $300,000. A's and B's interests in the capital of the partnership are 
25 percent and 75 percent, respectively, and A and B each has a 50 
percent profit interest in the partnership. The partnership agreement 
provides that upon liquidation any unrealized gain will be distributed 
in accordance with the partners' profit interest. In 1984 the 
partnership has no items of income or deduction, and the fair market 
value of its parcel of undeveloped land is $500,000. In 1984 the 
percentage ownership interest of A in the partnership is 35 percent [the 
ratio of $100,000 (the liquidation value of A's profit interest in 1984) 
plus $75,000 (the liquidation value of A's 25 percent interest in the 
partnership's $300,000 capital) to $500,000 (the sum of the liquidation 
values of all outstanding interests in the partnership)]. The percentage 
ownership interest of B in the partnership in 1984 is 65 percent [the 
ratio of $325,000 (B's $100,000 profit interest plus his $225,000 
capital interest) to $500,000]

    (3) Proportionate share of assets held by trusts and estates--(i) In 
general. A person's proportionate or pro rata share of assets held by a 
trust or estate is determined by multiplying--
    (A) The person's percentage ownership interest in the trust or 
estate, by
    (B) The fair market value of the assets held by the trust or estate 
(or the book value of such assets, in the case of a determination 
pursuant to Sec.  1.897-2(b)(2)).
    (ii) Percentage ownership interest--(A) General rule. A person's 
percentage ownership interest in a trust or an estate--is the percentage 
equal to the ratio of:
    (1) The sum of the actuarial values of such person's interests in 
the cash and other assets held by the trust or estate after satisfaction 
of the liabilities of the trust or estate to persons holding interests 
in the trust or estate solely as creditors, to (2) the entire amount of 
such cash and other assets after satisfaction of liabilities to persons 
holding interests in the trust or estate solely as creditors. For 
purposes of calculating this ratio, the fair market value of the trust's 
or estate's assets, the amount of cash held by the trust or estate, and 
the amount of the liabilities to persons having interests solely as 
creditors is determined on the date with respect to which the percentage 
ownership interest is determined. With respect to a trust or estate that 
has interests outstanding that grant a presently-exercisable option to 
acquire or right to convert into or otherwise acquire an interest in the 
trust or estate other than solely as a creditor, the liquidation value 
of all interests in such entity shall be calculated as though such 
option or right had been exercised, giving effect both to the payment of 
any consideration required to exercise the option or right and to the 
issuance of the additional interest. With respect to a trust or estate 
that has interests outstanding that entitle any person to a distribution 
of U.S.

[[Page 604]]

real property interests upon liquidation that is disproportionate to 
such person's interest in the total assets of the trust or estate, such 
disproportionate right shall be disregarded in the calculation of the 
interest-holders' proportionate share of the U.S. real property 
interests held by the entity. For purposes of determining his own 
percentage ownership interest in a trust, a grantor or other person will 
be treated as owning any portion of the trust's cash and other assets 
which such person is treated as owning under sections 671 through 679.
    (B) Discretionary trusts and estates. In determining percentage 
ownership interest in a trust or an estate, the sum of the definitely 
ascertainable actuarial values of interests in the cash and the other 
assets of the trust or estate held by persons in existence on the date 
with respect to which such determination is made must equal the amount 
in paragraph (e)(3)(ii)(A)(2) of this section. If the amount in 
paragraph (e)(3)(ii)(A)(2) of this section exceeds the sum of the 
definitely ascertainable actuarial values of the interests held by 
persons in existence on the determination date, the excess will be 
considered to be owned in total by each beneficiary who is in existence 
on such date, whose interest in the excess is not definitely 
ascertainable and who is potentially entitled to such excess. However, 
such excess shall not be considered to be owned in total by each 
beneficiary if the discretionary terms of the trust or estate were 
included for a principal purpose of avoiding the provisions of section 
897, 1445, or 6039C by causing assets other than U.S. real property 
interests to be attributed in total to each beneficiary. The rules of 
this paragraph (e)(3) are illustrated by the following example.

    Example. A, a U.S. person, established a trust on December 31, 1984, 
and contributed real property with a fair market value of $10,000 to the 
trust. The terms of that trust provided that the trustee, a bank that is 
unrelated to A, at its discretion may retain trust income or may 
distribute it to X, a foreign person, or to the head of state of any 
country other than the United States. The remainder upon the death of X 
is to go in equal shares to such of Y and Z, both foreign persons, as 
survive X. On December 31, 1984, the total value of the trust's assets 
is $10,000. On the same date, the actuarial values of the remainder 
interests of Y and Z in the corpus of the trust are definitely 
ascertainable. They are $1,000 and $500, respectively. Neither the 
income interest of X nor of the head of state of any country other than 
the United States has a definitely ascertainable actuarial value on 
December 31, 1984. The interests of Y and Z in the income portion of the 
trust similarly have no definitely ascertainable actuarial values on 
such date since the income may be distributed rather than retained by 
the trust. Since the sum of the actuarial values of definitely 
ascertainable interests of persons in existence ($1,500) is less than 
$10,000, the difference ($8,500) is treated as owned by each beneficiary 
who is in existence on December 31, 1984, and who is potentially 
entitled to such excess. Therefore, X, Y, Z, and the head of state of 
any country other than the United States are each considered as owning 
the entire $8,500 income interest in the trust. On December 31, 1984, 
the total actuarial value of X's interest is $8,500, and his percentage 
ownership interest is 85 percent. The total actuarial value of Y's 
interest in the trust is $9,500 ($1,000 plus $8,500), and his percentage 
ownership interest is 95 percent. The total actuarial value of Z's 
interest is $9,000 ($500 plus $8,500), and his percentage ownership 
interest is 90 percent. The actuarial value of the interest of the head 
of state of each country other than the United States is $8,500, and his 
percentage ownership interest is 85 percent.

    (4) Dates with respect to which percentage ownership interests are 
determined. The dates with respect to which percentage ownership 
interests are determined are the applicable determination dates outlined 
in Sec.  1.897-2 or in regulations under section 6039C.
    (f) Asset used or held for use in a trade or business--(1) In 
general. The term ``asset used or held for use in a trade or business'' 
means--
    (i) Property, other than a U.S. real property interest, that is--
    (A) Stock in trade of an entity or other property of a kind which 
would properly be included in the inventory of the entity if on hand at 
the close of the taxable year, or property held by the entity primarily 
for sale to customers in the ordinary course of its trade or business, 
or
    (B) Depreciable property used or held for use in the trade or 
business, as described in section 1231(b)(1) but without regard to the 
holding period limitations of section 1231(b), or

[[Page 605]]

    (C) Livestock, including poultry, used or held for use in a trade or 
business for draft, breeding, dairy, or sporting purposes, and
    (ii) Goodwill and going concern value, patents, inventions, formulas 
copyrights, literary, musical, or artistic compositions, trademarks, 
trade names, franchises, licenses, customer lists, and similar 
intangible property, but only to the extent that such property is used 
or held for use in the entity's trade or business and subject to the 
valuation rules of Sec.  1.897-1(o)(4), and
    (iii) Cash, stock, securities, receivables of all kinds, options or 
contracts to acquire any of the foregoing, and options or contracts to 
acquire commodities, but only to the extent that such assets are used or 
held for use in the corporation's trade or business and do not 
constitute U.S. real property interests.
    (2) Used or held for use in a trade or business. An asset is used or 
held for use in an entity's trade or business if it is, under the 
principles of Sec.  1.864-4(c)(2)--
    (i) Held for the principal purpose of promoting the present conduct 
of the trade or business,
    (ii) Acquired and held in the ordinary course of the trade or 
business, as, for example, in the case of an account or note receivable 
arising from that trade or business (including the performance of 
services), or
    (iii) Otherwise held in a direct relationship to the trade or 
business.


In determining whether an asset is held in a direct relationship to the 
trade or business, consideration shall be given to whether the asset is 
needed in that trade or business. An asset shall be considered to be 
needed in a trade or business only if the asset is held to meet the 
present needs of that trade or business and not its anticipated future 
needs. An asset shall be considered as needed in the trade or business 
if, for example, the asset is held to meet the operating expenses of 
that trade or business. Conversely, an asset shall be considered as not 
needed in the trade or business if, for example, the asset is held for 
the purpose of providing for future diversification into a new trade or 
business, future expansion of trade or business activities, future plant 
replacement, or future business contingencies. An asset that is held to 
meet reserve or capitalization requirements imposed by applicable law 
shall be presumed to be held in a direct relationship to the trade or 
business.
    (3) Special rules concerning liquid assets--(i) Safe harbor amount. 
Assets described in paragraph (f)(1)(iii) of this section shall be 
presumed to be used or held for use in a trade or business, in an amount 
up to 5 percent of the fair market value of other assets used or held 
for use in the trade or business. However, the rule of this paragraph 
(f)(3)(i) shall not apply with respect to any assets described in 
paragraph (f)(1)(iii) of this section that are held or acquired for the 
principal purpose of avoiding the provisions of section 897 or 1445.
    (ii) Investment companies. Assets described in paragraph (f)(1)(iii) 
of this section shall be presumed to be used or held for use in an 
entity's trade or business if the principal business of the entity is 
trading or investing in such assets for its own account. An entity's 
principal business shall be presumed to be trading or investing in 
assets described in paragraph (f)(1)(iii) of this section if the fair 
market value of such assets held by the entity equals or exceeds 90 
percent of the sum of the fair market values of the entity's U.S. real 
property interests, interests in real property located outside the 
United States, assets otherwise used or held for use in trade or 
business, and assets described in paragraph (f)(1)(iii) of this section.
    (4) Examples. The application of this paragraph (f) may be 
illustrated by the following examples:

    Example 1. M, a domestic corporation engaged in industrial 
manufacturing, is required to hold a large current cash balance for the 
purposes of purchasing materials and meeting its payroll. The amount of 
the cash balance so required varies because of the fluctuating seasonal 
nature of the corporation's business. In months when large cash balances 
are not required, the corpration invests the surplus amount in U.S. 
Treasury bills. Since both the cash and the Treasury bills are held to 
meet the present needs of the business, they are held in a direct 
relationship to that business, and, therefore, constitute assets used or 
held for use in the trade or business.

[[Page 606]]

    Example 2. R, a domestic corporation engaged in the manufacture of 
goods, engages a stock brockerage firm to manage securities which were 
purchased with funds from R's general surplus reserves. The funds 
invested in these securities are intended to provide for the future 
expansion of R into a new trade or business. Thus, the funds are not 
necessary for the present needs of the business; they are accordingly 
not held in a direct relationshp to the business and do not constitute 
assets used or held for use in the trade or business.
    Example 3. B, a federally chartered and regulated bank, is required 
by law to hold substantial reserves of cash, stock, and securities. 
Pursuant to the rule of paragraph (f)(2) of this section, such assets 
are presumed to be held in a direct relationship to B's business, and 
thus constitute assets used or held for use in the trade or business. In 
addition, B holds substantial loan receivables which are acquired and 
held in the ordinary course of its banking business. Pursuant to the 
rule of paragraph (f)(1)(iii) of this section, such receivables 
constitute assets used or held for use in the trade or business.

    (g) Disposition. For purposes of sections 897, 1445, and 6039C, the 
term ``disposition'' means any transfer that would constitute a 
disposition by the transferor for any purpose of the Internal Revenue 
Code and regulations thereunder. The severance of crops or timber and 
the extracion of minerals do not alone constitute the disposition of a 
U.S. real property interest.
    (h) Gain or loss. The amount of gain or loss arising from the 
disposition of the U.S. real property interest shall be determined as 
provided in section 1001 (a) and (b). Such gain or loss shall be subject 
to the provisions of section 897 (a) and (b), unless a nonrecognition 
provision is applicable pursuant to section 897 (d) or (e) and 
regulations thereunder. Amounts otherwise treated for Federal income tax 
purposes as principal and interest payments on debt obligations of all 
kinds (including obligations that are interests other than solely as a 
creditor) do not give rise to gain or loss that is subject to section 
897(a). However, principal payments on installment obligations described 
in Sec. Sec.  1.897-1(d)(2)(ii)(A) and 1.897-1(d)(3)(ii)(A) do give rise 
to gain or loss that is subject to section 897(a), to the extent such 
gain or loss is required to be recognized pursuant to section 453. The 
rules of paragraphs (g) and (h) are illustrated by the following 
examples.

    Example 1. Foreign individual C has an undivided fee interest in a 
parcel of real property located in the United States. The fair market 
value of C's interest is $70,000, and C's basis in such interest is 
$50,000. The only liability to which the real property is subject is the 
liability of $65,000 secured by a mortgage in the same amount. C 
transfers his fee interest in the property subject to the mortgage by 
gift to D. C realizes $15,000 of gain upon such transfer. As a transfer 
by gift constitutes a disposition for purposes of the Code, and as gain 
is realized upon that transfer, the gift is a disposition for purposes 
of sections 897, 1445, and 6039C and is subject to section 897(a) to the 
extent of the gain realized. However, section 897(a) would not be 
applicable to the transfer if the mortgage on the U.S. real property 
were equal to or less than C's $50,000 basis, since the transfer then 
would not give rise to the realization of gain or loss under the 
Internal Revenue Code.
    Example 2. Foreign corporation Y makes a loan of $1 million to 
domestic individual Z, secured by a mortgage on residential real 
property purchased with the loan proceeds. The loan agreement provides 
that Y is entitled to receive fixed monthly payments from Z, 
constituting repayment of principal plus interest at a fixed rate. In 
addition, the agreement provides that Y is entitled to receive a 
percentage of the appreciation value of the real property as of the time 
that the loan is retired. The obligation in its entirety is considered 
debt for Federal income tax purposes. However, because of Y's right to 
share in the appreciation in value of the real property, the debt 
obligation gives Y an interest in the real property other than solely as 
a creditor. Nevertheless, as principal and interest payments do not 
constitute gain under section 1001 and paragraph (h) of this section, 
and both the monthly and final payments received by Y are considered to 
consist solely of principal and interest for Federal income tax 
purposes, section 897(a) shall not apply to Y's receipt of such 
payments. However, Y's sale of the debt obligation to foreign 
corporation A would give rise to gain that is subject to section 897(a).

    (i) Related person. For purposes of sections 897, 1445, and 6039C, 
persons are considered to be related if they are partners or 
partnerships described in section 707(b)(1) of the Code or if they are 
related within the meaning of section 267 (b) and (c) of the Code 
(except that section 267(f) shall apply without regard to section 
1563(b)(2)).
    (j) Domestic corporation. The term ``domestic corporation'' has the 
same meaning as set forth in section 7701(a) (3) and (4) and Sec.  
301.7701-5. For purposes

[[Page 607]]

of sections 897 and 6039C, it also includes a foreign corporation with 
respect to which an election under section 897(i) and Sec.  1.897-3 or 
section 897(k) and Sec.  1.897-4 to be treated as domestic corporation 
is in effect.
    (k) [Reserved]
    (l) Foreign corporation. The term ``foreign corporation'' has the 
meaning ascribed to such term in section 7701(a) (3) and (5) and Sec.  
301.7701-5. For purposes of sections 897 and 6039C, however, the term 
does not include a foreign corporation with respect to which there is in 
effect an election under section 897(i) and Sec.  1.897-3 or section 
897(k) and Sec.  1.897-4 to be treated as a domestic corporation.
    (m) Established securities market. For purposes of sections 897, 
1445, and 6039C, the term ``established securities market'' means--
    (1) A national securities exchange which is registered under section 
6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f),
    (2) A foreign national securities exchange which is officially 
recognized, sanctioned, or supervised by governmental authority, and
    (3) Any over-the-counter market. An over-the-counter market is any 
market reflected by the existence of an interdealer quotation system. An 
interdealer quotation system is any system of general circulation to 
brokers and dealers which regularly disseminates quotations of stocks 
and securities by identified brokers or dealers, other than by quotation 
sheets which are prepared and distributed by a broker or dealer in the 
regular course of business and which contain only quotations of such 
broker or dealer.
    (n) [Reserved]
    (o) Fair market value--(1) In general. For purposes of sections 897, 
1445, and 6039C only, the term ``fair market value'' means the value of 
the property determined in accordance with the rules, contained in this 
paragraph (o). The definition of fair market value provided herein is 
not to be used in the calculation of gain or loss from the disposition 
of a U.S. real property interest pursuant to section 1001. An 
independent professional appraisal of the value of property must be 
submitted only if such an appraisal is specifically requested in 
connection with the negotiation of a security agreement pursuant to 
section 1445.
    (2) Method of calculating fair market value--(i) In general. The 
fair market value of property is its gross value (as defined in 
paragraph (o)(2)(ii) of this section) reduced by the outstanding balance 
of any debts secured by the property which are described in paragraph 
(o)(2)(iii) of this section. See Sec.  1.897-2(b) for the alternative 
use of book values in certain limited circumstances.
    (ii) Gross value. Gross value is the price at which the property 
would change hands between an unrelated willing buyer and willing 
seller, neither being under any compulsion to buy or to sell and both 
having reasonable knowledge of all relevant facts. Generally, with 
respect to trade or business assets, going concern value should be used 
as it will provide the most accurate reflection of such a price. 
However, taxpayers may use other methods of valuation if they can 
establish that such method will provide a more accurate determination of 
gross value and if they consistently apply such method to all assets to 
be valued. See subdivisions (3) and (4) of this paragraph (o) for 
special rules with respect to the valuation of leases and of intangible 
assets.
    (iii) Debts secured by the property. The gross value of property 
shall be reduced by the outstanding balance of debts that are:
    (A) Secured by a mortgage or other security interest in the property 
that is valid and enforceable under the law of the jurisdiction in which 
the property is located, and
    (B) Either (1) Incurred to acquire the property (including long-term 
financing obtained in replacement of construction loans or other short-
term debt within one year of the acquisition or completion of the 
property), or (2) otherwise incurred in direct connection with the 
property, such as property tax liens upon real property or debts 
incurred to maintain or improve property.


In addition, if any debt described in this paragraph (o)(2)(iii) is 
refinanced for a valid business purpose (such as

[[Page 608]]

obtaining a more favorable rate of interest), the principal amount of 
the replacement debt does not exceed the outstanding balance of the 
original debt, and the replacement debt is secured by the property, then 
the gross value of the property shall be reduced by the replacement 
debt. Obligations to related persons shall not be taken into account for 
purposes of this paragraph (o)(2)(iii) unless such obligations 
constitute interests solely as a creditor pursuant to the provisions of 
paragraph (d)(4) of this section and unless the related person has made 
similar loans to unrelated persons on similar terms and conditions.
    (iv) Anti-abuse rule. The gross value of real property located 
outside the United States and of assets used or held for use in a trade 
or business shall be reduced by the outstanding balance of any debt that 
was entered into for the principal purpose of avoiding the provisions of 
section 897, 1445, or 6039C by enabling the corporation to acquire such 
assets. The existence of such a purpose shall be determined with 
reference to all the facts and circumstances. Debts that a particular 
corporation routinely enters into in the ordinary course of its 
acquisition of assets used or held for use in its trade or business will 
not be considered to be entered into for the principal purpose of 
avoiding the provisions of section 897, 1445, or 6039C.
    (3) Fair market value of leases and options. For purposes of 
sections 897, 1445, and 6039C, the fair market value of a leasehold 
interest in real property is the price at which the lease could be 
assigned or the property sublet, neither party to such transaction being 
under any compulsion to enter into the transaction and both having 
reasonable knowledge of all relevant facts. Thus, the value of a 
leasehold interest will generally consist of the present value, over the 
period of the lease remaining, of the difference between the rental 
provided for in the lease and the current rental value of the real 
property. A leasehold interest bearing restrictions on its assignment or 
sublease has a fair market value of zero, but only if those restrictions 
in practical effect preclude (rather than merely condition) the lessee's 
ability to transfer, at a gain, the benefits of a favorable lease. The 
normal commercial practice of lessors may be used to determine whether 
restrictions in a lease have the practical effect of precluding transfer 
at a gain. The fair market value of an option to purchase any property 
is, similarly, the price at which the option could be sold, consisting 
generally of the difference between the option price and the fair market 
value of the property, taking proper account of any restrictions upon 
the transfer of the option.
    (4) Fair market value of intangible assets. For purposes of 
determining whether a corporation is a U.S. real property holding 
corporation, the fair market value of intangible assets described in 
Sec.  1.897-1(f)(1)(ii) may be determined in accordance with the 
following rules.
    (i) Purchase price. Intangible assets described in Sec.  1.897-
1(f)(1)(ii) that were acquired by purchase from a person not related to 
the purchaser within the meaning of Sec.  1.897-1(i) may be valued at 
their purchase price. However, such purchase price must be adjusted to 
reflect any amortization required by generally accepted accounting 
principles applied in the United States. Intangible assets acquired by 
purchase shall include any amounts allocated to goodwill or going 
concern valued pursuant to section 338(b)(3) and regulations thereunder. 
Intangible assets acquired by purchase shall not include assets that 
were acquired indirectly through an acquisition of stock to which 
section 338 does not apply. Such assets must be value pursuant to a 
method described in subdivision (ii) or (iii) of this paragraph (o)(4).
    (ii) Book value. Intangible assets described in Sec.  1.897-
1(f)(1)(ii) (other than good will and going concern value) may be valued 
at the amount at which such assets are carried on the financial 
accounting records of the holder of such assets, provided that such 
amount is determined in accordance with generally accepted accounting 
principles applied in the United States. However, this method may not be 
used with respect to assets acquired by purchase from a related person 
within the meaning of Sec.  1.897-1(i).

[[Page 609]]

    (iii) Other methods. Intangible assets described in Sec.  1.897-
1(f)(1)(ii) may be valued pursuant to any other reasonable method at an 
amount reflecting the price at which the asset would change hands 
between an unrelated willing buyer and willing seller, neither being 
under any compulsion to buy or to sell and both having reasonable 
knowledge of all relevant facts. However, a corporation that uses a 
method of valuation other than the purchase price or book value methods 
may be required to comply with the special notification requirements of 
Sec.  1.897-2(h)(1)(iii)(A).
    (p) Identifying number. The ``identifying number'' of an individual 
is the individual's United States social security number or the 
identification number assigned by the Internal Revenue Service (see 
Sec.  301.6109-1 of this chapter). The ``identifying number'' of any 
other person is its United States employer identification number.

(Approved by the Office of Management and Budget under control number 
l545-0123)

(Sec. 897 (94 Stat. 2683; 26 U.S.C. 897), sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the 
Internal Revenue Code of 1954)

[T.D. 7999, 49 FR 50693, Dec. 31, 1984; 50 FR 12530, Mar. 29, 1985, as 
amended by T.D. 8113, 51 FR 46626, Dec. 24, 1986; T.D. 8198, 53 FR 
16217, May 5, 1988; T.D. 8657, 61 FR 9343, Mar. 8, 1996; 61 FR 14248, 
Apr. 1, 1996; T.D. 9082, 68 FR 46082, Aug. 5, 2003]



Sec.  1.897-2  United States real property holding corporations.

    (a) Purpose and scope. This section provides rules regarding the 
definition and consequences of U.S. real property holding corporation 
status. U.S. real property holding corporation status is important for 
determining whether gain from the disposition by a foreign person of an 
interest in a domestic corporation is taxable. Such status is also 
important for purposes of the withholding and reporting requirements of 
sections 1445 and 6039C. For example, a person that buys stock of a U.S. 
real property holding corporation from a foreign person is required to 
withhold under section 1445. In addition, for purposes of determining 
whether another corporation is a U.S. real property holding corporation, 
an interest in a foreign corporation is a U.S. real property interest 
unless it is established that the foreign corporation is not a U.S. real 
property holding corporation. The general definition of a U.S. real 
property holding corporation is provided in paragraph (b) of this 
section. Paragraph (c) provides rules regarding the dates on which U.S. 
real property holding corporation status must be determined. The assets 
that must be included in making the determination of a corporation's 
status are set forth in paragraph (d), while paragraph (e) provides 
special rules regarding the treatment of interests held by a corporation 
in partnerships, trusts, estates, and other corporations. Rules 
regarding the termination of U.S. real property holding corporation 
status are set forth in paragraph (f). Paragraph (g) explains the manner 
in which an interest-holder can establish that a corporation is not a 
U.S. real property holding corporation, and paragraph (h) provides rules 
regarding certain notification requirements applicable to corporations.
    (b) U.S. real property holding corporation--(1) In general. A 
corporation is a U.S. real property holding corporation if the fair 
market value of the U.S. real property interests held by the corporation 
on any applicable determination date equals or exceeds 50 percent of the 
sum of the fair market values of its--
    (i) U.S. real property interests;
    (ii) Interests in real property located outside the United States; 
and
    (iii) Assets other than those described in subdivision (i) or (ii) 
of this paragraph (b)(1) that are used or held for use in its trade or 
business.


See paragraphs (d) and (e) of this section for rules regarding the 
directly and indirectly held assets that must be included in the 
determination of whether a corporation is a U.S. real property holding 
corporation. The term ``interest in real property located outside the 
United States'' means an interest other than solely as a creditor (as 
defined in Sec.  1.897-1(d)) in real property (as defined in Sec.  
1.897-(b)) that is located outside the United States or the Virgin 
Islands. If a corporation qualifies as a U.S. real property holding 
corporation on any applicable determination date after June 18, 1980, 
any interest in it shall be treated as a U.S. real

[[Page 610]]

property interest for a period of five years from that date, unless the 
provisions of paragraph (f)(2) of this section are applicable.
    (2) Alternative test--(i) In general. The fair market value of a 
corporation's U.S. real property interests shall be presumed to be less 
than 50 percent of the fair market value of the aggregate of its assets 
described in paragraphs (d) and (e) of this section if on an applicable 
determination date the total book value of the U.S. real property 
interests held by the corporation is 25 percent or less of the book 
value of the aggregate of the corporation's assets described in 
paragraphs (d) and (e) of this section.
    (ii) Definition of book value. For purposes of this section and 
Sec.  1.897-1(e) the term ``book value'' shall be defined as follows. In 
the case of assets that are held directly by the corporation, the term 
means the value at which an item is carried on the financial accounting 
records of the corporation, if such value is determined in accordance 
with generally accepted accounting principles applied in the United 
States. In the case of assets of which a corporation is treated as 
holding a pro rata share pursuant to paragraphs (e) (2) and (3) of this 
section and Sec.  1.897-1(e), the term ``book value'' means the 
corporation's share of the value at which the asset is carried on the 
financial accounting records of the entity that directly holds the 
asset, if such value is determined in accordance with generally accepted 
accounting principles applied in the United States. For purposes of this 
paragraph (b)(2)(ii), an entity need not keep all of its books in 
accordance with U.S. accounting principles, so long as the value of the 
relevant assets is determined in accordance therewith.
    (iii) Denial of presumption. If the Internal Revenue Service 
determines, on the basis of information as to the fair market values of 
a corporation's assets, that the presumption allowed by this paragraph 
(b)(2) may not accurately reflect the status of the corporation, the 
Service will notify the corporation that it may not rely upon the 
presumption. The Service will provide a written notice to the 
corporation that sets forth the general grounds for the Service's 
conclusion that the presumption may be inaccurate. By the 90th day 
following the date on which the corporation receives the Service's 
notification, the corporation must determine whether on its most recent 
determination date it was a U.S. real property holding corporation 
pursuant to the general rule set forth in paragraph (b)(1) of this 
section and must notify the Service of its determination. If the 
corporation determines that it was not a U.S. real property holding 
corporation pursuant to the general rule, then the corporation may upon 
future determination dates rely upon the presumption allowed by this 
paragraph (b)(2), unless on the basis of additional information the 
Service again requests that the determination be made pursuant to the 
general rule. If the corporation determines that it was a U.S. real 
property holding corporation on its most recent determination date, then 
by the 180th day following the date on which the corporation received 
the Service's notification the corporation (if a domestic corporation) 
must notify each holder of an interest in it that contrary to any prior 
representations it was a U.S. real property holding corporation as of 
its most recent determination date.
    (iv) Applicability of penalties. A corporation that had previously 
relied upon the presumption allowed by this paragraph (b)(2) but that is 
determined to be a U.S. real property holding corporation shall not be 
subject to penalties for any incorrect notice previously given pursuant 
to the requirements of paragraph (h) of this section, if:
    (A) The corporation in fact carried out the necessary calculations 
enabling it to rely upon the presumption allowed by this paragraph 
(b)(2); and
    (B) The corporation complies with the provisions of paragraph 
(b)(2)(iii) of this section. However, a corporation shall remain subject 
to any applicable penalties if at the time of its reliance on the 
presumption allowed by this paragraph (b)(2) the corporation knew that 
the book value of relevant assets was substantially higher or lower than 
the fair market value of those assets and therefore had reason to 
believe

[[Page 611]]

that under the general test of paragraph (b)(1) of this section the 
corporation would probably be a U.S. real property holding corporation. 
Information with respect to the fair market value of its assets is known 
by a corporation if such information is included on any books and 
records of the corporation or its agent, is known by its directors or 
officers, or is known by employees who in the course of their employment 
have reason to know such information. A corporation relying upon the 
presumption allowed by this paragraph (b)(2) has no affirmative duty to 
determine the fair market values of assets if such values are not 
otherwise known to it in accordance with the preceding sentence. The 
rules of this paragraph (b)(2)(iv) may be illustrated by the following 
examples.

    Example 1. DC is a domestic corporation engaged in light 
manufacturing that knows that it has foreign shareholders. On its 
December 31, 1985 determination date DC held assets used in its trade or 
business, consisting largely of recently-purchased equipment, with a 
book value of $500,000. DC's only real property interest was a factory 
that it had occupied for over 50 years, which had a book value of 
$200,000. The factory was located in a deteriorated downtown area, and 
DC had no knowledge of any facts indicating that the fair market value 
of the property was substantially higher than its book value. Therefore, 
DC was entitled to rely upon the presumption allowed by Sec.  1.897-
2(b)(2) and any incorrect statement pursuant to Sec.  1.897-2(h) that 
arose out of such reliance would not give rise to penalties.
    Example 2. The facts are the same as in Example 1, except as 
follows. By the time of DC's December 31, 1989 determination date, the 
downtown area in which DC's factory was located had become the subject 
of an extensive urban renewal program. On December 1, 1989, the 
president of DC was offered $750,000 for the factory by a developer who 
planned to convert the property into condominiums. Because DC thus had 
knowledge of the fair market value of its assets which made it clear 
that the corporation would probably be a U.S. real property holding 
corporation under the general rule of Sec.  1.897-2(b)(1), DC was not 
entitled to rely upon the presumption allowed by Sec.  1.897-2(b)(2) 
after December 1, 1989, and any false statements arising out of such 
reliance thereafter would give rise to penalties.

    (v) Effect on interest-holders and related persons. For the effect 
on interest holders and related persons of reliance on a statement 
issued by a corporation that made a determination as to whether it was a 
U.S. real property holding corporation under the provisions of Sec.  
1.897-2(b), see Sec. Sec.  1.897-2(g)(1)(ii)(A) and 1.897-2(g)(2)(ii).
    (c) Determination dates for applying U.S. real property holding 
corporation test--(1) In general. Whether a corporation is a U.S. real 
property holding corporation is to be determined as of the following 
dates:
    (i) The last day of the corporation's taxable year;
    (ii) The date on which the corporation acquires any U.S. real 
property interest;
    (iii) The date on which the corporation disposes of an interest in 
real property located outside the United States or disposes of other 
assets used or held for use in a trade or business during the calendar 
year, subject to the provisions of paragraph (c)(2)(i) of this section; 
and
    (iv) In the case of a corporation that is treated pursuant to 
paragraph (d)(4) or (5) of this section as owning a portion of the 
assets held by an entity in which the corporation directly or indirectly 
holds an interest, the date on which that entity either (A) acquires a 
U.S. real property interest, (B) disposes of an interest in real 
property located outside the United States or (C) disposes of other 
assets used or held for use in a trade or business during the calendar 
year, subject to the provisions of paragraph (c)(2)(ii) of this section. 
A determination that is triggered by a transaction described in 
subdivision (ii), (iii), or (iv) of this paragraph (c)(1) must take such 
transaction into account. However, the first determination of a 
corporation's status need not be made until the 120th day after the 
later of the date of incorporation or of the date on which the 
corporation first acquires a shareholder. In addition, no determination 
of a corporation's status need be made during the 12-month period 
beginning on the date on which a corporation adopts a plan of complete 
liquidation, provided that all the assets of the corporation (other than 
assets retained to meet claims) are distributed within such period.

[[Page 612]]

    (2) Transactions not requiring a determination--(i) Transactions by 
corporation. Notwithstanding the provisions of paragraph (c)(1) of this 
section, a determination of U.S. real property holding corporation 
status need not be made on the date of:
    (A) A corporation's disposition of inventory or livestock (as 
described in Sec.  1.897-1(f)(1)(i) (A) and (C));
    (B) The satisfaction of accounts receivable arising from the 
disposition of inventory or livestock or from the performance of 
services;
    (C) The disbursement of cash to meet the regular operating needs of 
the business (e.g., to acquire inventory or to pay wages and salaries);
    (D) A corporation's disposition of assets used or held for use in a 
trade or business (other than inventory or livestock) not in excess of a 
limitation amount determined in accordance with the rules of subdivision 
(iii) of this paragraph (c)(2); or
    (E) A corporation's acquisition of U.S. real property interests not 
in excess of a limitation amount determined in accordance with the rules 
of subdivision (iii) of this paragraph (c)(2).
    (ii) Transactions by entity other than corporation. Notwithstanding 
the provisions of paragraph (c)(1)(iv) or (c)(2)(v) of this section, in 
the case of a corporation that is treated as owning a portion of the 
assets held by an entity in which the corporation directly or indirectly 
holds an interest, a determination of U.S. real property holding 
corporation status need not be made on the date of:
    (A) The entity's disposition of inventory or livestock (as described 
in Sec.  1.897-1(f)(1)(i) (A) and (C));
    (B) The satisfaction of accounts receivable arising from the 
entity's disposition of inventory or livestock or from the performance 
of personal services;
    (C) The entity's disbursement of cash to meet the regular operating 
needs of its business (e.g. to acquire inventory or to pay wages and 
salaries);
    (D) The entity's disposition of assets used or held for use in a 
trade or business (other than inventory or livestock) not in excess of a 
limitation amount determined in accordance with the rules of subdivision 
(iii) of this paragraph (c)(2); or
    (E) The entity's acquisition of U.S. real property interests not in 
excess of a limitation amount determined in accordance with the rules of 
subdivision (iii) of this paragraph (c)(2).
    (iii) Calculation of limitation amount. The amount of assets used or 
held for use in a trade or business that may be disposed of, and the 
amount of U.S. real property interests that may be acquired, by a 
corporation or other entity without triggering a determination date 
shall be calculated in accordance with the following rules:
    (A) If, in accordance with the provisions of paragraphs (d) and (e) 
of this section, a corporation on its most recent determination date was 
considered to hold U.S. real property interests having a fair market 
value that was less than 25 percent of the aggregate fair market value 
of all the assets it was considered to hold, then the applicable 
limitation amount shall be 10 percent of the fair market value of all 
trade or business assets or all U.S. real property interests (as 
applicable) held directly by the corporation or by another entity 
described in paragraph (c)(1)(iv) of this section on that determination 
date.
    (B) If, in accordance with the provisions of paragraphs (d) and (e) 
of this section, a corporation on its most recent determination date was 
considered to hold U.S. real property interests having a fair market 
value that was equal to or greater than 25 and less than 35 percent of 
the aggregate fair market value of all the assets it was considered to 
hold, then the applicable limitation amount shall be 5 percent of the 
fair market value of all trade or bussiness assets or all U.S. real 
property interests (as applicable) held directly by the corporation or 
by another entity described in paragraph (c)(1)(iv) of this section on 
that determination date.
    (C) If, in accordance with the provisions of paragraphs (d) and (e) 
of this section, a corporation on its most recent determination date was 
considered to hold U.S. real property interests having a fair market 
value that


was equal to or greater than 35 percent of the aggregate fair market 
value of all the assets it was considered to hold, then the applicable 
limitation amount

[[Page 613]]

shall be 2 percent of the fair market value of all trade or business 
assets or all U.S. real property interests (as applicable) held directly 
by the corporation or by another entity described in paragraph 
(c)(1)(iv) of this section on that determination date.
    (D) If a corporation is not a U.S. real property holding corporation 
under the alternative test of paragraph (b)(2) of this section (relating 
to the book value of the corporation's assets), then the applicable 
limitation shall be 10 percent of the book value of all trade or 
business assets or all U.S. real property interests (as applicable) held 
directly by the corporation or by another entity described in paragraph 
(c)(1)(iv) of this section on the most recent determination date.
    Dispositions or acquisitions by the corporation or other entity of 
assets having a value less than the applicable limitation amount must be 
cumulated by the corporation or entity making such dispositions or 
acquisitions, and a determination must be made on the date of a 
transaction that causes the total of either type to exceed the 
applicable limitation. Once a determination is triggered by a 
transaction that causes the applicable limitation to be exceeded, the 
computation of the amount of trade or business assets disposed of or 
real property interests acquired after that date shall begin again at 
zero.
    The rules of this paragraph (c)(2) may be illustrated by the 
following examples.

    Example 1. DC is a domestic corporation, no class of stock of which 
is regularly traded on an established securities market, that knows that 
it has several foreign shareholders. As of December 31, 1984, DC holds 
U.S. real property interests with a fair market value of $500,000, no 
real property interests located outside the U.S. and other assets used 
in its trade or business with a fair market value of $1,600,000. Thus, 
the fair market value of DC's U.S. real property interests ($500,000) is 
less than 25% ($525,000) of the total ($2,100,000) of DC's U.S. real 
property interests ($500,000), interests in real property located 
outside the United States (zero), and assets used or held for use in a 
trade or business ($1,600,000). DC is not a U.S. real property holding 
corporation, and under the rule of paragraph (c)(2)(i) of this section 
it may dispose of trade or business assets with a fair market value 
equal to 10 percent ($160,000) of the total fair market value 
($1,600,000) of such assets held by it on its most recent determination 
date (December 31, 1984), without triggering a determination of its U.S. 
real property holding corporation status. Therefore, when DC disposes of 
$60,000 worth of trade or business assets (other than inventory or 
livestock) on March 1, 1985, and again on April 1, 1985, no 
determination of its status is required on either date. However, when DC 
disposes of a further $60,000 worth of such trade or business assets on 
May 1, its total dispositions of such assets ($180,000) exceeds its 
applicable limitation amount, and DC is therefore required to determine 
its U.S. real property holding corporation status. On May 1, 1985, the 
fair market value of DC's U.S. real property interests ($500,000) is 
greater than 25 percent ($480,000) and less than 35 percent ($672,000) 
of the total ($1,920,000) of DC's U.S. real property interests 
($500,000), interests in real property located outside the United States 
(zero), and assets used or held for use in a trade or business 
($1,420,000). DC is still not a U.S. real property holding corporation, 
but must now compute its applicable limitation amount as of the May 1 
determination date. Under the rule of paragraph (c)(2)(iii)(B) of this 
section. DC could now dispose of trade or business assets other than 
inventory or livestock with a total fair market value equal to 5 percent 
of the fair market value of all trade or business assets held by DC on 
the May 1 determination date. Therefore, disposition of such trade or 
business assets with a fair market value of more than $71,000 (5 percent 
of $1,420,000) will trigger a further determination date for DC.
    Example 2. DC is a domestic corporation, no class of stock of which 
is regularly traded on an established securities market, that knows that 
it has several foreign shareholders. As of December 31, 1986, DC's only 
assets are a U.S. real property interest with a fair market value of 
$300,000 other assets used or held for use in its trade or business with 
a fair market value of $600,000, and a 50 percent partnership interest 
in domestic partnership DP. DC's interest in DP constitutes a percentage 
ownership interest in the partnership of 50 percent, and pursuant to the 
rules of paragraph (e)(2) of this section DC is treated as owning a 
portion of the assets of DP determined by multiplying that percentage by 
the fair market value of DP's assets. As of December 31, 1986, DP's only 
assets are U.S. real property interests with a fair market value of 
$120,000 and other assets used in its trade or business with a fair 
market value of $380,000. As of its December 31, 1986, determination 
date, the fair market value ($360,000) of the U.S. real property 
interests DC holds ($300,000) and is treated as holding ($80,000 [The 
fair market value of DP's U.S. real property interest ($120,000) 
multiplied by DC's percentage ownership interest in DP (50 percent)]), 
is equal to 31 percent of the sum

[[Page 614]]

of the fair market values ($1,150,000) of the U.S. real property 
interests DC holds and is treated as holding ($360,000) DC's interest in 
real property located outside the United States (zero), and assets used 
or held for use in a trade or business that DC holds or is treated as 
holding ($790,000 [$600,000 (held directly) plus $190,000 (DC's 50 
percent share of assets used or held for use in a trade or business by 
DP)]). Thus, under the rules of paragraph (c)(2) (i) and (iii)(B) of 
this section DC may dispose of assets used or held for use in its trade 
or business with a fair market value equal to 5 percent ($30,000) of the 
total fair market value ($600,000) of such assets held directly by it on 
its most recent determination date (December 31, 1986), without 
triggering a determination of its U.S. real property holding corporation 
status. In addition, under the rules of paragraph (c)(2) (ii) and 
(iii)(A) of this section, a determination date for DC would not be 
triggered by DP's disposition of trade or business assets (other than 
inventory or livestock) with a fair market value equal to 5 percent 
($19,000) of the total fair market value ($380,000) of such assets held 
by it as of DC's most recent determination date (December 31, 1986). 
However, any disposition of such assets by DP exceeding that limitation 
would trigger a determination of DC's U.S. real property holding 
corporation status. In addition under the rule of paragraph (c)(1)(iv) 
of this section, any disposition of a U.S. real property interest by DP 
would trigger a determination date for DC, while under the rule of 
paragraph (c)(2)(ii) of this section no disposition of inventory or 
livestock by DP would trigger a determination for DC.

    (3) Alternative monthly determination dates--(i) In general. 
Notwithstanding the provisions of paragraphs (c) (1) and (2) of this 
section, a corporation may choose to determine its U.S. real property 
holding corporation status in accordance with the rules of this 
paragraph (c)(3). In the case of a corporation that has determined that 
it is not a U.S. real property holding corporation pursuant to the 
alternative test of paragraph (b)(2) of this section (relating to the 
book value of the corporation's assets), the rules of this paragraph 
(c)(3) may be applied by using book values rather than fair market 
values in all relevant calculations.
    (ii) Monthly determinations. A corporation that determines its U.S. 
real property holding corporation status in accordance with the rules of 
this paragraph (c)(3) must make a determination at the end of each 
calendar month.
    (iii) Transactional determinations. A corporation that determines 
its U.S. real property holding corporation status in accordance with the 
rules of this paragraph (c)(3) must make a determination as of the date 
on which, pursuant to a single transaction (consisting of one or more 
transfers):
    (A) U.S. real property interests are acquired, and/or
    (B) Interests in real property located outside the U.S. and/or 
assets used or held for use in a trade or business are disposed of,


if the total fair market value of the assets acquired and/or disposed of 
exceeds 5 percent of the sum of the fair market values of the U.S. real 
property interests, interests in real property located outside the U.S., 
and assets used or held for use in a trade or business held by the 
corporation.
    (iv) Exceptions. Notwithstanding any other provision of this 
paragraph (c)(3), the first determination of a corporation's status need 
not be made until the 120th day after the later of the date of 
incorporation or the date on which the corporation first acquires a 
shareholder. In addition, no determination of a corporation's status 
need be made during the 12-month period beginning on the date on which a 
corporation adopts a plan of complete liquidation, if all the assets of 
the corporation (other than assets retained to meet claims) are 
distributed within such period.
    (4) Valuation date methods--(i) In general. For purposes of 
determining whether a corporation is a U.S. real property holding 
corporation on any applicable determination date, the fair market value 
of the assets held by the corporation (in accordance with Sec.  1.897-
2(d)) as of that determination date must be used.
    (ii) Alternative valuation date method for determination dates other 
than the last day of the taxable year. For purposes of paragraph 
(c)(4)(i) of this section, if an applicable determination date under 
paragraph (c) (1), (2), or (3) of this section is other than the last 
day of the taxable year, property may be valued as of the later of the 
last day of the previous taxable year or the date such property was 
acquired. For purposes of the determination date that

[[Page 615]]

falls on the last day of the taxable year, fair market value as of that 
date must always be used.
    (iii) Consistent methods. The valuation date method selected under 
this paragraph (c)(4) for the first determination date in a taxable year 
must be used for all subsequent determination dates for such year. In 
addition, the valuation date method selected must be used for all 
property with respect to which the determination is made. The use of one 
method for one taxable year does not preclude the use of the other 
method for any other taxable year.
    (5) Illustrations. The rules of this paragraph (c) are illustrated 
by the following examples:

    Example 1. Nonresident alien individual C purchased 100 shares of 
stock of domestic corporation K on July 26, 1985. Although K has 
additional shares of common stock outstanding, its stock has never been 
traded on an established securities market. At all times during calendar 
year 1985, K's only assets were a parcel of U.S. real estate (parcel A) 
and a parcel of country Z real estate (parcel B). On December 31, 1985, 
the fair market value of parcel A was $1,000,000 and the fair market 
value of parcel B was $2,000,000. For purposes of determining whether K 
was a U.S. real property holding corporation during 1985, the only 
applicable determination date was December 31, 1985, because K did not 
make any acquisitions or dispositions described in paragraph (c)(1) of 
this section during the year. The test of paragraph (b) of this section 
is applied using the fair market value of the property held on that 
date. K was not a U.S. real property holding corporation during 1985 
because as of December 31, 1985, the fair market value ($1,000,000) of 
the U.S. real property interests held by K did not equal or exceed 50 
percent ($1,500,000) of the sum ($3,000,000) of the fair market value of 
K's U.S. real property interest ($1,000,000), the interests in real 
property located outside the United States ($2,000,000), plus other 
assets used or held for use by K in a trade or business (zero).
    Example 2. The facts are the same as in example 1, except that on 
April 7, 1986, K purchased another parcel of U.S. real estate for 
$2,000,000. K's purchase of real property on April 7 triggered a 
determination on that date. As provided in paragraph (c)(3)(ii) of this 
section, K chooses to use the value of parcels A and B as of the 
previous December 31, while newly acquired parcel C must be valued as of 
its acquisition on April 7, 1986. On that date, K qualifies as a U.S. 
real property holding corporation, since the fair market value of its 
U.S. real property interests ($3,000,000) exceeds 50 percent 
($2,500,000) of the sum ($5,000,000) of the fair market value of K's 
U.S. real property interests ($3,000,000), its interests in real 
property located outside the U.S. ($2,000,000), and its other assets 
used or held for use in a trade or business (zero).

    (d) Assets held by a corporation. The assets that must be included 
in the determination of whether a corporation is a U.S. real property 
holding corporation are the following:
    (1) U.S. real property interests that are held directly by the 
corporation (including directly-held interests in foreign corporations 
that are treated as U.S. real property interests pursuant to the rules 
of paragraph (e)(1) of this section);
    (2) Interests in real property located outside the United States 
that are held directly by the corporation;
    (3) Assets used or held for use in a trade or business that are held 
directly by the corporation;
    (4) A proportionate share of assets held through a partnership, 
trust, or estate pursuant to the rules of paragraph (e)(2) of this 
section; and
    (5) A proportionate share of assets held through a domestic or 
foreign corporation in which a corporation holds a controlling interest, 
pursuant to the rules of paragraph (e)(3) of this section.
    (e) Special rules regarding assets held by a corporation--(1) 
Interests in foreign corporations. For purposes only of determining 
whether any corporation is a U.S. real property holding corporation, an 
interest in a foreign corporation shall be treated as a U.S. real 
property interest unless it is established that the interest was not a 
U.S. real property interest under the rules of this section on the 
applicable determination date. The rules of paragraph (g)(2) of this 
section must be complied with to establish that the interest is not a 
U.S. real property interest. However, regardless of whether an interest 
in a foreign corporation is treated as a U.S. real property interest for 
this purpose, gain or loss from the disposition of an interest in such 
corporation will not be treated as effectively connected with the 
conduct of a U.S. trade or business by reason of section 897(a). The 
rules of this paragraph (e)(1) are illustrated by the following 
examples. In each example, fair market value is determined as of the 
applicable determination dates

[[Page 616]]

under paragraph (c)(4)(i) of this section.

    Example 1. Nonresident alien individual F holds all of the stock of 
domestic corporation DC. DC's only assets are 40 percent of the stock of 
foreign corporation FC, with a fair market value of $500,000, and a 
parcel of country W real estate, with a fair market value of $400,000. 
Foreign corporation FP, unrelated to DC, holds the other 60 percent of 
the stock of FC. FC's only asset is a parcel of U.S. real estate with a 
fair market value of $1,250,000. FC is a U.S. real property holding 
corporation because the fair market value of its U.S. real property 
interests ($1,250,000) exceeds 50 percent ($625,000) of the sum of the 
fair market values of its U.S. real property interests ($1,250,000), its 
interests in real property located outside the United States (zero), 
plus its other assets used or held for use in a trade or business 
(zero). Consequently DC's interest in FC is treated as a U.S. real 
property interest under the rules of this paragraph (e)(1). DC is a U.S. 
real property holding corporation because the fair market value 
($500,000) of its U.S. real property interest (the stock of FC) exceeds 
50 percent ($450,000) of the sum ($900,000) of the fair market value of 
its U.S. real property interests ($500,000), its interests in real 
property located outside the United States ($400,000), plus its other 
assets used or held for use in a trade or business (zero). If F disposes 
of her stock within 5 years of the current determination date, her gain 
or loss on the disposition of her stock in DC will be treated as 
effectively connected with a U.S. trade or business under section 
897(a). However, FP's gain on the disposition of its FC stock would not 
be subject to the provisions of section 897(a) because the stock of FC 
is a U.S. real property interest only for purposes of determining 
whether DC is a U.S. real property holding corporation.
    Example 2. Nonresident alien individual B holds all of the stock of 
domestic corporation US. US's only assets are 40 percent of the stock of 
foreign corporation FC1. Nonresident alien individual N, unrelated to 
US, holds the other 60 percent of FC1's stock. FC1's only assets are 40 
percent of the stock of foreign corporation FC2. The remaining 60 
percent of the stock of FC2 is owned by nonresident alien individual X, 
who is unrelated to FC1. FC2's only asset is a parcel of U.S. real 
estate with fair market value of $1,000,000. FC2, therefore, is a U.S. 
real property holding corporation, and the stock of FC2 held by FC1 is a 
U.S. real property interest for purposes of determining whether FC1 is a 
U.S. real property holding corporation (but not for purposes of treating 
FC1's gain from the disposition of FC2 stock as effectively connected 
with a U.S. trade or business under section 897(a)). As all of FC1's 
assets are U.S. real property interests, the stock of FC1 held by US is 
a U.S. real property interest for purposes of determining whether US is 
a U.S. real property holding corporation (but not for purposes of 
subjecting N's gain on the disposition of FC1 stock to the provisions of 
section 897(a)). As US is a domestic corporation and as all of its 
assets are U.S. real property interests, US is a U.S. real property 
holding corporation, and the stock of US held by B is a U.S. real 
property interest for purposes of section 897(a)). Therefore, B's gain 
or loss upon the disposition of the stock of US within 5 years of the 
most recent determination date is subject to the provisions of section 
897(a).

    (2) Proportionate ownership of assets held by partnerships, trusts, 
and estates. For purposes of determining whether a corporation is a U.S. 
real property holding corporation, a holder of an interest in a 
partnership, a trust, or an estate (whether domestic or foreign) shall 
be treated pursuant to section 897(c)(4)(B) as holding a proportionate 
share of the assets held by the entity.


However, a holder of an interest shall not be treated as holding a 
proportionate share of assets that in the hands of the entity are 
subject to the rule of Sec.  1.897-1(f)(3)(ii) (concerning the trade or 
business assets of investment companies). Such proportionate share is to 
be determined in acordance with the rules of Sec.  1.897-1(e) on each 
applicable determination date. The interest in the entity shall itself 
be disregarded when a proportionate share of the entity's assets is 
attributed to the interest-holder pursuant to the rule of this paragraph 
(e)(2). Any asset treated as held by a holder of an interest by reason 
of this paragraph (e)(2) which is used or held for use in a trade or 
business by the partnership, trust, or estate shall be treated as so 
used or held for use by the holder of the interest. The proportionate 
ownership rule of this paragraph (e)(2) applies successively upward 
through a chain of ownership. The proportionate ownership rule of this 
paragraph (e)(2) is illustrated by the following examples. In each 
example fair market value is determined as of the applicable 
determination date under paragraph (c)(4)(i) of this section.


[[Page 617]]


    Example 1. Nonresident alien individual F holds all of the stock of 
domestic corporation DC. DC is a partner in foreign partnership FP, and 
DC's percentage ownership interest in FP is 50 percent. DC's other 
assets are a parcel of country F real estate with a fair market value of 
$500,000 and other assets which it uses in its business with a fair 
market value of $100,000, FP's assets are a parcel of country Z real 
estate with a fair market value of $300,000 and a parcel of U.S. real 
estate with a fair market value of $2,000,000. For purposes of 
determining whether DC is a U.S. real property holding corporation, DC 
is treated as holding its pro rata share of the assets held by FP. DC's 
pro rata share of the U.S. real estate held by FP is $1,000,000, 
determined by multiplying the fair market value ($2,000,000) of the U.S. 
real property interests held by FP by DC's percentage ownership interest 
in FP (50 percent). DC's pro rata share of the country Z real estate 
held by FP is $150,000, determined in the same manner. DC is a U.S. real 
property holding corporation because the fair market value ($1,000,000) 
of its U.S. real property interests (the U.S. real estate it is treated 
as holding proportionately) exceeds 50 percent ($875,000) of the sum 
($1,750,000) of the fair market value of its U.S. real property 
interests ($1,000,000), its interests in real property located outside 
the United States [($650,000) (its country F real estate and its pro 
rata share of the country Z real estate)], plus its other assets which 
are used or held for use in a trade or business ($100,000). Because DC 
is a domestic U.S. real property holding corporation, the stock of DC is 
a U.S. real property interest and F's gain or loss on the disposition of 
this DC stock within 5 years of the current determination date will be 
treated as effectively connected with a U.S. trade or business under 
section 897(a).
    Example 2. Nonresident alien individual B holds all of the stock of 
domestic corporation US. US is a beneficiary of foreign trust FT. US's 
percentage ownership interest in FT is 90 percent. US has no other 
assets. FT is a partner in domestic partnership DP. FT's percentage 
ownership interest in DP is 30 percent. FT has no other assets. DP's 
only asset is a parcel of U.S. real estate with a fair market value of 
$1,000,000. FT is treated as holding U.S. real estate with a fair market 
value of $300,000 (30 percent of the U.S. real estate held by DP with a 
fair market value of $1,000,000). For purposes of determining whether US 
is a U.S. real property holding corporation, the proportionate ownership 
rule is applied successively upward through the chain of ownership. 
Thus, US is treated as holding 90 percent of FT's $300,000 pro rata 
share of the U.S. real estate held by DP. US is a U.S. real property 
holding corporation because the fair market value ($270,000) of its U.S. 
real property interests (its pro rata share of the U.S. real estate held 
by DP) exceeds 50 percent ($135,000) of the sum of the fair market 
values of its U.S. real property interests ($270,000), its interests in 
real property located outside the United States (zero), plus its other 
assets used or held for use in a trade or business (zero). Because US is 
a domestic U.S. real property holding corporation, the stock of US is a 
U.S. real property interest, and B's gain or loss from the disposition 
of US stock within 5 years of the current determination date will be 
treated as effectively connected with a U.S. trade or business under 
section 807(a).

    (3) Controlling interests in corporations. For purposes only of 
determining whether a corporation is a U.S. real property holding 
corporation, if the corporation (the ``first corporation'') holds a 
controlling interest in a second corporation--
    (i) The first corporation is treated as holding a proportionate 
share of each asset (i.e., U.S. real property interests, interests in 
real property located outside the United States, and assets used or held 
for use in a trade or business) held by the second corporation, 
determined in accordance with the rules of Sec.  1.897-1(e);
    (ii) Any asset so treated as held proportionately by the first 
corporation which is used or held for use by the second corporation in a 
trade or business shall be treated as so used or held for use by the 
first corporation; and
    (iii) Interests in the second corporation held by the first 
corporation are not themselves taken into account as U.S. real property 
interests (regardless of whether the second corporation is a U.S. real 
property holding corporation) or as trade or business assets. However, 
the first corporation shall not be treated as holding a proportionate 
share of assets that in the hands of the second corporation are subject 
to the rules of Sec.  1.897-1(f)(3)(ii) (concerning the trade or 
business assets of investment companies). A determination of what 
portion of the assets of the second corporation are considered to be 
held by the first corporation shall be made as of the applicable dates 
for determining whether the first corporation is a U.S. real property 
holding corporation.


A ``controlling interest'' means 50 percent or more of the fair market 
value of all classes of stock of the corporation, determined as of the 
applicable

[[Page 618]]

determination date. In determining whether a corporation holds a 
controlling interest in another corporation, section 318(a) shall apply 
(except that sections 318(a)(2)(C) and (3)(C) are applied by 
substituting the phrase ``5 percent'' for ``50 percent''). However, a 
corporation that does not directly hold any interest in a second 
corporation shall not be treated as holding a controlling interest in 
the second corporation by reason of the application of section 
318(a)(3)(C). The rules of this paragraph (e)(3) apply successively 
upward through a chain of ownership. For example, if the second 
corporation owns a controlling interest in a third corporation, the 
rules of this paragraph shall be applied first to determine the portion 
of the assets of the third corporation that is considered to be held by 
the second corporation and then to determine the portion of the assets 
held and considered to be held by the second corporation that is 
considered to be held by the first corporation. The controlling interest 
rules of this paragraph (e)(3) apply, regardless of whether a 
corporation is domestic or foreign, whenever it is necessary to 
determine whether a corporation is a U.S. real property holding 
corporation. The rules of this paragraph (e)(3) are illustrated by the 
following examples. In each example fair market value is determined as 
of the applicable determination date under paragraph (c)(4)(i) of this 
section and no corporation holds constructively any interest not 
specified in the example.

    Example 1. Nonresident alien individual N owns all of the stock of 
domestic corporation DC. DC's only assets are 60 percent of the fair 
market value of all classes of stock of foreign corporation FS and 60 
percent of the fair market value of all classes of stock of domestic 
corporation DS. The percentage ownership interest of DC in each of FS 
and DS is 60 percent. The balance of the stock in FS and DS is held by 
nonresident alien individual B, who is unrelated to DC. FS's only asset 
is a parcel of country F real estate with a fair market value of 
$1,000,000. DS's only asset is a parcel of U.S. real estate with a fair 
market value of $2,000,000. The value of DC stock in FS and DS is not 
taken into account for purposes of determining whether DC is a U.S. real 
property holding corporation. Rather, because DC holds a controlling 
interest (60 percent) in each of FS and DS, DC is treated as holding a 
portion of each asset held by FS and DS. DC's portion of the country F 
real estate held by FS is $600,000, determined by multiplying the fair 
market value ($1,000,000) of the country F real estate by DC's 
percentage ownership interest (60 percent). Similarly, DC's portion of 
the U.S. real estate held by DS is $1,200,000 (60 percent of 
$2,000,000). DC is a U.S. real property holding corporation, because the 
fair market value ($1,200,000) of its U.S. real property interests (its 
portion of the U.S. real estate) exceeds 50 percent ($900,000) of the 
sum ($1,800,000) of the fair market values of its U.S. real property 
interests ($1,200,000), its interests in real property located outside 
the United States (the $600,000 portion of country F real estate), plus 
its other assets used or held for use in a trade or business (zero). 
Because DC is a domestic U.S. real property holding corporation, the 
stock of DC is a U.S. real property interest, and N's gain or loss on 
the disposition of DC stock within 5 years of the current determination 
date would be treated as effectively connected with a U.S. trade or 
business under section 897(a).
    Example 2. (i) Nonresident alien individual F owns all of the stock 
of domestic corporation US1. US1's only asset is 85 percent of the fair 
market value of all classes of stock of domestic corporation US2. US2's 
only assets are 60 percent of the fair market value of all classes of 
stock of domestic corporation US3, with a fair market value of $600,000, 
and a parcel of country D real estate with a fair market value of 
$800,000. US3's only asset is a parcel of U.S. real estate with a fair 
market value of $2,000,000. The percentage ownership interest of F in 
US1 is 100 percent.


Although US1 owns 85 percent of the stock of US2, US1's percentage 
ownership interest in US2 is 75 percent, because US2 has other interests 
other than solely as a creditor outstanding. US2's percentage ownership 
interest in US3 is 60 percent.
    (ii) US2 holds a controlling interest in US3, since it holds more 
than 50 percent of the fair market value of all classes of stock of US3. 
Consequently, the value of US2's stock in US3 is not taken into account 
in determining whether US2 is a U.S. real property holding corporation, 
even though US3 is a U.S. real property holding corporation. Instead, 
US2 is treated as holding a portion of the U.S. real estate held by US3. 
US2's portion of the U.S. real estate is $1,200,000, determined by 
multiplying US2's percentage ownership interest (60 percent) by the fair 
market value ($2,000,000) of the U.S. real estate. US1 holds a 
controlling interest in US2 (75 percent.). By reapplying the rules of 
paragraph (e)(3) of this section successively upward through the chain 
of ownership, US1's stock in US2 is not taken into account, and US1 is 
treated as holding a portion of the

[[Page 619]]

country D real estate held by US2 and the U.S. real estate which US2 is 
treated as holding proportionately. US1's portion of the country D real 
estate is $600,000, determined by multiplying US1's percentage ownership 
interest (75 percent) by the fair market value ($800,000) of the country 
D real estate. US1's portion of the U.S. real estate which US2 is 
treated as owning is $900,000, determined by multiplying US1's 
percentage ownership interest (75 percent) by the fair market value 
($1,200,000) of US2's portion of U.S. real estate held by US3. US1 is a 
U.S. real property holding corporation, because the fair market value 
($900,000) of its U.S. real property interests (its portion of US2's 
portion of U.S. real estate) is more than 50 percent ($750,000) of the 
sum ($1,500,000) of fair market values of its U.S. real property 
interests ($900,000), its interests in real property located outside the 
United States ($800,000), plus its other assets need or held for use in 
a trade or business (zero). Because US1 is a U.S. real property holding 
corporation and is a domestic corporation, the stock of US1 is a U.S. 
real property interest, and F's gain or loss on the disposition of US1 
stock within 5 years of the current determination date will be treated 
as effectively connected with a U.S. trade or business under section 
897(a).
    Example 3. Nonresident alien individual B holds all of the stock of 
domestic corporation DC. DC's only assets are 40 percent of the fair 
market value of all classes of stock of foreign corporation FC and a 
parcel of country R real estate with a fair market value of $100,000. 
FC's only asset is one parcel of U.S. real estate with a fair market 
value of $1,000,000. The fair market value of the FC stock held by DC is 
$200,000. FC is a U.S. real property holding corporation. Since DC does 
not hold a controlling interest in FC, the controlling interest rules of 
paragraph (e)(3) of this section do not apply to treat DC as holding a 
portion of the U.S. real estate held by FC. However, because FC is a 
U.S. real property holding corporation, the stock of FC is a U.S. real 
property interest for purposes of determining whether DC is a U.S. real 
property holding corporation. DC is a U.S. real property holding 
corporation because the fair market value ($200,000) of its U.S. real 
property interest (the stock of FC) exceeds 50 percent ($150,000) of the 
sum ($300,000) of the fair market values of its U.S. real property 
interest ($200,000), its interests in real property located outside the 
United States ($100,000), plus its other assets used or held for use in 
a trade or business (zero). Because DC is a U.S. real property holding 
corporation and is a domestic corporation, its stock is a U.S. real 
property interest, and B's gain or loss on the disposition of DC stock 
within 5 years of the current determination date would be subject to the 
provisions of section 897(a).
    Example 4. Nonresident alien individual C owns all of the stock of 
domestic corporation DC1. DC1's only assets are 25 percent of the fair 
market value of all classes of stock of domestic corporation DC2, and a 
parcel of U.S. real estate with a fair market value of $100,000. The 
stock of DC2 is not an asset used or held for use in DC1's trade or 
business. DC2's only assets are a building located in the U.S. with a 
fair market value of $100,000 and manufacturing equipment and inventory 
with a fair market value of $200,000, DC2 is not a U.S. real property 
holding corporation. Since DC1 does not hold a controlling interest in 
DC2, the rules of this paragraph (e)(3) do not apply to treat DC1 as 
holding a portion of the assets held by DC2. In addition, since DC2 is 
not a U.S. real property corporation, its stock does not constitute a 
U.S. real property interest. Therefore, for purposes of determining 
whether DC1 is a real property holding corporation, its interest in DC2 
is not taken into account. Since DC1's only other asset is a parcel of 
U.S. real estate, DC1 is a U.S. real property holding corporation, and 
C's gain or loss on the disposition of DC1 stock within 5 years of the 
current determination date would be subject to the provisions of section 
897(a).

    (4) Co-application of rules of this paragraph (e). The rules of this 
paragraph (e) apply in conjunction with one another for purposes of 
determining whether a corporation is a U.S. real property holding 
corporation. The rule of this paragraph (e)(4) is illustrated by the 
following example. In the example fair market value is determined as of 
the applicable determination date in accordance with paragraph (c)(4)(i) 
of this section.

    Example. Nonresident alien individual B holds 100 percent of the 
stock of domestic corporation US. US's only asset is 10 percent of the 
stock of foreign corporation FC1. FC1's only asset is 100 percent of the 
stock of foreign corporation FC2. FC2's only asset is a 50 percent 
interest in domestic partnership DP. FC2's percentage ownership interest 
in DP is 50 percent. DP's only asset is a parcel of U.S. real estate 
with a fair market value of $10,000,000. In determining whether US is a 
U.S. real property holding corporation, the rules of this paragraph (e) 
apply in conjunction with one another. Consequently, under paragraph 
(e)(2) of the section FC2 is treated as holding U.S. real estate with a 
fair market value of $5,000,000 (50 percent of $10,000,000, its pro rata 
share of real estate held by DP). Under paragraph (e)(3) of this 
section, FC1 is treated as holding 100 percent of the assets of FC2 
(U.S. real estate with a

[[Page 620]]

fair market value of $5,000,000). FC1, therefore, is a U.S. real 
property holding corporation. Under paragraph (e)(1) of this section, 
the stock of FC1 is treated as U.S. real property interest. US is a U.S. 
real property holding corporation because 100 percent of its assets (the 
stock of FC1) are U.S. real property interests. As US is a U.S. real 
property holding corporation and is a domestic corporation, the stock of 
US is a U.S. real property interest, and B's gain or loss from the 
disposition of stock of US within 5 years of the current determination 
date will be subject to the provisions of section 897(a).

    (f) Termination of U.S. real property holding corporation status--
(1) In general. A U.S. real property holding corporation may voluntarily 
determine its status as of the date of any acquisition or disposition of 
assets. If the fair market value of its U.S. real property interests on 
such date no longer equals or exceeds 50 percent of the fair market 
value of all assets described in paragraphs (d) and (e) of this section, 
such corporation shall cease to be U.S. real property holding 
corporation as of such date, and on the day that is five years after 
such date interests in such corporation shall cease to be treated as 
U.S. real property interests (unless subsequent transactions within the 
five-year period have caused the fair market value of the corporation's 
U.S. real property interests to equal or exceed 50 percent of the fair 
market value of assets described in paragraphs (d) and (e) of this 
section). A corporation that determines that interests in it have ceased 
to be U.S. real property interests pursuant to the rules of this 
paragraph (f) may so inform the Internal Revenue Service, as provided in 
paragraph (h) of this section.
    (2) Early termination. Interests in a U.S. real property holding 
corporation shall immediately cease to be U.S. real property interests 
as of the first date on which the following conditions are met--
    (i) The corporation does not hold any U.S. real property interests;
    (ii) All of the U.S. real property interests directly or indirectly 
held by such corporation at any time during the previous five years (but 
disregarding any disposed of before June 19, 1980) either (A) were 
directly of indirectly disposed of in transactions in which the full 
amount of the gain (if any) was recognized or (B) ceased to be U.S. real 
property interests by reason of the application of this paragraph (f) to 
one or more other corporations; and
    (iii) If the disposition occurs on or after December 18, 2015, 
neither the corporation nor any predecessor of the corporation was a 
regulated investment company or a real estate investment trust at any 
time during the shorter of the periods described in section 
897(c)(1)(A)(ii).


For purposes of this paragraph (f)(2), a corporation that disposes of 
all U.S. real property interests other than a lease that has a fair 
market value of zero will be considered to have disposed of all of its 
U.S. real property interests, provided that the leased property is used 
in the conduct by the corporation of a trade or business in the United 
States. Such a lease may include an option to renew, but only if such 
option is for a renewal at fair market rental rates prevailing at the 
time of renewal.
    (g) Establishing that a corporation is not a U.S. real property 
holding corporation--(1) Foreign persons disposing of interests--(i) In 
general. A foreign person disposing of an interest in a domestic 
corporation (other than an interest solely as a creditor) must establish 
that the interest was not a U.S. real property interest as of the date 
of disposition, either by:
    (A) Obtaining a statement from the corporation pursuant to the 
provisions of subdivision (ii) of this paragraph (g)(1), or
    (B) Obtaining a determination by the Commissioner, Small Business/
Self Employed Division (SB/SE) pursuant to the provisions of subdivision 
(iii) of this paragraph (g)(1).


If the foreign person does not establish by either method that the 
interest disposed of was not a U.S. real property interest then the 
interest shall be presumed to have been a U.S. real property interest 
the disposition of which is subject to section 897(a). See paragraph 
(g)(3) of this section for certain exceptions to this rule. It should be 
noted that the rules of this section relate solely to interests in a 
corporation that are interests other than solely as a creditor. 
Therefore, a statement by a

[[Page 621]]

corporation or a determination by the Commissioner (under paragraphs (g) 
or (h) of this section) that an interest is not a U.S. real property 
interest depends solely upon whether or not the corporation was a U.S. 
real property holding corporation during the period described in section 
897(c)(1)(A)(ii) (subject to certain special rules). The determination 
of whether an interest is one solely as a creditor is made under the 
rules of Sec.  1.897-1(d).
    (ii) Statement from corporation--(A) In general. A foreign person 
disposing of an interest in a domestic corporation may establish that 
the interest was not a U.S. real property interest as of the date of the 
disposition by requesting and obtaining from the corporation a statement 
that the interest was not a U.S. real property interest as of that date. 
However, a corporation's statement shall not be valid for purposes of 
this rule, and thus may not be relied upon for purposes of establishing 
that an interest was not a U.S. real property interest, unless the 
corporation complies with the notice requirements of paragraph (h) (2) 
or (h)(4) of this section.


A foreign person that requests and obtains such a statement is not 
required to forward the statement to the Internal Revenue Service and is 
not required to take any further action to establish that the interest 
disposed of was not a U.S. real property interest. To qualify under this 
rule, the foreign person must obtain the corporation's statement no 
later than the date, including any extensions, on which a tax return 
would otherwise be due with respect to a disposition. A foreign person 
that relies in good faith upon a statement from the corporation is not 
thereby excused from filing a return and paying any taxes and interest 
due thereon if the corporation's statement is later found to have been 
incorrect. However, such reliance shall be taken into account in 
determining whether the foreign person shall be subject to any penalty 
for the previous failure to file. However, a foreign person that knew or 
had reason to know that a corporation's statement was incorrect is not 
entitled to rely upon such statement and shall remain liable for all 
applicable penalties.
    (B) Coordination with section 1445. Pursuant to section 1445 and 
regulations thereunder, withholding of tax is not required with respect 
to a foreign person's disposition of an interest in a domestic 
corporation, if the transferee is furnished with a statement by the 
corporation under paragraph (h) of this section that the interest is not 
a U.S. real property interest. A foreign person that obtains a 
corporation's statement for that purpose prior to the date of 
disposition may also rely upon the statement for purposes of this 
paragraph (g)(1)(ii), unless the corporation informs the foreign person 
(pursuant to paragraph (h)(1)(iv)(C) of this section) that it became a 
U.S. real property holding corporation after the date of the notice but 
prior to the actual date of disposition.
    (iii) Determination by Commissioner--(A) In general. A foreign 
person disposing of an interest in a domestic corporation may establish 
that the interest was not a U.S. real property interest as of the date 
of disposition by requesting and obtaining a determination to that 
effect from the Commissioner. Such a determination may be requested 
pursuant to the provisions of subdivision (B) or (C) of this paragraph 
(g)(1)(iii). A request for a determination should be addressed to: 
Commissioner, Small Business/Self Employed Division (SB/SE); S C3-413 
NCFB, 500 Ellin Road, Lanham, MD 20706. A foreign transferor who has 
requested a determination by the Commissioner pursuant to the rules of 
this paragraph (g)(1)(iii) is not thereby excused from filing a return 
and paying any tax due by the date, including any extensions, on which 
such return and payment would otherwise be due with respect to a 
disposition. If the Commissioner subsequently determines and notifies 
the foreign transferor that the interest was not a U.S. real property 
interest, the foreign transferor shall be entitled to a refund of any 
taxes, penalties, and interest paid by reason of the application of 
section 897(a) pursuant to the rules of paragraph (g)(1)(i) of this 
section, together with any interest otherwise due on such refund, if a 
claim for refund is made within the applicable time limits.

[[Page 622]]

    (B) Determination based on Commissioner's information. A foreign 
person may request that the Commissioner make a determination based on 
information contained in the Commissioner's records, if:
    (1) The foreign person made a request to the corporation for 
information as to the status of its interest no later than the 90th day 
before the date, including any extensions, on which a tax return would 
otherwise be due with respect to a disposition, and
    (2) The corporation failed to respond to such request by the 30th 
day following the date the request was delivered to the corporation.


If the Commissioner is unable to make a determination based on 
information available to him, he shall inform the foreign person that 
the interest must be treated as a U.S. real property interest unless the 
person subsequently obtains either the necessary statement from the 
corporation or a determination pursuant to subdivision (C) of this 
paragraph (g)(1)(iii).
    (C) Determination based on information supplied by foreign person. A 
foreign person may request that the Commissioner make a determination 
based on information supplied by the foreign person. Such information 
may be drawn, for example, from annual reports, financial statements, or 
records of the corporation, and must establish to the satisfaction of 
the Commissioner that the foreign person's interest was not a U.S. real 
property interest as of the date of disposition.
    (D) Determination by Commissioner on his own motion. Notwithstanding 
any other provision of this section, a foreign person shall not treat 
the disposition of an interest in a domestic corporation as a 
disposition of a U.S. real property interest if such person is notified 
that the Commissioner has upon his own motion determined that the 
interest was not a U.S. real property interest as of the date of 
disposition.
    (2) Corporations determining U.S. real property holding corporation 
status--(i) In general. A corporation that must determine whether it is 
a U.S. real property holding corporation, and that holds an interest in 
another corporation (other than a controlling interest as defined in 
paragraph (e)(3) of this section), must determine whether or not that 
interest was a U.S. real property interest as of its own determination 
date, by either:
    (A) Obtaining a statement from the second corporation pursuant to 
the provisions of subdivision (ii) of this paragraph (g)(2);
    (B) Obtaining a determination by the Commissioner pursuant to the 
provisions of subdivision (iii) of this paragraph (g)(2); or
    (C) Making an independent determination pursuant to the provisions 
of subdivision (iv) of this paragraph (g)(2).


A corporation that is unable to determine by any of the above methods 
whether its interest in a second corporation is a U.S. real property 
interest must presume that such interest is a U.S. real property 
interest.
    (ii) Statement from corporation. A corporation may determine whether 
or not an interest in a second corporation was a U.S. real property 
interest as of its own determination date by obtaining from the second 
corporation a statement that the interest was not a U.S. real property 
interest as of that date. However, the second corporation's statement 
shall not be valid for purposes of this rule, and thus may not be relied 
upon for purposes of establishing that an interest was not a U.S. real 
property interest, unless such corporation complies with the notice 
requirements of paragraph (h)(2) or (h)(4) of this section.


A corporation that requests and obtains such a statement is not required 
to forward the statement to the Internal Revenue Service and is not 
required to take any further action to establish that the interest in 
the second corporation was not a U.S. real property interest. If the 
second corporation's statement is later found to have been incorrect, 
the first corporation shall not be subject to penalties arising out of 
past failures to comply with the requirements of section 897 or 1445, if 
such failures were attributable to reliance upon the second 
corporation's statement. By the 90th day following receipt of a 
notification from the Service or from the second corporation that a 
prior statement was incorrect, the first corporation must redetermine 
its

[[Page 623]]

status (as of its most recent determination date) and if appropriate 
notify the Internal Revenue Service that it is a U.S. real property 
holding corporation in accordance with paragraph (h)(1)(ii)(C) of this 
section. However, a corporation that knew or had reason to know that a 
second corporation's statement was incorrect is not entitled to rely 
upon such statement and shall remain liable for all applicable taxes, 
penalties, and interest arising out of the second corporation's status 
as a U.S. real property holding corporation.
    (iii) Determination by Commissioner--(A) In general. A corporation 
may determine whether or not an interest in a second corporation was a 
U.S. real property interest as of its own determination date by 
requesting and obtaining a determination to that effect from the 
Commissioner. Such a determination may be requested pursuant to the 
provisions of subdivision (B) or (C) of this paragraph (g)(2)(iii). A 
request for a determination must be addressed to: Commissioner, Small 
Business/Self Employed Division (SB/SE); S C3-413 NCFB, 500 Ellin Road, 
Lanhan, MD 20706. A corporation that has requested a determination by 
the Commissioner pursuant to the provisions of this paragraph is not 
thereby excused from taking any action required by section 897 or 1445 
by the date on which such action would otherwise be due. However, the 
Commissioner may grant a reasonable extension of time for the 
satisfaction of any requirement if the Commissioner is satisfied that 
the corporation has not sought a determination pursuant to this 
paragraph (g)(2)(iii) for a principal purpose of delay.
    (B) Determination based on Commissioner's information. A corporation 
may request that the Commissioner make a determination based on 
information contained in the Commissioner's records, if:
    (1) The corporation made a request to the second corporation for 
information as to the status of its interest no later than the fifth day 
following the first corporation's determination date, and
    (2) The second corporation failed to respond to such request by the 
30th day following the date the request was delivered to the second 
corporation.


Pending his resolution of such a request, the Commissioner will 
generally grant an extension with respect to the change-of-status 
notification that may otherwise be required pursuant to paragraph 
(h)(1)(ii) of this section. If the Commissioner is unable to make a 
determination based on information available to him, he shall inform the 
corporation that the interest must be treated as a U.S. real property 
interest unless the corporation subsequently obtains either the 
necessary statement from the second corporation or a determination 
pursuant to paragraph (g)(2)(iii)(C) or (g)(2)(iv) of this section.
    (C) Determination based on information supplied by corporation. A 
corporation may request that the Commissioner make a determination based 
on information supplied by the corporation. Such information may be 
drawn, for example, from annual reports, financial statements, or 
records of the second corporation, and must establish to the 
satisfaction of the Commissioner that the interest in the second 
corporation was not a U.S. real property interest as of the first 
corporation's determination date.
    (D) Determination by Commissioner on his own motion. Notwithstanding 
any other provision of this section, a corporation shall not treat an 
interest in a second corporation as a U.S. real property interest if the 
corporation is notified that the Commissioner has upon his own motion 
determined that the interest in the second corporation is not a U.S. 
real property interest.
    (iv) Independent determination by corporation. A corporation may 
independently determine whether or not an interest in a second 
corporation was a U.S. real property interest as of the first 
corporation's own determination date. Such determination must be based 
upon the best evidence available, drawn from annual reports, financial 
statements, records of the second corporation, or from any other source, 
that demonstrates to a reasonable certainty that the interest in the 
second corporation was not a U.S. real property interest. A corporation 
that makes an independent determination pursuant to this paragraph 
(g)(2)(iv) shall be subject to the special notification rule of 
paragraph (h)(1)(iii)(D) of

[[Page 624]]

the section. If the Commissioner subsequently determines that the 
corporation's independent determination was incorrect, the corporation 
shall be subject to penalties for any past failure to comply with the 
requirements of section 897 or 1445 only if the corporation's 
determination was unreasonable in view of facts that the corporation 
knew or had reason to know.
    (3) Requirements not applicable. If at any time during the calendar 
year any class of stock of a corporation is regularly traded on an 
established securities market, the requirements of this paragraph (g) 
shall not apply with respect to any holder of an interest in such 
corporation other than a person who holds an interest described in Sec.  
1.897-1(c)(2)(iii) (A) or (B). For example, a corporation determining 
whether it is a U.S. real property holding corporation need not 
ascertain from a regularly traded corporation in which it neither holds, 
nor has held during the period described in section 897(c)(1)(A)(ii), 
more than a 5 percent interest whether that regularly traded corporation 
is itself a U.S. real property holding corporation.


In addition, the requirements of this paragraph (g) do not apply to any 
holder of an interest in a domestically-controlled RETT, as defined in 
section 897(h)(4)(B).
    (h) Notice requirements applicable to corporations--(1) Statement to 
foreign interest-holder--(i) In general. A domestic corporation must, 
within a reasonable period after receipt of a request from a foreign 
person holding an interest in it, inform that person whether the 
interest constitutes a U.S. real property interest. No particular form 
is required for this statement, which need only indicate the 
corporation's determination. The statement must be dated and signed by a 
responsible corporate officer who must verify under penalties of perjury 
that the statement is correct to his knowledge and belief.
    (ii) Required determination. For purposes of the statement required 
by paragraph (h)(1)(i) of this section, an interest in a corporation is 
a U.S. real property interest if the corporation was a U.S. real 
property holding corporation on any determination date during the 5-year 
period ending on the date specified in the interest-holder's request, or 
on the date such request was received if no date is specified (or during 
such shorter period ending on the date that is applicable pursuant to 
section 897(c)(1)(A)(ii). However, an interest in a corporation is not a 
U.S. real property interest if such interest is excluded under section 
897(c)(1)(B).
    (2) Notice to the Internal Revenue Service. If a foreign interest 
holder requests that a domestic corporation provide a statement 
described in paragraph (h)(1) of this section, then such corporation 
must provide a notice to the Internal Revenue Service in accordance with 
this paragraph (h)(2). No particular form is required for such notice, 
but the following must be provided:
    (i) A statement that the notice is provided pursuant to the 
requirements of Sec.  1.897-2(h)(2);
    (ii) The name, address, and identifying number of the corporation 
providing the notice;
    (iii) The name, address, and identifying number (if any) of the 
foreign interest holder that requested the statement (this information 
may be omitted from the notice if fully set forth in the statement to 
the foreign interest holder attached to the notice).
    (iv) Whether the interest in question is a U.S. real property 
interest;
    (v) A statement signed by a responsible corporate officer verifying 
under penalties of perjury that the notice (including any attachments 
thereto) is correct to his knowledge and belief. A copy of any statement 
provided to the foreign interest holder must be attached to the notice. 
The notice must be mailed to the address specified in the Instructions 
for Form 8288 under the heading ``Where To File'' on or before the 30th 
day after the statement referred to in Sec.  1.897-2(h)(1) is mailed to 
the interest holder that requested it. Failure to mail such notice 
within the time period set forth in the preceding sentence will cause 
the statement provided pursuant to Sec.  1.897-2(h)(1) to become an 
invalid statement.
    (3) Requirements not applicable. The requirements of this paragraph 
(h) do not apply to domestically-controlled REITS, as defined in section 
897(h)(4)(B). These requirements also do not apply to a corporation any 
class of

[[Page 625]]

stock in which is regularly traded on an established securities market 
at any time during the calendar year. However, such a corporation may 
voluntarily choose to comply with the requirements of paragraph (h)(4) 
of this section.
    (4) Voluntary notice to Internal Revenue Service--(i) In general. A 
domestic corporation which determines that it is not a U.S. real 
property holding corporation--
    (A) On each of the applicable determination dates in a taxable year, 
or
    (B) Pursuant to section 897(c)(1)(B), may attach to its income tax 
return for that year a statement informing the Internal Revenue Service 
of its determination. A corporation that has provided a voluntary notice 
described in this Sec.  1.897-2(h)(4)(i) for the immediately preceding 
taxable year and that does not have an event described in Sec.  1.897-
2(c)(1) (ii), (iii) or (iv) prior to receiving a request from a foreign 
person under Sec.  1.897-2(h)(1), is exempt from the notice requirement 
of Sec.  1.897-2(h)(2).
    (ii) Early termination of real property holding corporation status. 
A corporation that determines during the course of its taxable year that 
interests in it have ceased to be U.S. real property interests pursuant 
to the rules of section 897(c)(1)(B) may, on the day of its 
determination or thereafter, provide a statement to the address 
specified in the Instructions for Form 8288 under the heading ``Where To 
File'', informing the Service of its determination. No particular form 
is required but the statement must set forth the corporation's name, 
address, identification number, a brief statement regarding its 
determination and the date such determination was made. Such statement 
will enable foreign interest-holders to dispose of their interests 
without being subject to section 897(a), as provided in paragraph (g) of 
this section.
    (5) Supplemental statements--(i) By corporations with substantial 
intangible assets. A corporation that is subject to the requirements of 
paragraph (h)(2) of this section (or that voluntarily complies with the 
requirements of paragraph (h)(4) of this section) must submit a 
supplemental statement to the Internal Revenue Service if--
    (A) Such corporation values any of the intangible assets described 
in Sec.  1.897-1(f)(1)(ii) (other than goodwill or going concern value) 
by a method other than the purchase price or book value methods 
described in Sec.  1.897-1(o)(4); and
    (B) The fair market value of such intangible assets equals or 
exceeds 25 percent of the total of the fair market values of the assets 
the corporation is considered to hold in accordance with the provisions 
of paragraphs (d) and (e) of this section.
    The supplemental statement must inform the Internal Revenue Service 
that the corporation meets the criteria of subdivisions (A) and (B) of 
this paragraph (h)(5)(i), and must summarize the methods and 
calculations upon which the corporation's determination of the fair 
market value of its intangible assets is based. In addition, the 
supplemental statement must list any intangible assets that were 
purchased from any person that have been valued by the corporation at an 
amount other than their purchase price, and must provide a justification 
for such a departure from the purchase price. The supplemental statement 
must be attached to or incorporated in the statement provided under 
paragraph (h)(2) or (h)(4) of this section.
    (ii) Corporation not valuing goodwill or going concern value at 
purchase price. A corporation that is subject to the requirements of 
paragraph (h)(2) of this section (or that voluntarily complies with the 
requirements of paragraph (h)(4) of this section) must submit a 
supplemental statement to the Internal Revenue Service if such 
corporation values goodwill or going concern value pursuant to Sec.  
1.897-1(o)(4)(iii). The supplemental statement must set forth that it is 
made pursuant to this paragraph (h)(5)(ii), and must summarize the 
methods and calculations upon which the corporation's determination of 
the fair market value of such intangible assets is based. In addition, 
the supplemental statement must list any such assets that were purchased 
from any person that have been valued by the corporation at an amount 
other than their purchase price, and must provide a justification for 
such a departure from the purchase price. The supplemental statement 
must be attached

[[Page 626]]

to or incorporated in the statement provided under paragraph (h)(2) or 
(h)(4) of this section.
    (iii) Corporation using alternative U.S. real property holding 
corporation test. A corporation that is subject to the requirements of 
paragraph (h)(2) of this section (or that voluntarily complies with the 
requirements of paragraph (h)(4) of this section) must submit a 
supplemental statement to the Internal Revenue Service if--
    (A) Such corporation utilizes the rule of paragraph (b)(2) of this 
section (regarding the book values of assets held by the corporation) to 
presume that it is not a U.S. real property holding corporation; and
    (B) Such corporation is engaged in or is planning to engage in a 
trade or business of mining, farming, or forestry, or of buying and 
selling or developing real property, or of leasing real property to 
tenants.
    The supplemental statement must inform the Internal Revenue Service 
that the corporation meets the criteria of subdivisions (A) and (B) of 
this paragraph (h)(5)(iii), and must be attached to or incorporated in 
the statement provided under paragraph (h)(2) or (h)(4) of this section.
    (iv) Corporation determining real property holding corporation 
status of second corporation. A corporation that is subject to the 
requirements of paragraph (h)(2) of this section (or that voluntarily 
complies with the requirements of paragraph (h)(4) of this section) must 
submit a supplemental statement to the Internal Revenue Service if such 
corporation independently determines whether or not an interest in a 
second corporation is a U.S. real property interest, pursuant to 
paragraph (g)(2)(iv) of this section. The supplemental statement must 
set forth that it is made pursuant to this paragraph (h)(5)(iv) and must 
briefly summarize the facts upon which the corporation's determination 
is based and the sources of the information relied upon by the 
corporation. The supplemental statement must be attached to or 
incorporated in the statement provided under paragraph (h)(2) or (h)(4) 
of this section.
    (i) Transition Rules--(1) General waiver of penalties for failure to 
file. If a foreign person disposed of an interest in a domestic 
corporation between June 18, 1980 and January 23, 1987, and such person 
establishes under the rules of paragraph (g) of this section at any time 
that the interest disposed of was not a U.S. real property interest, 
then such person shall not be subject to tax under section 897 and shall 
not be subject to penalties (or interest) for failure to file an income 
tax return with respect to such disposition.
    (2) Foreign persons that met the requirements of prior regulations. 
A foreign person that disposed of an interest in a domestic corporation 
between June 18, 1980 and January 23, 1987, shall be deemed to have 
satisfied the requirements of paragraph (g) of this section with respect 
to such disposition if such person established under prior temporary or 
prior final regulations issued under section 897 that the interest 
disposed of was not a U.S. real property interest.

(Sec. 897 (94 Stat. 2683; 26 U.S.C. 897), sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the 
Internal Revenue Code of 1954)

[T.D. 7999, 49 FR 50702, Dec. 31, 1984; 50 FR 12531, Mar. 29, 1985; T.D. 
8113, 51 FR 46627, Dec. 24, 1986; 52 FR 3796, 3916, Feb. 6, 1987; T.D. 
9082, 68 FR 46083, Aug. 5, 2003; T.D. 9751, Feb. 19, 2016]



Sec.  1.897-3  Election by foreign corporation to be treated as 
a domestic corporation under section 897(i).

    (a) Purpose and scope. This section provides rules pursuant to which 
a foreign corporation may elect under section 897(i) to be treated as a 
domestic corporation for purposes of sections 897, 1445, and 6039C and 
the regulations thereunder. A foreign corporation with respect to which 
an election under section 897(i) is in effect is subject to all rules 
under sections 897 and 1445 that apply to domestic corporations. Thus, 
for example, if a foreign corporation that has made an election under 
section 897(i) is a U.S. real property holding corporation, interests in 
it are U.S. real property interests that are subject to withholding 
under section 1445, and any gain or loss from the disposition of such 
interests by a foreign person will be treated as effectively connected

[[Page 627]]

with a U.S. trade or business under section 897(a). Similarly, if a 
foreign corporation makes an election under section 897(i), its 
distribution of a U.S. real property interest pursuant to section 301 
will be subject to the carryover basis rule of section 897(f). However, 
an interest in an electing corporation is not a U.S. real property 
interest if following the election the interest is described in section 
897(c)(1)(B) or Sec.  1.897-1(c)(2) (subject to the exceptions of 
subdivisions (i) and (ii) of that section). In addition, section 897(d) 
will not apply to any distribution of a U.S. real property interest by 
such corporation or to any sale or exchange of such interest pursuant to 
a plan of complete liquidation under section 337. A foreign corporation 
that makes an election under section 897(i) shall not be treated as a 
domestic corporation for purposes of any other provision of the Code or 
regulations, except to the extent that it is required to consent to such 
treatment as a condition to making the election. For further information 
concerning the effect of an election under section 897(i) upon the 
withholding requirements of section 1445, see Sec.  1.1445-7. An 
election under section 897(i) is the exclusive remedy of any foreign 
person claiming discriminatory treatment under any treaty with respect 
to the application of sections 897, 1445, and 6039C to a foreign 
corporation. Therefore, if a corporation does not make an effective 
election, relief under a nondiscrimination article of any treaty shall 
not be otherwise available with respect to the application of sections 
897, 1445, and 6039C to such corporation.
    (b) General conditions. A foreign corporation may make an election 
under section 897(i) only if it meets all three of the following 
conditions.
    (1) Holding a U.S. real property interest. The foreign corporation 
must hold a U.S. real property interest at the time of the election. 
This condition is satisfied when a U.S. real property interest is 
acquired simultaneously with the effective date of an election. For 
example, this condition is satisfied when real property is acquired in 
an exchange described in section 351 that is carried out simultaneously 
with the effective date of the election. This condition is also 
satisfied by a corporation that indirectly holds a U.S. real property 
interest through a partnership, trust, or estate.
    (2) Entitlement to nondiscriminatory treatment. The foreign 
corporation must be entitled to nondiscriminatory treatment with respect 
to its U.S. real property interest under any treaty to which the United 
States is a party. Where the corporation indirectly holds a U.S. real 
property interest through a partnership, trust, or estate, the 
corporation itself must be entitled to nondiscriminatory treatment with 
respect to such property interest.
    (3) Submission of election in proper form. The foreign corporation 
must comply with the requirements of paragraph (c) of this section 
respecting the manner and form in which an election must be submitted.
    (c) Manner and form of election. An election under section 897(i) is 
made by filing the materials described in subparagraphs (1) through (5) 
of this paragraph (c) at the address specified in the Instructions for 
Form 8288 under the heading ``Where To File''. The required items may be 
incorporated in a single document.
    (1) General statement. The foreign corporation must supply a general 
statement indicating that an election under section 897(i) is being 
made. The general statement must be signed by a responsible corporate 
officer, who must verify under penalty of perjury that the statement and 
all other documents submitted pursuant to the requirements of this 
paragraph (c) are true and correct to his knowledge and belief. No 
particular form is required for the statement, which must contain all 
the following information--
    (i) The name, address, identifying number, and place and date of 
incorporation of the foreign corporation;
    (ii) The treaty and article under which the foreign corporation is 
seeking nondiscriminatory treatment;
    (iii) A description of the U.S. real property interests held by the 
corporation, either directly or through a partnership, trust, or estate, 
including the dates such interests were acquired, the corporation's 
adjusted bases in such interests, and their fair market values as of the 
date of the election (or book values if the corporation is not a U.S. 
real

[[Page 628]]

property holding corporation under the alternative test of Sec.  1.897-
2(b)(2)); and
    (iv) A list of all dispositions of any interests in the foreign 
corporation after December 31, 1979, and before June 19, 1980, between 
related persons (as defined in section 453(f)(1)), giving the type and 
the amount of any interest transferred, the name and address of the 
related person to whom the interest was transferred, the transferor's 
basis in the interest transferred, and the amount of any nontaxed gain 
as defined in section 1125(d) of Pub. L. 96-499.
    (2) Waiver of treaty benefits. The foreign corporation must submit a 
binding waiver of the benefits of any U.S. treaty with respect to any 
gain or loss from the disposition of a U.S. real property interest 
during the period in which the election is in effect.
    (3) Consent to be taxed. The foreign corporation must submit a 
binding agreement to treat as though it were a domestic corporation any 
gain or loss that is recognized upon--
    (i) The disposition of any U.S. real property interest during the 
period in which the election is in effect, and
    (ii) The disposition of any property that it acquired in exchange 
for a U.S. real property interest in a nonrecognition transaction (as 
defined under section 897(e)) during the period in which the election is 
in effect.
    (4) Interest-holders' consent to election--(i) In general. The 
foreign corporation must submit both a signed consent to the making of 
the election and a waiver of U.S. treaty benefits with respect to any 
gain or loss from the disposition of an interest in the corporation from 
each person who holds an interest in the corporation on the date the 
election is made. In the case of a corporation any class of stock of 
which is regularly traded on an established securities market at any 
time during the calendar year, the signed consent and waiver need only 
be provided by a person who holds an interest described in Sec.  1.897-
1(c)(2)(iii)(A) or (B) (determined after application of the constructive 
ownership rules of section 897(c)(6)(C). The foreign corporation must 
also include with the signed consents and waivers a list that identifies 
and describes the interest in the corporation held by each interest 
holder, including the type and amount of such interest and its fair 
market value as of the date of the election.
    (ii) Corporation's retention of interest-holders' consents. A 
corporation need not file the consents and waivers of its interest-
holders as required by paragraph (c)(4)(i) of this section, if it 
instead complies with the requirements of subdivisions (A) through (D) 
of this paragraph (c)(4)(ii).
    (A) The corporation must place a legend on each outstanding 
certificate for shares of its stock that reads substantially as follows: 
``(Name of corporation) has made an election under section 897(i) of the 
United States Internal Revenue Code to be treated as a U.S. corporation 
for certain tax purposes, and any purchaser of this interest may 
therefore be required to withhold tax at the time of the purchase.'' The 
corporation must certify that the foregoing requirement has been met and 
that it will place an equivalent legend on every stock certificate that 
is issued while the election under section 897(i) is in effect and the 
corporation retains the consents and waivers of its interest-holders 
under the rules of this paragraph (c)(4)(ii). However, with respect to 
any registered certificate issued prior to January 30, 1985, in lieu of 
placing a legend on the certificate the corporation may certify that it 
will provide the purchaser of the interest with a copy of the legend at 
the time the certificate is surrendered for issuance of a new 
certificate.
    (B) The corporation must include with its election a statement that 
the corporation has received both a signed consent to the making of the 
election and a waiver of U.S. treaty benefits with respect to any gain 
or loss from the disposition of an interest in the corporation from each 
person who holds an interest in the corporation on the date the election 
is made. In the case of a corporation any class of stock of which is 
regularly traded on an established securities market at any time during 
the calendar year, the signed consent and waiver need only be provided 
by a person who holds or has held an interest described in Sec.  1.897-
1(c)(2)(iii) (A) or (B) (determined after

[[Page 629]]

application of the constructive ownership rules of section 897(c)(6)(C).
    (C) The corporation must include with its election a list that 
describes the interests in the corporation held by each interest-holder. 
The list need not identify the interest-holders by name, but must set 
forth the type, amount, and fair market value of the interests held by 
each.
    (D) The corporation must include with its election an agreement that 
the corporation will retain all signed consents and waivers for a period 
of three years from the date of the election and supply such documents 
to the Director within 30 days of his request for production thereof. 
The Director's review of the signed consents and waivers pursuant to 
this provision shall not constitute an examination for purposes of 
section 7605(b).
    (5) Statement regarding prior dispositions. The foreign corporation 
must state that no interest in the corporation was disposed of during 
the shortest of (A) the period from June 19, 1980, through the date of 
the election, (B) the period from the date on which the corporation 
first holds a U.S. real property interest through the date of the 
election or (C) the five-year period ending on the date of the election. 
If the corporation cannot state that no such dispositions have been 
made, it may make the section 897(i) election only if it states that it 
has complied with the requirements of paragraph (d)(2) of this section.
    (d) Time and duration of election--(1) In general. A foreign 
corporation that meets the conditions of paragraph (b) of this section 
may make an election under section 897(i) at any time before the first 
disposition of an interest in the corporation which would be subject to 
section 897(a) if the election had been made before that disposition, 
except as otherwise provided in paragraph (d)(2) of this section. The 
period to which the election applies begins on the date on which the 
election is made, or such earlier date as is specified in the election, 
but not earlier than June 19, 1980. Unless revoked, an election applies 
for the duration of the time for which the corporation remains in 
existence. An election is made on the date that the statements described 
in paragraph (c) of this section are delivered to the address specified 
in the Instructions for Form 8288 under the heading ``Where To File''. 
If the election is delivered by United States mail, the provisions of 
section 7502 and the regulations thereunder shall apply in determining 
the date of delivery.
    (2) Election after disposition of stock. An election under section 
897(i) may be made after any disposition of an interest in the 
corporation which would have been subject to section 897(a) if the 
election had been made before that disposition, but only if the 
requirements of either subdivision (i) or (ii) of this paragraph (d)(2) 
are met with respect to all dispositions of interests during the period 
described in paragraph (c)(5) of this section.
    (i) There is a payment of an amount equal to any taxes which would 
have been imposed by reason of the application of section 897 upon all 
persons who had disposed of interests in the corporation during the 
period described in paragraph (c)(5) of this section had the corporation 
made the election prior to such dispositions. Such payment must be made 
by the later of the date the election is made, or the date on which 
payment of such taxes would otherwise have been due, and must include 
any interest that would have accrued had tax actually been due with 
respect to the disposition. As an election made prior to any disposition 
of interests in the corporation would have been conditioned on a waiver 
of treaty benefits by the interest-holders, payment of an amount equal 
to tax and any interest with respect to such prior disposition is 
required as a condition to making a subsequent election under this 
subdivision (i) irrespective of the application of any treaty provision. 
For this purpose, it is not necessary that the payment be made by the 
person who would have owed the tax if the election under this section 
had been made prior to the disposition, and that person is under no 
obligation to supply any information to the present holders of interests 
in the electing corporation. The payment shall be made to the U.S. 
Treasury. Where the payment is made by a present holder of an interest, 
the basis

[[Page 630]]

of the person's interest in the corporation shall be increased to the 
extent of the amount paid.
    (ii) Each person that acquired an interest in the electing 
corporation took a basis in the interest that was equal to the basis of 
the interest in the hands of the person from which the interest was 
acquired, increased by the sum of any gain recognized by the transferor 
of the interest and any tax paid under chapter 1 by the person that 
acquired the interest, if such interest was acquired after June 18, 
1980.
    (3) Adequate proof of basis. For purposes of meeting the conditions 
of paragraph (d)(2) (i) or (ii) of this section, a corporation must 
establish the bases of and amount of gain realized by all persons who 
disposed of interests in the corporation during the period described in 
paragraph (c)(5) of this section. See paragraph (g)(3) of this section 
for an exception to this rule.
    (4) Acknowledgement of receipt. Within 60 days after its receipt of 
an election udner section 897(i), the Internal Revenue Service will 
acknowledge receipt of the election. Such acknowledgement either will 
indicate that the information submitted with the election is complete or 
will specify any documents that remain to be submitted pursuant to the 
requirements of paragraph (c) of this section respecting the manner and 
form in which an election must be made.
    (e) Anti-abuse rule--(1) In general. A corporation that is otherwise 
eligible to make an election under section 897(i) may do so only by 
complying with the requirements of subdivision (2) of this paragraph, if 
during the period described in paragraph (c)(5) of this section--
    (i) Prior to receipt of a U.S. real property interest by the 
corporation seeking to make the election, stock in such corporation (or 
in any corporation controlled by such corporation) was acquired in a 
transaction in which the person acquiring such stock obtained an 
increase in basis in the stock over the adjusted basis of the stock in 
the hands of the person from whom it was acquired;
    (ii) The full amount of gain realized by the person from whom the 
stock was acquired was not subject to U.S. tax; and
    (iii) The corporation seeking to make the election received the U.S. 
real property interest in a transaction or series of transactions to 
which section 897 (d)(1)(B) or (e)(1) applies to allow for 
nonrecognition of gain.
    (2) Recognition of gain. A corporation described in subparagraph (1) 
of this paragraph (e) may make an election under section 897(i) only if 
it pays an amount equal to the tax on the full amount of gain realized 
by the transferors of the stock of such corporation (or of any 
corporation controlled by it) in the transaction described in paragraph 
(e)(1)(i) of this section. However, such amount must be paid only if the 
stock of the corporation seeking to make the election (or the stock of a 
corporation controlled by it) would have constituted a U.S. real 
property interest had it (or a corporation controlled by it) made the 
election before that acquisition. Such amount must be paid by the later 
of the date of the election or the date on which such tax would 
otherwise be due, and must include any interest that would have accrued 
had tax actually been due with respect to the disposition.
    (3) Definition of control. For purposes of this paragraph, a 
corporation controls a second corporation if it holds 80 percent or more 
of the total combined voting power of all classes of stock entitled to 
vote, and 80 percent or more of the total number of shares of all other 
classes of stock of the second corporation. In a chain of corporations 
where each succeeding corporation is controlled within the meaning of 
this subparagraph (3) by the corporation immediately above it in the 
chain, each corporation in the chain shall be considered to be 
controlled by all corporations that preceded it in the chain.
    (4) Examples. The rules of this paragraph (e) are illustrated by the 
following examples.

    Example 1. Nonresident alien individual X owns 100 percent of the 
stock of foreign corporation L which was organized in 1981. L's only 
asset is a parcel of U.S. real property which it has held since 1981. 
The fair market value of the U.S. real property held by L on January 1, 
1984, is $1,000,000. L's basis in the property is $200,000. X's basis in 
the L stock is $500,000. On June 1, 1984, M corporation, a

[[Page 631]]

foreign corporation owned by foreign persons who are unrelated to X, 
purchases the stock of L from X for $1,000,000 with title passing 
outside of the United States. Since the stock of L is not a U.S. real 
property interest, X's gain from the disposition of the L stock 
($500,000) is not treated as effectively connected with a U.S. trade or 
business under section 897(a). In addition, since X was neither engaged 
in a U.S. trade or business nor present in the U.S. at any time during 
1984, such gain is not subject to U.S. tax under section 871. On January 
1, 1987, M liquidates L under a plan of liquidation adopted on that same 
date. Under section 332 of the Code M recognizes no gain on receipt of 
the parcel of U.S. real property distributed by L in liquidation. Under 
section 334(b)(1) M takes $200,000 as its basis in the U.S. real 
property received from L. Under section 897(d)(1)(B) no gain would be 
recognized to L under section 897(d)(1)(A) on the liquidating 
distribution. As a consequence, no gain is recognized to L under section 
336 of the Code. After its receipt of the U.S. real property from L, M 
seeks to make an election to be treated as a domestic corporation. Thus, 
M acquired the L stock in a transaction in which it obtained a basis in 
such stock in excess of the adjusted basis of X in the stock, U.S. tax 
was not paid on the full amount of the gain realized by X, and M has 
received the property in a distribution to which section 897(d)(1)(B) 
applied to provide for nonrecognition of gain to L. Therefore, M may 
make the election only if it pays an amount equal to the tax on the full 
amount of X's gain, pursuant to the rule of subparagraph (e)(2) of this 
section.
    Example 2. Nonresident alien individual X owns 100 percent of the 
stock of foreign corporation A which owns 100 percent of the stock of 
foreign corporation B. X's basis in the A stock is $500,000. A's basis 
in the B stock is $500,000. B owns U.S. real property with a fair market 
value of $1,000,000. B's basis in the U.S. real property is $500,000. On 
January 1, 1985, X sells the stock of A to Y, an unrelated individual, 
for $1,000,000 with title passing outside of the United States. In 
addition, X was neither engaged in a U.S. trade or business nor present 
in the U.S. at any time during 1985. Since the A stock is not a U.S. 
real property interest, X's gain on such disposition is not treated as 
effectively connected with a U.S. trade or business under section 897(a) 
and is therefore not subject to U.S. tax under section 871. On July 1, 
1987, a plan of liquidation is adopted, and B is liquidated into A. 
Under sections 332, 334(b)(1), 336, and 897(d)(1)(B), there is no tax to 
A on receipt of U.S. real property from B and no tax to B on the 
distribution of the U.S. real property interest to A. After receipt of 
the property A seeks to make an election under section 897(i). Under the 
rules of paragraph (e) of this section, A may make the election only if 
it pays an amount equal to the tax on the full amount of X's gain. 
(Assuming that A is a U.S. real property holding corporation, the same 
result would be required by the rule of paragraph (d)(2) of this 
section.)

    (f) Revocation of election--(1) In general. An election under 
section 897(i) may be revoked only with the consent of the Commissioner. 
A request for revocation shall be in writing and shall be delivered to 
the address specified in the Instructions for Form 8288 under the 
heading ``Where To File''. The request shall include the name, address, 
and identifying number of the corporation seeking to revoke the 
election, and a description of all U.S. real property interests held by 
the corporation on the date of the request for revocation, including the 
dates such interests were acquired, the corporation's adjusted bases in 
such interests, and their fair market values as of the date of the 
request (or book value if the corporation is not a U.S. real property 
holding corporation under the alternative test of Sec.  1.897-2(b)(2)). 
The request shall be signed by a responsible officer of the corporation 
under penalty of perjury and shall contain a statement either that the 
corporation has made no distributions described in subparagraph (2) of 
this paragraph (f) or that the conditions of that subparagraph have been 
satisifed. A revocation will be effective as of the date the request is 
delivered to the address specified in the Instructions for Form 8288 
under the heading ``Where To File'', unless the Commissioner provides 
otherwise in his consent to the revocation. If the request is delivered 
by United States mail, the provisions of section 7502 and the 
regulations thereunder shall apply in determining the date of delivery. 
The Commissioner will generally consent to a revocation, provided either 
that there have been no distributions described in subparagraph (2) of 
this paragraph (f), or that the conditions of that subparagraph have 
been satisfied. Within 90 days after its receipt of a request to revoke 
an election under section 897(i), the Internal Revenue Service will 
acknowledge receipt of the request. Such acknowledgement either will 
indicate that the information submitted with the request is complete or 
will specify any information that remains to be

[[Page 632]]

submtted pursuant to the requirements of this paragraph (f).
    (2) Revocation after distribution. If there have been any 
distributions of U.S. real property interests by the corporation during 
the period to which an election made under section 897(i) applies, the 
Commissioner shall consent to the revocation of such election only if 
one of the following conditions is met.
    (i) The full amount of gain realized by the corporation upon the 
distribution was subject to U.S. income tax.
    (ii) There is a payment of an amount equal to the taxes that would 
have been imposed upon the corporation by reason of the application of 
section 897 if the election had not been in effect on the date of the 
distribution. Such payment must be made by the later of the date of the 
request for revocation or the date on which payment of such tax would 
otherwise have been due, and must include any interest that would have 
accrued had tax actually been due with respect to the distribution. If 
under the terms of any treaty to which the United States is a party such 
distribution would not have been subject to U.S. income tax 
notwithstanding the provisions of section 897, then this condition may 
be satisfied by providing a statement with the request for revocation 
setting forth the treaty and article which would have exempted the 
distribution from U.S. tax had the election under section 897(i) not 
been in effect on the date thereof.
    (iii) At the time of the receipt of the distributed property, the 
distributee would be subject to taxation under chapter 1 of the Code on 
a subsequent disposition of the distributed property, and the basis of 
the distributed property in the hands of the distributee is no greater 
than the adjusted basis of such property before the distribution, 
increased by the amount of gain (if any) recognized by the distributing 
corporation. For purposes of this paragraph (f)(2)(i)(C), a distributee 
shall be considered to be subject to taxation upon a subsequent 
disposition of distributed property only if such distributee waives the 
benefits of any U.S. treaty that would otherwise render such disposition 
not taxable by the United States. Such waiver must be attached to the 
corporation's request for revocation.
    (g) Transitional rules--(1) In general. An election under section 
897(i) that was made at any time after June 18, 1980, must be amended to 
comply with the requirements of paragraphs (b), (c), and (d) of this 
section. Such amendment must be delivered in writing to the Director, 
Philadelphia Service Center by April 1, 1985. If the amendment is 
delivered by United States mail, the provisions of section 7502 and the 
regulations thereunder shall apply in determining the date of delivery. 
An election that is properly amended pursuant to the requirements of 
this section shall be effective as of the date of the original election.
    (2) Corporations previously entitled to make election. A foreign 
corporation that would have been entitled under the rules of this 
section to make a section 897(i) election at any time between June 19, 
1980, and January 30, 1985, may retroactively make such an election 
pursuant to the requirements of this section. Such election must be 
delivered to the Director, Foreign Operations District, by March 1, 
1985.
    (3) Interests in corporation disposed of prior to publication. Where 
interests in a corporation were disposed of before January 3, 1984, the 
requirement of paragraph (d)(2) of this section may be met, 
notwithstanding the requirement of paragraph (d)(3), by paying a tax 
that is based upon a reasonable estimate of the gain upon the prior 
dispositions. Such estimate must be based on all facts and circumstances 
known to, and ascertainable through the exercise of reasonable diligence 
by, the corporation seeking to make the election.
    (h) Effective date. The requirement in paragraph (c)(1)(i) of this 
section that the statement making the section 897(i) election contain 
the identifying number of the foreign corporation (in all cases) is 
applicable November 3, 2003.

(Sec. 897 (94 Stat. 2683; 26 U.S.C. 897), sec. 6011 (68A Stat. 732; 26 
U.S.C. 6011) and sec. 7805 (68A Stat. 917; 26 U.S.C. 7805) of the 
Internal Revenue Code of 1954)

[T.D. 7999, 49 FR 50713, Dec. 31, 1984; 50 FR 12531, Mar. 29, 1985; T.D. 
8113, 51 FR 46629, Dec. 24, 1986; T.D. 9082, 68 FR 46083, Aug. 5, 2003; 
T.D. 9751, 81 FR 8400, Feb. 19, 2016]

[[Page 633]]



Sec.  1.897-4AT  Table of contents (temporary).

           Sec.  1.897-5T Corporate distributions (temporary).

    (a) Purpose and scope.
    (b) Distributions by domestic corporations.
    (1) Limitation of basis upon dividend distribution of U.S. real 
property interest.
    (2) Distributions by U.S. real property holding corporation under 
generally applicable rules.
    (3) Section 332 liquidations of U.S. real property holding 
corporations.
    (i) General rules.
    (ii) Distribution to a foreign corporation under section 332 after 
June 18, 1980, and before the repeal of the General Utilities doctrine.
    (iii) Distribution to a foreign corporation under section 332 and 
former section 334(b)(2) after June 18, 1980.
    (iv) Distribution to a foreign corporation under section 332(a) 
after July 31, 1986 and after the repeal of the General Utilities 
doctrine.
    (A) Liquidation of domestic corporation.
    (B) Liquidation of certain foreign corporations making a section 
897(i) election.
    (v) Transfer of foreign corporation stock followed by a section 332 
liquidation treated as a reorganization.
    (4) Section 897(i) companies.
    (5) Examples.
    (6) Section 333 elections.
    (i) General rule.
    (ii) Example.
    (c) Distributions of U.S. real property interests by foreign 
corporations.
    (1) Recognition of gain required.
    (2) Recognition of gain not required.
    (i) Statutory exception.
    (ii) Section 332 liquidations.
    (A) In general.
    (B) Recognition of gain required in certain section 332 
liquidations.
    (iii) Examples.
    (3) Limitation of gain recognized under paragraph (c)(1) of this 
section for certain section 355 distributions.
    (i) In general.
    (ii) Example.
    (4) Distribution by a foreign corporation in certain 
reorganizations.
    (i) In general.
    (ii) Statutory exception.
    (iii) Regulatory limitation on gain recognized.
    (iv) Examples.
    (5) Sales of U.S. real property interests by foreign corporations 
under section 337.
    (6) Section 897(l) credit.
    (7) Other applicable rules.
    (d) Rules of general application.
    (1) Interests subject to taxation upon later dispositions.
    (i) In general.
    (ii) Effects of income tax treaties.
    (A) Effect of treaty exemption from tax.
    (B) Effect of treaty reduction of tax.
    (C) Waiver of treaty benefits to preserve nonrecognition.
    (iii) Procedural requirements.
    (2) Treaty exception to imposition of tax.
    (3) Withholding.
    (4) Effect on earnings and profits.
    (e) Effective date.

Sec.  1.897-6T Nonrecognition exchanges applicable to corporations their 
shareholders, and other taxpayers, and certain transfers of property in 
                 corporate reorganizations (temporary).

    (a) Nonrecognition exchanges.
    (1) In general.
    (2) Definition of nonrecognition provision.
    (3) Consequence of nonapplication of nonrecognition provisions.
    (4) Section 355 distributions treated as exchanges.
    (5) Section 1034 rollover of gain.
    (i) Purchase of foreign principal residence.
    (ii) Purchase of U.S. principal residence.
    (6) Determination of basis.
    (7) Examples.
    (8) Treatment of nonqualifying property.
    (i) In general.
    (ii) Treatment of mixed exchanges.
    (A) Allocation of nonqualifying property.
    (B) Recognition of gain.
    (C) Treatment of other amounts.
    (iii) Example.
    (9) Treaty exception to imposition of tax.
    (b) Certain foreign to foreign exchanges.
    (1) Exceptions to the general rule.
    (2) Applicability of exception.
    (3) No exceptions.
    (4) Examples.
    (5) Contribution of property.
    (c) Denial of nonrecognition with respect to certain tax avoidance 
transfers.
    (1) In general.
    (2) Certain transfers to domestic corporations.
    (i) General rule.
    (ii) Example.
    (3) Basis adjustment for certain related person transactions.
    (4) Rearrangement of ownership to gain treaty benefit.
    (d) Effective date.

 Sec.  1.897-7T Treatment of certain partnership interests as entirely 
     U.S. real property interests under section 897(g) (temporary).

    (a) Rule.
    (b) Effective date.

 Sec.  1.897-8T Status as a U.S. real property holding corporation as a 
    condition for electing section 897(i) pursuant to Sec.  1.897-3 
                              (temporary).

    (a) Purpose and scope.
    (b) General conditions.
    (c) Effective date.

[[Page 634]]

    Sec.  1.897-9T Treatment of certain interests in publicly traded 
corporations, definition of foreign person, and foreign governments and 
                international organizations (temporary).

    (a) Purpose and scope.
    (b)
    (c) Foreign person.
    (d) Regularly traded.
    (e) Foreign governments and international organizations.
    (f) Effective date.

[T.D. 8198, 53 FR 16217, May 5, 1988]



Sec.  1.897-5  Corporate distributions.

    (a) through (d)(1)(iii)(E) [Reserved]. For further guidance, see 
Sec.  1.897-5T(a) through (d)(1)(iii)(E).
    (d)(1)(iii)(F) Identification by name and address of the distributee 
or transferee, including the distributee's or transferee's taxpayer 
identification number;
    (d)(1)(iii)(G) through (d)(4) [Reserved]. For further guidance, see 
Sec.  1.897-5T(d)(1)(iii)(G) through (d)(4).
    (e) Effective date. This section is applicable to transfers and 
distributions after November 3, 2003.

[T.D. 9082, 68 FR 46083, Aug. 5, 2003]



Sec.  1.897-5T  Corporate distributions (temporary).

    (a) Purpose and scope. This section provides rules concerning the 
recognition of gain or loss and adjustments to basis required with 
respect to certain corporate distributions that are subject to section 
897. Paragraph (b) of this section provides rules concerning such 
distributions by domestic corporations, including distributions under 
section 301, distributions in redemption of stock, and distributions in 
liquidation. Paragraph (c) sets forth rules concerning distributions by 
foreign corporations, including distributions under sections 301 and 
355, distributions in redemption of stock, and distributions in 
liquidation. Finally, various rules generally applicable to 
distributions subject to this section, as well as to transfers subject 
to Sec.  1.897-6T, are set forth in paragraph (d). The rules contained 
in this section are also subject to the tax avoidance rules of Sec.  
1.897-6T(c).
    (b) Distributions by domestic corporations--(1) Limitation of basis 
upon dividend distribution of U.S. real property interest. Under section 
897(f), if any domestic corporation (distributing corporation) 
distributes a U.S. real property interest to a shareholder that is a 
foreign person (distributee) in a distribution to which section 301 
applies, then the basis of the distributed U.S. real property interest 
in the hands of the foreign distributee shall be determined in 
accordance with the provisions of section 301(d), and shall not exceed--
    (i) The adjusted basis of the property before the distribution in 
the hands of the distributing corporation, increased by
    (ii) The sum of--
    (A) Any gain recognized by the distributing corporation on the 
distribution, and
    (B) Any U.S. tax paid by or on behalf of the distributee with 
respect to the distribution.
    (2) Distributions by U.S. real property holding corporations which 
are taxable exchanges of stock under generally applicable rules. If a 
domestic corporation, stock in which is treated as a U.S. real property 
interest, distributes property with respect to such stock to a foreign 
shareholder, the distributee shall be treated as having disposed of a 
U.S. real property interest, and shall recognize gain or loss on the 
stock of such domestic corporation to the extent that, with respect to 
the distributees--
    (i) Part of all of the distribution is treated pursuant to section 
301(c)(3)(A) as a sale or exchange of stock;
    (ii) Part or all of the distribution is treated pursuant to section 
302(a) as made in part or full payment in exchange for stock; or
    (iii) Part or all of the distribution is treated pursuant to section 
331(a) as made in full payment in exchange for stock.


Stock in a domestic corporation shall not be considered a U.S. real 
property interest pursuant to the provisions of Sec.  1.897-2(f)(2) if 
the corporation does not hold any U.S. real property interests and has 
disposed of all of its U.S. real property interests owned within the 
previous five years in transactions in which the full amount of gain was 
recognized under the rules of Sec.  1.897-2(f)(2). If gain is recognized 
at the corporate level on either a distribution of a U.S.

[[Page 635]]

real property interest or a sale of a U.S. real property interest in a 
liquidation, such distribution or sale shall be considered a disposition 
for purposes of Sec.  1.897-2(f)(2). With regard to the consequences of 
a distribution from a U.S. real property holding corporation under 
section 355(a), see Sec.  1.897-6T(a) (1) and (4).
    (3) Section 332 liquidations of U.S. real property holding 
corporations--(i) General rules. Exchanges that are subject to section 
897(e) are normally covered by Sec.  1.897-6T(a) (1), (2) and (3). This 
paragraph (b)(3) provides rules concerning the application of section 
897(e) and the general principles of Sec.  1.897-6T(a) (1), (2) and (3) 
to section 332 liquidations of U.S real property holding corporations.
    (ii) Distribution to a foreign corporation under section 332 after 
June 18, 1980, and before the repeal of the General Utilities doctrine. 
Except for distributions under paragraph (b)(3)(iii) of this section 
(relating to section 332 and former section 334(b)(2)), the rules of 
this paragraph (b)(3)(ii) shall apply to section 332 distributions after 
June 18, 1980, and before January 1, 1990, pursuant to section 336(a) as 
in effect prior to the effective dates of the amendments made by section 
631 of the Tax Reform Act of 1986. A foreign corporation that meets the 
stock ownership requirements of section 332(b) with respect to stock in 
a domestic corporation that is a U.S. real property interest shall not, 
after December 31, 1984, be subject to taxation by reason of section 
367(a). The foreign corporation shall recognize gain pursuant to section 
897(e)(1) on such stock upon the receipt of property in a section 332(a) 
liquidation from such domestic corporation, but only to the extent that 
the property received constitutes property other than a U.S. real 
property interest. The gain on the stock in the domestic corporation to 
be recognized by the foreign corporation pursuant to section 897(e)(1) 
shall be determined by multiplying the gain realized on the distribution 
by a fraction. The numerator of the fraction shall be the fair market 
value of the property other than U.S. real property interests received 
by the foreign corporation on the distribution, and the denominator 
shall be the fair market value of all property received by the foreign 
corporation on the distribution. The bases of the distributed U.S. real 
property interests in the hands of the foreign corporation shall be the 
same as the bases in the hands of the domestic corporation. The bases of 
the property other than U.S. real property interests in the hands of the 
foreign corporation shall be the same as the bases in the hands of the 
domestic corporation, plus any gain recognized by the foreign 
corporation on the distribution allocated among such assets in 
proportion to the potential gain inherent in each such asset at the time 
of distribution. However, the basis of each asset is limited to its fair 
market value. Property, other than a U.S. real property interest that is 
distributed by the domestic corporation, shall not be considered to be 
distributed by the domestic corporation pursuant to a section 332 
liquidation (that is, the foreign corporation shall not be considered to 
be a corporation for purposes of section 332) if the requirements of 
section 367(a) are not satisfied. See, for example, sections 1245(b)(3) 
and 1250(d)(3) regarding the consequences to the distributing domestic 
corporation if the requirements of section 367(a) are not satisfied.
    (iii) Distribution to a foreign corporation under section 332 and 
former section 334(b)(2) after June 18, 1980. The rules of this 
paragraph (b)(2)(iii) shall apply to section 332 distributions after 
June 18, 1980 where the basis of the distributed property in the hands 
of the foreign corporation is determined under section 334(b)(2) as in 
effect prior to the Tax Equity and Fiscal Responsibility Act of 1982. A 
foreign corporation that meets the stock ownership requirements of 
section 332(b) with respect to stock in a domestic corporation that is a 
U.S. real property interest shall recognize gain on the receipt of 
property in a section 332(a) liquidation where section 334(b)(2) applies 
to the extent that the fair market value of the distributed assets that 
are not U.S real property interests exceeds the basis of such assets 
determined under section 334(b)(2) (for example, if the liquidation does 
not occur immediately upon the purchase of stock in the domestic 
corporation). The gain recognized shall

[[Page 636]]

not exceed the excess of the fair market value of the stock of the 
domestic corporation in the hands of the foreign corporation at the time 
of the distribution over the shareholder's adjusted basis in such stock. 
The basis of the distributed U.S. real property interests in the hands 
of the foreign corporation shall be determined under section 334(b)(2), 
by reference to the adjusted basis of the stock with respect to which 
the distribution was made. The basis of such property other than U.S. 
real property interests shall be tentatively determined under section 
334(b)(2), and then increased by any gain recognized by the foreign 
corporation on the distribution allocated among such assets in 
proportion to the potential gain inherent in each such asset at the time 
of distribution (computed using the tentative basis as determined under 
section 334(b)(2)). The basis of each asset is limited, however, to its 
fair market value.
    (iv) Distribution to a foreign corporation under section 332 after 
July 31, 1986 and after the repeal of the General Utilities doctrine. 
The rules of this subdivision (iv) shall apply to section 332 
distributions after July 31, 1986, pursuant to section 337(a) as in 
effect after the effectivie dates of the amendments of section 631 of 
the Tax Reform Act of 1986.
    (A) Liquidation of domestic corporation. A foreign corporation that 
meets the stock ownership requirements of section 332(b) with respect to 
stock in a domestic corporation that is a U.S. real property interest 
(except a foreign corporation that has made an effective election under 
section 897(i) and the stock of which is treated as a U.S. real property 
interest) shall not recognize any gain under sections 367(a) or 
897(e)(1) on the receipt of property in a section 332(a) liquidation. 
The domestic corporation shall not recognize gain under section 
367(e)(2) on the distribution of U.S. real property interests (other 
than stock in a former U.S. real property holding corporation which is 
treated as a U.S. real property interest) to the foreign corporation. 
The domestic corporation shall recognize gain under section 367(e)(2) on 
the distribution of stock in a former U.S. real property holding 
corporation which is treated as a U.S. real property interest. With 
respect to the recognition of gain or loss by the domestic corporation 
under section 367(e)(2) on the distribution of property other than U.S. 
real property interests, see the regulations under section 367(e)(2). 
The basis of the distributed U.S. real property interests (other than 
stock in a former U.S. real property holding corporation) in the hands 
of the foreign corporation shall be the same as it was in the hands of 
the domestic corporation. The basis of any property (other than U.S. 
real property interests) and stock in a former U.S. real property 
holding corporation that is a U.S. real property interest in the hands 
of the foreign corporation shall be the same as it was in the hands of 
the domestic corporation increased by any gain recognized by the 
distributing corporation on the distribution that was subject to U.S. 
taxation.
    (B) Liquidation of certain foreign corporations making a section 
897(i) election. A foreign corporation that meets the stock ownership 
requirements of section 332(b) with respect to stock in another foreign 
corporation, that has made an effective election under section 897(i) 
and the stock of which is treated as a U.S. real property interest, 
shall recognize gain pursuant to section 897(e)(1) on such stock upon 
the receipt from the distributing foreign corporation of property that 
is not a U.S. real property interest, and that is not used by the 
distributee foreign corporation in the conduct of a trade or business 
within the United States (if the distributee foreign corporation is not 
a resident of a country with which the United States maintains an income 
tax treaty) or in a permanent establishment within the United States (if 
the distributee foreign corporation is a resident of a country with 
which the United States maintains an income tax treaty). The gain on the 
stock in the foreign corporation (making an effective election under 
section 897(i)) to be recognized by the distributee foreign corporation 
pursuant to section 897(e)(1) shall be determined by multiplying the 
gain realized on the distribution by a fraction. The numerator of the 
fraction shall be the fair market value of the property received by the

[[Page 637]]

distributee foreign corporation upon which it must recognize gain, and 
the denominator of the fraction shall be the fair market value of all 
property received by the distributee foreign corporation on the 
distribution. The distributing foreign corporation shall not recognize 
gain under section 367(e)(2) on the distribution of U.S. real property 
interests to the distributee foreign corporation. With respect to the 
recognition of gain or loss under section 367(e)(2) on the distribution 
of property other than U.S. real property interests, see the regulations 
under section 367(e)(2). The basis of the distributed U.S. real property 
interests in the hands of the distributee foreign corporation shall be 
the same as it was in the hands of the distributing foreign corporation. 
The basis of the property upon which the distributee foreign corporation 
recognized gain in the hands of the distributee foreign corporation 
shall be the same as the basis in the hands of the distributing foreign 
corporation, plus any gain recognized by the distributee foreign 
corporation on the receipt of such property allocated among such 
property in proportion to the potential gain inherent in each such 
property at the time of the distribution. In regard to the basis of any 
other property received by the distributee foreign corporation in the 
liquidation, see the regulations under section 367(e)(2). However, the 
basis of each asset is limited to its fair market value.
    (v) Transfer of foreign corporation stock followed by a section 332 
liquidation treated as a reorganization. If a nonresident alien or 
foreign corporation transfers the stock of a foreign-corporation that 
owns a U.S. real property interest to a domestic corporation in exchange 
for stock of the domestic corporation (or its domestic or foreign parent 
corporation) in a reorganization under section 368(a)(1)(B) or in an 
exchange under section 351(a), and if the foreign corporation then 
distributes the U.S. real property interest to the domestic corporation 
in a liquidation described in section 332(a) within five years of the 
transfer of the stock of the foreign corporation to the domestic 
corporation, then the transfer of the foreign corporation stock and the 
liquidation shall be treated as a reorganization described in section 
368(a)(1) (C) or (D). The rules of Sec.  1.897-6T(a)(1) shall apply to 
the transfer of the U.S. real property interest to the domestic 
corporation in exchange for domestic corporation stock, and the rules of 
Sec.  1.897-5T(c)(4) shall apply to the distribution of domestic 
corporation stock by the foreign corporation. However, the rules of this 
paragraph (b)(3)(v) shall not apply if the transfer of the foreign 
corporation stock and the liquidation under section 332(a) are separate 
and independent transactions justified by substantial and verifiable 
business purposes.
    (4) Section 897(i) companies. Except as otherwise provided herein 
for purposes of this section and Sec.  1.897-6T, a foreign corporation 
that has made a valid election under section 897(i) shall be treated as 
a domestic corporation and not as a foreign corporation in determining 
the application of section 897. For rules concerning the making of a 
section 897(i) election, see Sec. Sec.  1.897-3 and 1.897-8T. In regard 
to section 367(e)(2) and foreign corporations that have made an 
effective election under section 897(i), see paragraph (b)(3)(iv) of 
this section.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (b). In each example there is no applicable income tax treaty 
to which the United States is a party.

    Example 1. (i) A is a nonresident alien who owns 100 percent of the 
stock of DC, a U.S. real property holding corporation. DC's only asset 
is Parcel P, a U.S. real property interest, with a fair market value of 
$500,000 and an adjusted basis of $300,000. DC completely liquidates in 
1987 and distributes Parcel P to A in exchange for the DC stock held by 
A.
    (ii) Under section 336(a), DC must recognize gain to the extent of 
the excess of the fair market value ($500,000) over the adjusted basis 
($300,000), or $200,000.
    (iii) A does not recognize any gain under section 897(a) because the 
DC stock in the hands of A is no longer a U.S. real property interest 
under paragraph (b)(2) of this section and paragraph 2(f) of Sec.  
1.897-2. A does recognize gain (if any) under section 331(a); however, 
the gain is not subject to taxation under section 871(a). A's adjusted 
basis in Parcel P is $500,000.
    (iv) If DC did not recognize all of the gain on the disposition 
under a transitional rule to section 631 of the Tax Reform Act of 1986, 
then paragraph (b)(2) of this section and paragraph 2(f) of Sec.  1.897-
2 would not apply to

[[Page 638]]

A. A would recognize gain (if any) under paragraph (b)(2) because the 
distribution is treated as in full payment in exchange for the DC stock 
under section 897(a).
    Example 2. (i) FC, a Country F corporation, owns 100 percent of the 
stock of DC, a U.S. real property holding corporation. FC's basis in the 
stock of DC is $400,000, and the fair market value of the DC stock is 
$800,000. DC owns a U.S. real property interest with an adjusted basis 
of $350,000 and a fair market value of $600,000. DC also owns other 
assets that are not U.S. real property interests that have an adjusted 
basis of $125,000 and a fair market value of $200,000. DC completely 
liquidates in 1985 and distributes all of its property to FC in exchange 
for the DC stock held by FC.
    (ii) Under paragraph (b)(3)(ii) of this section, FC recognizes 
$100,000 of gain under section 897(a) on the disposition of the DC 
stock. This is determined by multiplying FC's gain realized ($400,000) 
by a fraction. The numerator of the fraction is the fair market value of 
the property other than U.S. real property interests ($200,000), and the 
denominator of the fraction is the fair market value of all property 
received ($800,000). FC takes a carryover adjusted basis in the U.S. 
real property interest ($350,000). FC's adjusted basis in the assets 
that are not U.S. real property interests ($200,000) is the basis of 
those assets in the hands of DC ($125,000) plus the gain recognized by 
FC on the distribution ($100,000) not to exceed the fair market value 
($200,000).
    Example 3. (i) FC, a Country F corporation, owns 100 percent of the 
stock of DC, a U.S. real property holding corporation. FC's basis in the 
stock of DC is $300,000, and the fair market value of the DC stock is 
$500,000. DC owns Parcel P, a U.S. real property interest, with an 
adjusted basis of $250,000 and a fair market value of $400,000. DC also 
owns all of the stock of DX, a former U.S. real property holding 
corporation whose stock is a U.S. real property interest, with an 
adjusted basis of $50,000 and a fair market value of $100,000. DC 
completely liquidates in 1987 and distributes all of its property to FC 
in exchange for the DC stock held by FC.
    (ii) Under paragraph (b)(3)(iv)(A) of this section, DC recognizes 
$50,000 of gain on the distribution to FC of the DX stock. DC does not 
recognize any gain for purposes of section 367(e)(2) on the distribution 
to FC of Parcel P.
    (iii) Under paragraph (b)(3)(iv)(A) of this section, FC's 
disposition of its DC stock is not treated as a disposition of a U.S. 
real property interest. Under section 334(b)(1), FC takes a carryover 
adjusted basis of $250,000 in Parcel P. FC takes an increased basis of 
$100,000 in the DX stock which is equal to DC's basis ($50,000) 
increased by the gain recognized by DC ($50,000).
    (iv) The result would be the same if FC had made an effective 
election under section 897(i).

    (6) Section 333 elections--(i) General rule. A foreign shareholder 
that elects section 333 as in effect prior to its repeal by the Tax 
Reform Act of 1986 upon the distribution of property in a liquidation by 
a domestic corporation whose stock is treated as a U.S. real property 
interest shall recognize gain on such stock to the extent that--
    (A) The property received by the foreign shareholder constitutes 
property other than U.S. real property interests subject to U.S. 
taxation upon its disposition as specified by paragraph (a)(1) of this 
section, or
    (B) The basis of a U.S. real property interest subject to U.S. 
taxation upon its disposition in the hands of the recipient foreign 
shareholder exceeds the basis of the U.S. real property interest in the 
hands of the liquidating domestic corporation.


In determining the amount of gain recognized by the foreign shareholder, 
the foreign shareholder shall be considered to have exchanged the 
domestic corporation stock for all the property distributed on a 
proportionate fair market value basis. The gain recognized on a 
respective portion of domestic corporation stock shall not exceed the 
gain realized on that portion. Property other than U.S. real property 
interests subject to U.S. taxation upon disposition shall have a fair 
market value basis in the hands of the foreign shareholder. The basis of 
U.S. real property interests subject to U.S. taxation upon disposition 
shall be the basis of the proportionate part of the domestic corporation 
stock cancelled or redeemed in the liquidation, increased in the amount 
of gain recognized (other than gain recognized under this section) by 
the shareholder in respect to that proportionate part of the domestic 
corporation stock.
    (ii) Example. The rules of paragraph (b)(6)(i) of this section may 
be illustrated by the following example.

    Example. (i) A is a citizen and resident of Country F with which the 
U.S. does not have an income tax treaty. A owns all of the stock of DC, 
a U.S. real property holding corporation. The DC stock has a fair market 
value of $1,000,000. A acquired the DC stock in two

[[Page 639]]

purchases. The basis of one lot of the DC stock is $150,000, and the 
basis of the other lot is $650,000.
    (ii) DC owns Parcel P, a U.S. real property interest, with a fair 
market value of $750,000 and an adjusted basis of $400,000. DC's only 
other property is equipment with a fair market value of $250,000 and an 
adjusted basis of $100,000. DC does not have any earnings and profits.
    (iii) DC completely liquidates in 1985 in accordance with section 
333 by distributing Parcel P and the equipment to A. A elects section 
333 treatment.
    (iv) A is considered as having exchanged 75 percent (fair market 
value of Parcel P/fair market value of all property distributed) of the 
DC stock for Parcel P. A realized gain of $150,000 on that portion of 
the DC stock ($750,000-$600,000). All of the gain of $150,000 is 
recognized under section 897 (a) because A's basis in Parcel P under 
section 334 (c) ($600,000) would exceed DC's basis in Parcel P 
($400,000) by at least the amount of realized gain. A takes a basis of 
$750,000 in Parcel P.
    (v) A is considered as having exchanged 25 percent (fair market 
value of equipment/fair market value of all property distributed) of the 
DC stock for the equipment. A realized gain of $50,000 on that portion 
of the DC stock ($250,000-$200,000). All of the gain of $50,000 is 
recognized under section 897 (a). A takes a basis of $250,000 in the 
equipment.

    (c) Distributions of U.S. real property interests by foreign 
corporations--(1) Recognition of gain required. If a foreign corporation 
makes a distribution (including a distribution in liquidation or 
redemption) of a U.S. real property interest to a shareholder (whether 
foreign or domestic), then, except as provided in paragraph (c) (2), 
(3), or (4) of this section, the distributing corporation shall 
recognize gain (but not loss) on the distribution under section 897 (d) 
(1). The gain recognized shall be equal to the excess of the fair market 
value of the U.S. real property interest (as of the time of the 
distribution) over its adjusted basis. Except as otherwise provided, the 
distributee's basis in the distributed U.S. real property interest shall 
be determined under the otherwise applicable sections of the Code. The 
distributee (whether domestic or foreign) of a foreign corporation in a 
liquidation under section 332 shall take the foreign corporation's basis 
in the distributed U.S. real property interest increased by any gain 
recognized (and subject to U.S. income taxation) by the foreign 
corporation on the distribution of such U.S. real property interest.
    (2) Recognition of gain not required--(i) Statutory exception rule. 
Under section 897(d)(2)(A), gain shall not be recognized by a 
distributing foreign corporation if--
    (A) At the time of the receipt of the distributed U.S. real property 
interest, the distributee would be subject to U.S. income taxation on a 
subsequent disposition of the U.S. real property interest, determined in 
accordance with the rules of paragraph (d)(1) of this section;
    (B) The basis of the distributed U.S. real property interest in the 
hands of the distributee is no greater than the adjusted basis of such 
property before the distribution, increased by the amount of gain (if 
any) recognized by the distributing corporation upon the distribution 
and added to the adjusted basis under the otherwise applicable 
provisions; and
    (C) The distributing corporation complies with the filing 
requirements of paragraph (d)(1)(iii) of this section.
    (ii) Section 332 liquidations--(A) In general. A distributing 
foreign corporation that meets the requirements of paragraph (c)(2)(i) 
in a section 332(a) liquidation shall not recognize gain on the 
distribution of U.S. real property interests to a foreign corporation 
meeting the stock ownership requirements of section 332(b) if the 
distributing corporation complies with the procedural requirements of 
paragraph (d)(1)(iii). Whether a foreign corporation recognizes gain on 
the distribution of U.S. real property interests to a U.S. corporation 
meeting the stock ownership requirements of section 332(b) depends upon 
whether the U.S. corporation satisfies the subject to tax requirement 
provided in paragraph (d)(1)(i) (in addition to the procedural 
requirements of paragraph (d)(1)(iii)). With respect to section 332 
distributions by a foreign corporation occurring after July 31, 1986, 
section 367(e)(2) shall not affect the application of section 337(a) (as 
in effect after the Tax Reform Act of 1986) and paragraph (c)(2)(i) of 
this section to the distribution of a U.S. real property interest.

[[Page 640]]

    (B) Recognition of gain required in certain section 332 
liquidations. Notwithstanding the other rules of this paragraph (c), a 
foreign corporation shall, pursuant to the authority conferred by 
section 897(e)(2), recognize gain on its distribution after May 5, 1988 
of a U.S. real property interest to a domestic corporation meeting the 
stock ownership requirements of section 332(b) if--
    (1) The foreign corporation has not made an election under section 
897(i), and any gain on the stock in the foreign corporation would be 
subject to U.S. taxation if an election were made on the date of the 
liquidation; and
    (2) The distribution of the U.S. real property interest by the 
foreign corporation to the domestic corporation pursuant to section 
332(a) occurs less than five years after the date of the last gain from 
the disposition of stock of the foreign corporation that would be 
subject to payment of tax under Sec.  1.897-3(d)(2)(i) if an election 
under section 897(i) were made by the foreign corporation on the date of 
its liquidation.


With regard to the treatment of certain foreign corporations as domestic 
corporations under section 897(i), however, see Sec. Sec.  1.897-3 and 
1.897-8T.
    (iii) Examples. The rules of this paragraph (c)(2) may be 
illustrated by the following examples.

    Example 1. (i) DC, a domestic corporation, owns 100 percent of the 
stock of FC, a Country F corporation, FC's only asset is Parcel P, a 
U.S. real property interest, with a fair market value of $500x and an 
adjusted basis of $100x. In September 1987, FC liquidates under section 
332(a) and transfers Parcel P to DC. The transitional rules contained in 
section 633 of the Tax Reform Act of 1986 concerning the repeal of the 
General Utilities doctrine would not be applicable to a subsequent 
distribution or disposition of assets by DC.
    (ii) Assume that FC complies with the filing requirements of 
paragraph (d)(1)(iii). DC will be subject to U.S. income taxation on a 
subsequent disposition of Parcel P under the rules of paragraph (d)(1). 
The basis of Parcel P in the hands of DC will be $100x under section 
334(b)(1), and thus no greater than the basis of Parcel P in the hands 
of FC. FC does not recognize any gain under the rules of paragraph 
(c)(1) of this section on the distribution because the exception of 
paragraph (d)(2)(i) applies.
    Example 2. If in Example (1) the distribution by FC to DC occurred 
in September 1985, and DC sold or exchanged Parcel P under scctions 
336(a) or 337(a) as in effect prior to the Tax Reform Act of 1986, then 
FC must recognize gain of $400x on the distribution of Parcel P. The 
gain must be recognized because Parcel P in the hands of DC is not 
considered subject to U.S. income taxation on a subsequent disposition 
under the rules of paragraph (d)(1) of this section.

    (3) Limitation of gain recognized under paragraph (c)(1) of this 
section for certain section 355 distributions--(i) In general. Under 
paragraph (c)(1) of this section, a foreign corporation that distributes 
stock in a domestic corporation that constitutes a U.S. real property 
interest in a distribution to which section 355 applies shall recognize 
gain on the distribution to the extent that the fair market value of the 
distributed stock exceeds its adjusted basis in the hands of the 
distributing foreign corporation. The gain recognized shall be limited 
under this paragraph (c)(3), however, to the amount by which the 
aggregate basis of the distributed stock in the hands of the 
distributees exceeds the aggregate adjusted basis of the distributed 
stock in the hands of the distributing corporation. The distributees' 
basis in the distributed U.S. real property interest shall be determined 
under the otherwise applicable provisions of section 358. (Thus, the 
distributees' basis in the distributed U.S. real property interest shall 
be determined without any increase for any gain recognized by the 
foreign corporation).
    (ii) Example. The rules of paragraph (c)(3)(i) of this section may 
be illustrated by the following example.

    Example. (i) C is a citizen and resident of Country F. C owns all of 
the stock of FC, a Country F corporation. The fair market value of the 
FC stock is 1000x, and C has a basis of 600x in the FC stock. Country F 
does not have an income tax treaty with the United States.
    (ii) In a transaction qualifying as a distribution of stock of a 
controlled corporation under section 355(a), FC distributes to C all of 
the stock of DC, a U.S. real property holding corporation. C does not 
surrender any of the FC stock. The DC stock has a fair market value of 
600x, and FC has an adjusted basis of 200x in the DC stock. After the 
distribution, the FC stock has a fair market value of 400x.
    (iii) Under paragraph (c)(3)(i) of this section, FC must recognize 
gain on the distribution of the DC stock to C equal to the difference 
between the fair market value of the

[[Page 641]]

DC stock (600x) and FC's adjusted basis in the DC stock (200x). This 
results in a potential gain of 400x. Under section 358, C takes a 360x 
adjusted basis in the DC stock. Provided that FC complies with the 
filing requirements of paragraph (d)(1)(iii) of this section, the gain 
recognized by FC is limited under paragraph (c)(3)(i) to 160x because 
(A) this is the amount by which the basis of the DC stock in the hands 
of C (360x) exceeds the adjusted basis of the DC stock in the hands of 
FC (200x), and (B) at the time of receipt of the DC stock, C would be 
subject to U.S. taxation on a subsequent disposition of the stock.
    (iv) C's adjusted basis in the DC stock is not increased by the 160x 
recognized by FC.

    (4) Distribution by a foreign corporation in certain 
reorganizations--(i) In general. Under paragraph (c)(1) of this section, 
a foreign corporation that transfers property to another corporation in 
an exchange under section 361(a) for stock of a domestic corporation 
which is a United States real property holding corporation immediately 
after the transfer in a reorganization under section 368(a)(1) (C), (D), 
or (F) shall recognize gain under section 897(d)(1) on the distribution 
(whether actual or deemed) of the stock of the domestic corporation 
received by the foreign corporation to its shareholders (whether 
domestic or foreign). See Sec.  1.897-6T(a) of the regulations for the 
consequences to the foreign corporation of the exchange of its property 
for the domestic corporation stock.
    (ii) Statutory exception. Pursuant to the exception provided in 
section 897(d)(2)(A), no gain shall be recognized by the foreign 
corporation on its distribution of the domestic corporation stock if--
    (A) At the time of the distribution, the distributee (i.e., the 
exchanging shareholder in the section 354 exchange) would be subject to 
U.S. taxation on a subsequent disposition of the stock of the domestic 
corporation, determined in accordance with the rules of paragraph (d)(1) 
of this section;
    (B) The distributee's adjusted basis in the stock of the foreign 
corporation immediately before the distribution was no greater than the 
foreign corporation's basis in the stock of the domestic corporation 
determined under section 358; and
    (C) The distributing corporation complies with the filing 
requirements of paragraph (d)(1)(iii) of this section.
    (iii) Regulatory limitation on gain recognized. If the requirements 
of subdivisions (A) and (C) of paragraph (c)(4)(ii) are met, the amount 
of any gain recognized by the foreign corporation shall not exceed the 
excess of the distributee's adjusted basis in the stock of the foreign 
corporation immediately before the distribution over the foreign 
corporation's basis in the stock of the domestic corporation immediately 
before the distribution as determined under section 358.
    (iv) Examples. The rules of paragraph (c)(4) of this section may be 
illustrated by the following examples.

    Example 1. (i) A, a nonresident alien, organized FC, a Country W 
corporation, in September 1980 to invest in U.S. real estate. In 1986, 
FC's only asset is Parcel P, a U.S. real property interest with a fair 
market value of $600,000 and an adjusted basis to FC of $200,000. Parcel 
P is subject to a mortgage with an outstanding balance of $100,000. The 
fair market value of the FC stock is $500,000, and A's adjusted basis in 
the stock is $100,000. FC does not have liabilities in excess of the 
adjusted basis in Parcel P. The United States does not have a treaty 
with Country W that entitles FC to nondiscriminatory treatment as 
described in section 1.897-3(b)(2) of the regulations.
    (ii) Pursuant to a plan of reorganization under section 
368(a)(1)(D), FC transfers Parcel P to DC, a newly formed domestic 
corporation, in exchange for DC stock. FC distributes the DC stock to A 
in exchange for A's FC stock.
    (iii) FC's exchange of Parcel P for the DC stock is a disposition of 
a U.S. real property interest. Under Sec.  1.897-6T(a)(1), there is an 
exchange of a U.S. real property interest (Parcel P) for another U.S. 
real property interest (DC stock) so that no gain is recognized on the 
exchange under section 897(e). DC takes FC's basis of $200,000 in Parcel 
P under section 362(b). Under section 358(a)(1), FC takes a $100,000 
basis in the DC stock because FC's substituted basis of $200,000 in the 
DC stock is reduced by the $100,000 of liabilities to which Parcel P is 
subject.
    (iv) Under section 897(d)(1) and paragraph (c)(4)(i) of this 
section, FC generally must recognize gain on the distribution of the DC 
stock received in exchange for FC's assets equal to the difference 
between the fair market value of the DC stock ($500,000) and FC's 
adjusted basis in the DC stock prior to the distribution ($100,000). 
This results in a potential gain of $400,000. Under section 358(a)(1), A 
takes a basis in the DC stock

[[Page 642]]

equal to its basis in the FC stock of $100,000. Provided that FC 
complies with the filing requirements of paragraph (d)(1)(iii) of this 
section, no gain is recognized by FC on the distribution of the DC stock 
under the statutory exception to the general rule of section 897(d)(1) 
provided in section 897(d)(2)(A) and paragraph (c)(4)(ii) of this 
section because (1) A's basis in the DC stock ($100,000) does not exceed 
FC's adjusted basis in the DC stock ($100,000) immediately prior to the 
distribution and (2) A, at the time of receipt of the DC stock, would be 
subject to U.S. taxation on a subsequent disposition of the stock.
    (v) The FC stock in the hands of A is not a U.S. real property 
interest because FC is a foreign corporation that has not elected to be 
treated as a domestic corporation under section 897(i). Accordingly, the 
exchange of the FC stock by A for DC stock is not a disposition of a 
U.S. real property interest under section 897(a).
    Example 2. The facts are the same as in Example 1, except that A 
purchased the FC stock in September 1983 for $100,000 from S, a 
nonresident alien, and that S had a basis of $40,000 in the FC stock at 
the time of the sale to A. The results are the same as in Example 1.
    Example 3. (i) The facts are the same as in Example 1, except that 
A's adjusted basis in the FC stock prior to the reorganization is 
$300,000. Following the distribution, A takes its basis of $300,000 in 
the FC stock as its basis in the DC stock pursuant to section 358(a)(1).
    (ii) FC does not qualify under the statutory exception of paragraph 
(c)(4)(ii) to the general recognition rule of section 897(d)(1) and 
paragraph (c)(4)(i) of this section because A's basis in the DC stock 
($300,000) exceeds FC's adjusted basis in the DC stock ($100,000) 
immediately prior to the distribution. However, provided that FC 
complies with the filing requirements of paragraph (d)(1)(iii) of this 
section, the gain recognized by FC is limited to $200,000 under the 
regulatory limitation of gain provided by paragraph (c)(4)(iii). This is 
the excess of A's basis in the FC stock immediately before the 
distribution ($300,000) over A's adjusted basis in the DC stock 
immediately before the distribution ($100,000).
    (iii) A takes a basis of $300,000 in the DC stock under section 
358(a)(1). A's basis in the DC stock is not increased by the gain 
recognized by FC. DC takes a basis of $200,000 in Parcel P under section 
362(b).
    Example 4. (i) The facts are the same as in Example 3, except that 
the United States has an income tax treaty with Country W entitling FC 
to nondiscriminatory treatment under section 1.897-3(b)(2) of the 
regulations. A valid election under section 897(i) is made to treat FC 
as a U.S. corporation.
    (ii) FC is treated as a domestic corporation for purposes of section 
897 and is not required to recognize gain under section 897(d)(1) and 
paragraph (c)(4)(i) of this section on the distribution of the DC stock 
as described in Example 3. (If a valid section 897(i) election were not 
made, the result would be same as in Example 3.)
    (iii) The FC stock in the hands of A is a U.S. real property 
interest because an election was made under section 897(i) to treat FC 
as a U.S. corporation. The exchange of the FC stock for DC stock by A is 
a disposition of a U.S. real property interest. Under section 897(e)(1) 
and paragraph (a) of Sec.  1.897-6T, A does not recognize gain on the 
exchange because there is an exchange of a U.S. real property interest 
(the FC stock) for another U.S. real property interest (the DC stock). 
Under section 358(a)(1), A takes as its basis in the DC stock A's basis 
in the FC stock ($300,000).

    (5) Sales of U.S. real property interests by foreign corporations 
under section 337. Section 337 as in effect prior to the Tax Reform Act 
of 1986 shall not apply to any sale or exchange (including a deemed 
section 337 sale pursuant to an election under section 338(a) to treat a 
stock purchase as an asset acquisition) of a U.S. real property interest 
by a foreign corporation.
    (6) Section 897(l) credit. If a foreign corporation adopts a plan of 
complete liquidation and if, solely by reason of section 897(d) and this 
section, section 337(a) (as in effect before the Tax Reform Act of 1986) 
does not apply to sales or exchanges of, or section 336 (as in effect 
before the Tax Reform Act of 1986) does not apply to distributions of, 
United States real property interests by the liquidating corporation, 
then--
    (i) The amount realized by the shareholder on the distribution shall 
be increased by its proportionate share of the amount by which the tax 
imposed by chapter 1 of the Code, as modified by the provisions of any 
applicable U.S. income tax treaty, on the liquidating corporation would 
have been reduced if section 897(d) and this section had not been 
applicable, and
    (ii) For purposes of the Code, the shareholder shall be deemed to 
have paid, on the last day prescribed by law for the payment of the tax 
imposed by subtitle A of the Code on the shareholder for the taxable 
year, an amount of tax equal to the amount of increase in the amount 
realized described in subdivison (i) of this paragraph (c).


[[Page 643]]



The special rule provided by this paragraph (c)(5) applies only to 
shareholders who are United States citizens or residents, and who have 
held stock in the liquidating corporation continuously since June 18, 
1980. This special rule also only applies for the first taxable year of 
any such shareholder in which the shareholder receives a distribution in 
complete liquidation from the foreign corporation.
    (7) Other applicable rules. For rules concerning exemption of gain 
pursuant to a U.S. income tax treaty, withholding of tax from 
distributions, and other applicable rules, see paragraph (d) of this 
section. For the treatment of liquidations described in section 
334(b)(2)(A) of certain foreign corporations acquired before November 6, 
1980, see Sec.  1.897-4.
    (d) Rules of general application--(1) Interests subject to taxation 
upon later disposition--(i) In general. Pursuant to the otherwise 
applicable rules of this section and Sec.  1.897-6T, nonrecognition of 
gain or loss may apply with respect to certain distribution or exchanges 
of U.S. real property interests if any gain from a subsequent 
disposition of the interests that are distributed or received by the 
transferor in the exchange would be included in the gross income of the 
distributee or transferor and be subject to U.S. taxation. Gain is 
considered subject to U.S. taxation if the gain is included on the 
income tax return of a U.S. tax paying entity even if there is no U.S. 
tax liability (for example, because of net operating losses or an 
investment tax credit). Gain is not considered subject to U.S. taxation 
if the gain is derived by a tax exempt entity. A real estate investment 
trust is considered to be a pass-through entity for purposes of the rule 
of taxability of this paragraph (d)(1)(i). Thus, for example, a tax 
exempt entity holding an interest in a real estate investment trust is 
not subject to tax. A domestic corporation (including a foreign 
corporation that makes an effective section 897(i) election after 
receipt of the U.S. real property interest) shall not be considered 
subject to U.S. taxation on a subsequent disposition of a U.S. real 
property interest if it received the U.S. real property interest prior 
to the effective date of the repeal of section 336(a) or 337(a) as in 
effect prior to the Tax Reform Act of 1986, unless the U.S. real 
property interest has not been sold or exchanged by the domestic 
corporation prior to such effective date in a transaction to which 
either section 336(a) or section 337(a) (as in effect prior to such 
effective date) applied. In addition, an interest shall be considered to 
be subject to U.S. taxation upon its subsequent disposition only if the 
requirements set forth in subdivision (iii) of this paragraph (d)(1) are 
met.
    (ii) Effects of income tax treaties--(A) Effect of treaty exemption 
from tax. Except as otherwise provided in subdivision (C) of this 
paragraph (d)(1)(ii), a U.S. real property interest shall not be 
considered to be subject to U.S. taxation upon a subsequent disposition 
if, at the time of its distribution or exchange, the recipient is 
entitled pursuant to the provisions of a U.S. income tax treaty to an 
exemption from U.S. taxation upon a disposition of the interest.
    (B) Effect of treaty reduction of tax. If, at the time of a 
distribution or exchange, a distributee of a U.S. real property interest 
in a distribution or a transferor who receives a U.S. real property 
interest in an exchange would be entitled pursuant to the provisions of 
a U.S. income tax treaty to reduced U.S. taxation upon the disposition 
of the interest, then a portion of the interest received shall be 
treated as an interest subject to U.S. taxation upon its disposition, 
and, therefore, that portion shall be entitled to nonrecognition 
treatment under the rules of this section or Sec.  1.897-6T. The portion 
of the interest that is treated as subject to U.S. taxation is 
determined by multiplying the fair market value of the interest by a 
fraction. The numerator of the fraction is the amount of tax that would 
be due pursuant to the provisions of the applicable U.S. income tax 
treaty upon the recipient's disposition of the interest, determined as 
of the date of the distribution or transfer. The denominator of the 
fraction is the amount of tax that would be due upon such disposition 
but for the provisions of the treaty. However, nonrecognition treatment 
may be preserved in accordance with the provisions of subdivision

[[Page 644]]

(C) of this paragraph (d)(1)(ii). With regard to the provisions of this 
paragraph, see Article XIII (9) of the United States-Canada Income Tax 
Convention.
    (C) Waiver of treaty benefits to preserve nonrecognition. 
Notwithstanding the provisions of subdivisions (A) and (B) of this 
paragraph (d)(1)(ii), an interest shall be considered to be subject to 
U.S. taxation upon its subsequent disposition if, in accordance with 
paragraph (d)(1)(iii)(F) of this section, the recipient waives the 
benefits of a U.S. income tax treaty that would otherwise entitle the 
recipient to an exemption from (or reduction of) U.S. tax upon a 
disposition of the interest.
    (iii) Procedural requirements. If a U.S. real property interest is 
distributed or transferred after December 31, 1987, the transferor or 
distributor (that is a nonresident alien individual or a foreign 
corporation) shall file an income tax return for the taxable year of the 
distribution or transfer. Also, if a U.S. real property interest is 
distributed or transferred in a transaction before January 1, 1988, with 
respect to which nonrecognition treatment would not have been available 
under the express provisions of section 897 (d) or (e) of the Code but 
is available under the provisions of this section or Sec.  1.897-6T, 
then the person that would otherwise be subject to tax by reason of the 
operation of section 897 must file an income tax return for the taxable 
year of the distribution or transfer. This requirement is satisfied by 
filing a tax return or an amended tax return for the year of the 
distribution or transfer by May 5, 1989, or by the date that the filing 
of the return is otherwise required. The person filing the return must 
attach thereto a document setting forth the following:
    (A) A statement that the distribution or transfer is one to which 
section 897 applies;
    (B) A description of the U.S. real property interest distributed or 
transferred, including its location, its adjusted basis in the hands of 
the distributor or tranferor immediately before the distribution or 
transfer, and the date of the distribution or transfer;
    (C) A description of the U.S. real property interest received in an 
exchange;
    (D) A declaration signed by an officer of the corporation that the 
distributing foreign corporation has substantiated the adjusted basis of 
the shareholder in its stock if the distributing corporation has 
nonrecognition or recognition limitation under paragraph (c) (3) or (4) 
of this section;
    (E) The amount of any gain recognized and tax withheld by any person 
with respect to the distribution or transfer;
    (F) [Reserved]. For further guidance, see Sec.  1.897-
5(d)(1)(iii)(F).
    (G) The treaty and article (if any) under which the distributee or 
transferor would be exempt from U.S. taxation on a sale of the 
distributed U.S. real property interest or the U.S. real property 
interest received in the transfer; and
    (H) A declaration, signed by the distributee or transferor or its 
authorized legal representative, that the distributee or transferor 
shall treat any subsequent sale, exchange, or other disposition of the 
U.S. real property interest as a disposition that is subject to U.S. 
taxation, notwithstanding the provisions of any U.S. income tax treaty 
or intervening change in circumstances.


A person who has provided or filed a notice described in Sec.  1.1445-
2(d)(2)(iii) or Sec.  1.1445-5(b)(2)(ii) in connection with a 
transaction may satisfy the requirement of this paragraph (d)(1)(iii) by 
attaching to his return a copy of that notice together with any 
information or declaration required by this subdivision not contained in 
that notice.
    (2) Treaty exception to imposition of tax. If gain that would be 
currently recognized pursuant to the provisions of this section or Sec.  
1.897-6T is subject to an exemption from (or reduction of) U.S. tax 
pursuant to a U.S. income tax treaty, then gain shall be recognized only 
as provided by that treaty, for dispositions occurring before January 1, 
1985. For dispositions occurring after December 31, 1984, all gain shall 
be recognized as provided in section 897 and the regulations thereunder, 
except as provided by Articles XIII (9) and XXX (5) of the United 
States-Canada Income Tax Convention or other income tax treaty entered 
into force after June 6, 1988.

[[Page 645]]

    With regard to Article XXX (5) of the Income Tax Treaty with Canada, 
see, Rev. Rul. 85-76, 1985-1 C.B. 409. With regard to basis adjustments 
for certain related person transactions, see, Sec.  1.897-6T(c)(3).
    (3) Withholding. Under sections 1441 and 1442, as modified by the 
provisions of any applicable U.S. income tax treaty, a corporation must 
withhold tax from a dividend distribution to which section 301 applies 
to a shareholder that is a foreign person, if the dividend is considered 
to be from sources inside the United States. For a description of 
dividends that are considered to be from sources inside the United 
States, see section 861(a)(2). Under section 1445, withholding is 
required with respect to certain dispositions and distributions of U.S. 
real property interests.
    (4) Effect on earnings and profits. With respect to adjustments to 
earnings and profits for gain recognized to a distributing corporation 
on a distribution, see section 312 and the regulations thereunder.
    (e) Effective date. Except as otherwise specifically provided in the 
text of these regulations, this section shall be effective for 
transfers, exchanges, distributions and other dispositions occurring 
after June 18, 1980.

[T.D. 8198, 53 FR 16217, May 5, 1988; 53 FR 18022, May 19, 1988; T.D. 
9082, 68 FR 46084, Aug. 5, 2003]



Sec.  1.897-6T  Nonrecognition exchanges applicable to corporations, 
their shareholders, and other taxpayers, and certain transfers of property 
in corporate reorganizations (temporary).

    (a) Nonrecognition exchanges--(1) In general. Except as otherwise 
provided in this section and in Sec.  1.897-5T, for purposes of section 
897(e) any nonrecognition provision shall apply to a transfer by a 
foreign person of a U.S. real property interest on which gain is 
realized only to the extent that the transferred U.S. real property 
interest is exchanged for a U.S. real property interest which, 
immediately following the exchange, would be subject to U.S. taxation 
upon its disposition, and the transferor complies with the filing 
requirements of paragraph (d)(1)(iii) of Sec.  1.897-5T. No loss shall 
be recognized pursuant to section 897(e) or the rules of this section 
unless such loss is otherwise permitted to be recognized. In the case of 
an exchange of a U.S. real property interest for stock in a domestic 
corporation (that is otherwise treated as a U.S. real property 
interest), such stock shall not be considered a U.S. real property 
interest unless the domestic corporation is a U.S. real property holding 
corporation immediately after the exchange. Whether an interest would be 
subject to U.S. taxation in the hands of the transferor upon its 
disposition shall be determined in accordance with the rules of Sec.  
1.897-5T(d)(1).
    (2) Definition of ``nonrecognition'' provision. A ``nonrecognition 
provision'' is any provision of the Code which provides that gain or 
loss shall not be recognized if the requirements of that provision are 
met. Nonrecognition provisions relevant to this section include, but are 
not limited to, sections 332, 351, 354, 355, 361, 721, 731, 1031, 1033, 
and 1036. For purposes of section 897(e), sections 121 and 453 are not 
nonrecognition provisions.
    (3) Consequence of nonapplication of nonrecognition provisions. If a 
nonrecognition provision does not apply to a transaction, then the U.S. 
real property interest transferred shall be considered exchanged 
pursuant to a transaction that is subject to U.S. taxation by reason of 
the operation of section 897. See, however, Sec.  1.897-5T (d)(2) with 
respect to the treaty exceptions to the imposition of tax. If a U.S. 
real property interest is exchanged for an interest the disposition of 
which is only partially subject to taxation under chapter 1 of the Code 
(as modified by the provisions of any applicable U.S. income tax 
treaty), then any nonrecognition provision shall apply only to the 
extent that the interest received in the exchange would be subject to 
taxation under chapter 1 of the Code, as modified. For example, the 
exchange of a U.S. real property interest for an interest in a 
partnership will receive nonrecognition treatment pursuant to section 
721 only to the extent that a disposition of the partnership interest 
will be subject to U.S. taxation by reason of the operation of section 
897(g).

[[Page 646]]

    (4) Section 355 distributions treated as exchanges. If a domestic 
corporation, stock in which is treated as a U.S. real property interest, 
distributes stock in a foreign corporation or stock in a domestic 
corporation that is not a U.S. real property holding corporation to a 
foreign person under section 355(a), then the foreign person shall be 
considered as having exchanged a proportionate part of the stock in the 
domestic corporation that is treated as a U.S. real property interest 
for stock that is not treated as a U.S. real property interest.
    (5) [Reserved]
    (6) Determination of basis. If a nonrecognition provision applies to 
the transfer of a U.S. real property interest pursuant to the provisions 
of this section, then the basis of the property received in the exchange 
shall be determined in accordance with the rules generally applicable 
with respect to such nonrecognition provision. Similarly, the basis of 
the exchanged property in the hands of the transferee shall be 
determined in accordance with the rules that generally apply to such 
transfer.
    (7) Examples. The rules of paragraphs (a) (1) through (6) of this 
section may be illustrated by the following examples. In each instance, 
the filing requirements of paragraph (d)(1)(iii) of Sec.  1.897-5T have 
been satisfied.

    Example 1. (i) A is a citizen and resident of Country F with which 
the U.S. does not have an income tax treaty. A owns Parcel P, a U.S. 
real property interest, with a fair market value of $500,000 and an 
adjusted basis of $300,000. A transfers Parcel P to DC, a newly formed 
U.S. real property holding corporation wholly owned by A, in exchange 
for DC stock.
    (ii) Under paragraph (a)(1) of this section, A has exchanged a U.S. 
real property interest (Parcel P) for another U.S. real property 
interest (DC stock) which is subject to U.S. taxation upon its 
disposition. The nonrecognition provisions of section 351(a) apply to 
A's transfer of Parcel P.
    (iii) Under paragraph (a)(6) of this section, the basis of the DC 
stock received by A is determined in accordance with the rules generally 
applicable to the transfer. A takes a $300,000 adjusted basis in the DC 
stock under the rules of section 358(a)(1).
    Examples 2-3. [Reserved]
    Example 4. (i) B is a citizen and resident of Country F with which 
the U.S. does not have an income tax treaty. B owns stock in DC1, a U.S. 
real property holding corporation. In a reorganization qualifying for 
nonrecognition under section 368(a)(1)(B), B exchanges the DC1 stock 
under section 354(a) for stock in DC2, a U.S. real property holding 
corporation.
    (ii) A does not recognize any gain under paragraph (a)(1) of this 
section on the exchange of the DC1 stock for DC2 stock because there is 
an exchange of a U.S. real property interest (the DC1 stock) for another 
U.S. real property interest (the DC2 stock) which is subject to U.S. 
taxation upon its disposition.
    Example 5. (i) C is a citizen and resident of Country F with which 
the U.S. does not have an income tax treaty. C owns all of the stock of 
DC, a U.S. real property holding corporation. The fair market value of 
the DC stock is 500x, and C has a basis of 100x in the DC stock.
    (ii) In a transaction qualifying as a distribution of stock of a 
controlled corporation under section 355(a), DC distributes to C all of 
the stock of FC, a foreign corporation that has not made a section 
897(i) election. C does not surrender any of the DC stock. The FC stock 
has a fair market value of 200x. After the distribution, the DC stock 
has a fair market value of 300x.
    (iii) Under the rules of paragraph (a)(4) of this section, C is 
considered to have exchanged DC stock with a fair market value of 200x 
and an adjusted basis of 40x for FC stock with a fair market value of 
200x. Because the FC stock is not a U.S. real property interest, C must 
recognize gain of 160x under section 897(a) on the distribution. C takes 
a basis of 200x in the FC stock. C's basis in the DC stock is reduced to 
60x pursuant to section 358(c).
    Example. (i) A is an individual citizen and resident of Country F. F 
has an income tax treaty with the United States that exempts gain from 
the sale of stock, but not real property, by a resident of F from U.S. 
taxation. In 1981, A transferred Parcel P, an appreciated U.S. real 
property interest, to DC, a U.S. real property holding corporation, in 
exchange for DC stock. A owned all of the stock of DC.
    (ii) Under the rules of paragraph (a)(1) of this section, A must 
recognize gain on the transfer of Parcel P. Even though there is an 
exchange of a U.S. real property interest for another U.S. real property 
interest, there is gain recognition because the U.S. real property 
interest received (the DC stock) would not have been subject to U.S. 
taxation upon a disposition immediately following the exchange. A may 
not convert a U.S. real property interest that was subject to taxation 
under section 897 into a U.S. real property interest that could be sold 
without taxation under section 897 due to a treaty exemption.

[[Page 647]]

    Example 7. (i) A, a nonresident alien, organized FC1, a Country W 
corporation in September 1980 to invest in U.S. real property. FC1's 
only asset is Parcel P, a U.S. real property interest with a fair market 
value of $500,000 and an adjusted basis of $200,000. The FCI stock has a 
fair market value of $500,000 and A's basis in the FC1 stock is 
$100,000. The United States does not have a treaty with Country W.
    (ii) A, organized FC2, a Country W corporation in July 1987. FC2 
organized DC in August 1987. Pursuant to a plan of reorganization under 
section 368 (a)(1)(C), FC1 transfers Parcel P to DC in exchange for FC2 
voting stock. As a result of the transfer, DC is a U.S. real property 
holding corporation wholly owned by FC2. The FC2 stock used by DC in the 
acquisition had been transferred by FC2 to DC as part of the plan of 
reorganization. FC1 distributes the FC2 stock to A in exchange for A's 
FC1 stock.
    (iii) FC1's exchange of Parcel P for the FC2 stock under section 
361(a) is a disposition of a U.S. real property interest. FC1 must 
recognize gain of $300,000 under section 897(e) and paragraph (a)(1) of 
this section on the exchange because the FC2 stock received in exchange 
for Parcel P is not a U.S. real property interest.
    (iv) Under section 362(b), DC takes a basis of $500,000 in Parcel P. 
FC2 takes a basis of $500,000 in the DC stock. A takes a basis of 
$100,000 in the FC2 stock under section 358(a)(1). Section 897(d) and 
paragraph (c)(1) of Sec.  1.897-5T do not apply to FC1's distribution of 
the FC2 stock because the FC2 stock is not a U.S. real property 
interest.
    Example 8. (i) The facts are the same as in Example 7, except that 
the United States has a treaty with Country W that entitles FC1 and FC2 
to nondiscriminatory treatment as described in Sec.  1.897-3(b)(2). FC1, 
but not FC2, makes a valid section 897(i) election prior to the 
transaction.
    (ii) FC1's transfer of Parcel P to DC in exchange for FC2 stock is 
not subject to section 897(e) and paragraph (a)(1) of this section 
because FC1 made an election under section 897(i). DC takes a basis of 
$200,000 in Parcel P under section 362(b).
    (iii) FC1's distribution of the FC2 stock to A in exchange for the 
FC1 stock is not subject to the section 897(d) and paragraph (c)(1) of 
Sec.  1.897-5T because FC1 made an election under section 897(i).
    (iv) A must recognize gain on the exchange under section 354(a) of 
the FC1 stock for the FC2 stock. A exchanged a U.S. real property 
interest (the FC1 stock) for an interest which is not a U.S. real 
property interest (the FC2 stock). A recognizes gain of $400,000. Under 
section 1012, A takes a $500,000 basis in the FC2 stock.
    Example 9. (i) The facts are the same as in Example 7 except that 
the United States has a treaty with Country W that entitles FC1 and FC2 
to nondiscriminatory treatment as described in Sec.  1.897-3(b)(2). FC2, 
but not FC1, makes a valid section 897(i) election prior to the 
transaction.
    (ii) FC1's exchange of Parcel P for the FC2 stock under section 
361(a) is a disposition of a U.S. real property interest. FC1 does not 
recognize any gain under section 897(e) and paragraph (a)(1) of this 
section because there is an exchange of a U.S. real property interest 
(Parcel P) for another U.S. real property interest (the FC2 stock). DC 
takes a basis of $200,000 in Parcel P under section 362(b). FC2 takes a 
basis of $200,000 in the DC stock.
    (iii) FC1's distribution of the FC2 stock to A in exchange for the 
FC1 stock is subject to section 897(d) and paragraph (c)(1) of Sec.  
1.897-5T. Because A takes a basis of $100,000 in the FC2 stock under 
section 358(a) (which is less than the $200,000 basis of the FC2 stock 
in the hands of FC1), and A would be subject to U.S. taxation under 
section 897(a) on a subsequent disposition of the FC2 stock, FC1 does 
not recognize any gain under paragraph (c)(1) of Sec.  1.897-5T due to 
the statutory exception of paragraph (c)(2)(i) of that section, provided 
that FC1 complies with the filing requirements of paragraph (d)(1)(C) of 
Sec.  1.897-5T.
    (iv) Since, the FC1 stock was not a U.S. real property interest, its 
disposition by A in the section 354(a) exchange for FC2 stock is not 
subject to section 897(e) and paragraph (a)(1) of this section.
    Example 10. (i) The facts are the same as in Example 7, except that 
the United States has a treaty with Country W that entitles FC1 and FC2 
to nondiscriminatory treatment as described in Sec.  1.897-3(b)(2). FC1 
and FC2 made valid section 897(i) elections prior to the transactions.
    (ii) FC1's transfer of Parcel P to DC in exchange for FC2 stock is 
not subject to section 897(e) and paragraph (a)(1) of this section 
because FC1 made an election under section 897(i). DC takes a basis of 
$200,000 in Parcel P under section 362(a). FC2 takes a basis of $200,000 
in the DC stock.
    (iii) FC1's distribution of the FC2 stock to A in exchange for the 
FC1 stock is not subject to section 897(d) and paragraph (c)(1) of Sec.  
1.897-5T because FC1 made an election under section 897(i).
    (iv) A does not recognize any gain on the exchange of the FC1 stock 
for the FC2 stock under section 354(a). Under paragraph (a)(1) of this 
section, there is an exchange of a U.S. real property interest (FC1 
stock) for another U.S. real property interest (FC2 stock). A takes a 
basis of $100,000 in the FC2 stock under section 358(a).

    (8) Treatment of nonqualifying property--(i) In general. If, under 
paragraph (a)(1) of this section, a nonrecognition provision would apply 
to an exchange but for the fact that nonqualifying property (cash or 
property other than

[[Page 648]]

U.S. real property interests) is received in addition to property (U.S. 
real property interests) that is permitted to be received under 
paragraph (a)(1) of this section, then the transferor shall recognize 
gain under this section equal to the lesser of--
    (A) The sum of the cash received plus the fair market value of the 
nonqualifying property received, or
    (B) The gain realized with respect to the U.S. real property 
interest transferred. However, no loss shall be recognized pursuant to 
this paragraph (a)(8) unless such loss is otherwise permitted to be 
recognized.
    (ii) Treatment of mixed exchanges. In a mixed exchange where both a 
U.S. real property interest and other property (including cash) is 
transferred in exchange both for property the receipt of which would 
qualify for nonrecognition treatment pursuant to paragraph (a)(1) of 
this section and for other property (including cash) which would not so 
qualify, the transferor will recognize gain in accordance with the rules 
set forth in subdivisions (A) through (C) of this paragraph (a)(8)(ii).
    (A) Allocation of nonqualifying property. The amount of 
nonqualifying property (including cash) considered to be received in 
exchange for U.S. real property interests shall be determined by 
multiplying the fair market value of the nonqualifying property received 
by a fraction (``real property fraction''). The numerator of the 
fraction is the fair market value of the U.S. real property interest 
transferred in the exchange. The denominator of the fraction is the fair 
market value of all property transferred in the exchange.
    (B) Recognition of gain. The amount of gain that must be recognized, 
and that shall be subject to U.S. taxation by reason of the operation of 
section 897, shall be equal to the lesser of:
    (1) The amount determined under subdivision (A) of this paragraph 
(a)(8)(ii), or
    (2) The gain or loss realized with respect to the U.S. real property 
interest exchanged.
    (C) Treatment of other amounts. The treatment of other amounts 
received in a mixed exchange shall be determined as follows:
    (1) The amount of nonqualifying property (including cash) considered 
to be received in exchange for property (including cash) other than U.S. 
real property interests shall be treated in the manner provided in the 
relevant nonrecognition provision. Such amounts shall be determined by 
subtracting the amount determined under subdivision (A) of this 
paragraph (a)(8)(ii) from the total amount of nonqualifying property 
received in the exchange.
    (2) The amount of qualifying property considered to be received in 
exchange for U.S. real property interests shall be treated in the manner 
provided in paragraph (a)(1) of this section. Such amount shall be 
determined by multiplying the total fair market value of qualifying 
property received in the exchange by the real property fraction 
described in subdivision (A) of this paragraph (a)(8)(ii).
    (3) The amount of qualifying property considered to be received in 
exchange for property other than U.S. real property interests shall be 
treated in the manner provided in the relevant nonrecognition provision. 
Such amount shall be determined by subtracting the amount determined 
under subdivision (2) of this paragraph (a)(8)(ii)(C) from the total 
fair market value of qualifying property received in the exchange.
    (iii) Example. The rules of paragraph (a)(8)(ii) of this section may 
be illustrated by the following example.

    Example. (i) A is an individual citizen and resident of country F. 
Country F does not have an income tax treaty with the United States. A 
is the sole proprietor of a business located in the United States, the 
assets of which consist of a U.S. real property interest with a fair 
market value of $1,000,000 and an adjusted basis of $700,000, and 
equipment used in the business with a fair market value of $500,000 and 
an adjusted basis of $250,000. A decides to incorporate the business, 
and on January 1, 1987, A transfers his assets to domestic corporation 
DC in exchange for 100 percent of the stock of DC, with a fair market 
value of $900,000. In addition, A receives a long term note 
(constituting a security) from DC for $600,000, bearing arm's length 
interest and repayment terms. DC has no assets other than those received 
in the exchange with A. Pursuant to section 897(c)(2) and Sec.  1.897-2, 
DC is a U.S. real property holding corporation. Therefore, the stock of 
DC

[[Page 649]]

is a U.S. real property interest. Assume that the note from DC 
constitutes an interest in the corporation solely as a creditor as 
provided by Sec.  1.897-1(d)(4) of the regulation. A complies with the 
filing requirements of paragraph (d)(1)(iii) of Sec.  1.897-5T.
    (ii) Because the note from DC would not be subject to U.S. taxation 
upon its disposition, it is nonqualifing property for purposes of 
determining whether A is entitled to receive nonrecognition treatment 
pursuant to section 351 with respect to his exchange of the U.S. real 
property interest. Thus, A must recognize gain in the manner provided in 
paragraph (a)(8)(ii) of this section. Pursuant to paragraph 
(a)(8)(ii)(A), the amount of nonqualifying property received in exchange 
for the real property interests is determined by multiplying the fair 
market value of such property ($600,000) by the real property fraction. 
The numerator of the fraction is $1,000,000, the fair market value of 
the real property transferred by A. The demoninator is $1,500,000, the 
fair market value of all property transferred by A. Thus, A is 
considered to have received $400,000 of the note in exchange for the 
real property ($600,000 x $1,000,000/$1,500,000). Pursuant to paragraph 
(a)(8)(ii)(B), A must recognize the lesser of the amount initially 
determined or the gain realized with respect to the U.S. real property 
interest. Therefore, A must recognize the $300,000 gain realized with 
respect to the real property.
    (iii) Pursuant to paragraph (a)(8)(ii)(C) of this section, A is 
considered to have received $200,000 of the note in exchange for 
equipment ($600,000 [total value of note received] minus $400,000 
[portion of note received in exchange for real property]), $600,000 of 
the stock in exchange for real property ($900,000 [total value of stock 
received] times $1,000,000/1,500,000) [proportion of property exchanged 
consisting of real property]), and $300,000 of the stock in exchange for 
equipment ($900,000 [total value of stock received] minus $600,000 
[portion of stock received in exchange for real property]). All three 
amounts are entitled to nonrecognition treatment pursuant to section 
351.
    (iv) Pursuant to paragraph (a)(2) of this section, A's basis in the 
stock and note received and DC's basis in the U.S. real property 
interest and equipment will be determined in accordance with the 
generally applicable rules. The $400,000 portion of the note received in 
exchange for the real property interest is other property. Pursuant to 
section 358(a)(2), A takes a fair market value ($400,000) basis for that 
portion of the note. Pursuant to section 358(a)(1), A's basis in the 
property received without the recognition of gain (the DC stock and the 
other portion of the note) will be equal to the basis of the property 
transferred ($950,000 [$700,000 basis of U.S. real property interest 
plus $250,000 basis of equipment]), decreased by the fair market value 
of the other property received ($400,000 portion of the note), and 
increased by the amount of gain recognized to A on the transaction 
($300,000). Thus, A's basis in the stock and the nonrecognition portion 
of the note is $850,000 ($950,000-$400,000 + $300,000). Under Sec.  
1.358-2(b)(2) of the regulations, the $850,000 is allocated between the 
stock and the nonrecognition portion of the note in proportion to their 
fair market values. A takes a basis of $697,000 in the DC stock 
($850,000 x 900,000/1,100,000). A takes a basis of $153,000 in the 
nonrecognition portion of the note ($850,000 x 200,000/1,100,000). A's 
basis in the note is $553,000 ($400,000 + $153,000). DC's basis in the 
property received from A will be determined under section 362(a). DC 
takes a basis of $1,000,000 in the real property interest (A's basis of 
$700,000 increased by the $300,000 of gain recognized by A on it). DC 
takes a basis of $250,000 in the equipment (A's basis of $250,000).

    (9) Treaty exception to imposition of tax. If gain that would be 
currently recognized pursuant to the provisions of this section is 
subject to an exemption from, or reduction of, U.S. tax pursuant to a 
U.S. income tax treaty, then gain shall be recognized only as provided 
by that treaty for dispositions occurring before January 1, 1985. For 
dispositions occurring after December 31, 1984, all gain shall be 
recognized as provided in section 897 and the regulations thereunder, 
except as provided by Articles XII (9) and XXX (5) of the United States-
Canada Income Tax Convention or other income tax treaty entered into 
after June 6, 1988. In regard to Article XXX (5) the Income Tax Treaty 
with Canada, see, Rev. Rul. 85-76, 1985-1 C.B. 409.
    (b) Certain foreign to foreign exchanges--(1) Exceptions to the 
general rule. Notwithstanding the provisions of paragraph (a)(1) of this 
section and pursuant to authority conferred by section 897(e)(2), a 
foreign person shall not recognize gain, in the instances described in 
paragraph (b)(2) of this section, on the transfer of a U.S. real 
property interest to a foreign corporation in exchange for stock in a 
foreign corporation, but only if the transferee's subsequent disposition 
of the transferred U.S. real property interest would be subject to U.S. 
taxation, as determined in accordance with the provisions of Sec.  
1.897-5T(d)(1), if the filing requirements of paragraph (d)(1)(iii) of 
Sec.  1.897-5T have been satisfied, if one of the five

[[Page 650]]

conditions set forth in paragraph (b)(2) exists, and if one of the 
following three forms of exchange takes place.
    (i) The exchange is made by a foreign corporation pursuant to 
section 361(a) in a reorganization described in section 368(a)(1) (D) or 
(F) and there is an exchange of the transferor corporation stock for the 
transferee corporation stock under section 354(a); or
    (ii) The exchange is made by a foreign corporation pursuant to 
section 361(a) in a reorganization described in section 368(a)(1)(C); 
there is an exchange of the transferor corporation stock for the 
transferee corporation stock (or stock of the transferee corporation's 
parent in the case of a parenthetical C reorganization) under section 
354(a); and the transferor corporation's shareholders own more than 
fifty percent of the voting stock of the transferee corporation (or 
stock of the transferee corporation's parent in the case of a 
parenthetical C reorganization) immediately after the reorganization; or
    (iii) The U.S. real property interest exchanged is stock in a U.S. 
real property holding corporation; the exchange qualifies under section 
351(a) of section 354(a) in a reorganization described in section 
368(a)(1)(B); and immediately after the exchange, all of the outstanding 
stock of the transferee corporation (or stock of the transferee 
corporation's parent in the case of a parenthetical B reorganization) is 
owned in the same proportions by the same nonresident alien individuals 
and foreign corporations that, immediately before the exchange, owned 
the stock of the U.S. real property holding corporation.


If, however, a nonresident alien individual or foreign corporation which 
received stock in an exchange described in subdivision (iii) of this 
paragraph (b)(1) (or the transferee corporation's parent) disposes of 
any of such foreign stock within three years from the date of its 
receipt, then that individual or corporation shall recognize that 
portion of the gain realized with respect to the stock in the U.S. real 
property holding corporation for which foreign stock disposed of was 
received.
    (2) Applicability of exception. The exception to the provisions of 
paragraph (a)(1) provided by paragraph (b)(1) shall apply only if one of 
the following five conditions exists.
    (i) Each of the interests exchanged or received in a transferor 
corporation or transferee corporation would not be a U.S. real property 
interest as defined in Sec.  1.897-1(c)(1) if such corporations were 
domestic corporations; or
    (ii) The transferee corporation (and the transferee corporation's 
parent in the case of a parenthetical B or C reorganization) is 
incorporated in a foreign country that maintains an income tax treaty 
with the United States that contains an information exchange provision; 
the transfer occurs after May 5, 1988; and the transferee corporation 
(and the transferee corporation's parent in the case of a parenthetical 
B or C reorganization) submit a binding waiver of all benefits of the 
respective income tax treaty (including the opportunity to make an 
election under section 897 (i)), which must be attached to each of the 
transferor and transferee corporation's income tax returns for the year 
of the transfer; or
    (iii) The transferee foreign corporation (and the transferee 
corporation's parent in the case of a parenthetical B or C 
reorganization) is a qualified resident as defined in section 884(e) and 
any regulations thereunder of the foreign country in which it is 
incorporated; or
    (iv) The transferee foreign corporation (and the transferee 
corporation's parent in the case of a parenthetical B or C 
reorganization) is incorporated in the same foreign country as the 
transferor foreign corporation; and there is an income tax treaty in 
force between that foreign country and the United States at the time of 
the transfer that contains an exchange of information provision; or
    (v) The transferee foreign corporation is incorporated in the same 
foreign country as the transferor foreign corporation; and the transfer 
is incident to a mere change in identity, form, or place of organization 
of one corporation under section 368(a)(1)(F).


For purposes of any election by a transferee foreign corporation (or the 
transferee corporation's parent in the

[[Page 651]]

case of a parenthetical C reorganization) to be treated as a domestic 
corporation under section 897(i) and Sec.  1.897-3 where the exchange 
was described in subdivisions (i) or (ii) of paragraph (b)(1) of this 
section, any prior dispositions of the transferor foreign corporation 
stock will be subject to the requirements of Sec.  1.897-3(d)(2) upon an 
election under section 897(i) by the transferee foreign corporation (or 
the transferee corporation's parent in the case of a parenthetical C 
reorganization).
    (3) No exceptions. No exception to recognition of gain under 
paragraph (a)(1) of this section is provided for the transfer of a U.S. 
real property interest by a foreign person to a foreign corporation in 
exchange for stock in a foreign corporation other than as provided in 
this paragraph (b). Thus, no exception is provided where--
    (i) Such exchange is made pursuant to section 351 and the U.S. real 
property interest transferred is not stock in a U.S. real property 
holding corporation; or
    (ii) Such exchange is made pursuant to section 361(a) in a 
reorganization described in section 368(a)(1) that does not qualify for 
nonrecognition of gain under this paragraph (b). With regard to the 
treatment of certain foreign corporations as domestic corporations under 
section 897(i), see Sec. Sec.  1.897-3 and 1.897-8T.
    (4) Examples. The rules of paragraph (b)(1) and (2) of this section 
may be illustrated by the following examples. In each instance, the 
filing requirements of paragraph (d)(1)(iii) of Sec.  1.897-5T have been 
satisfied.

    Example 1. (i) FC is a Country F corporation that has not made a 
section 897 (i) election. FC owns Parcel P, a U.S. real property 
interest, with a fair market value of $450x and an adjusted basis of 
100x.
    (ii) FC transfers Parcel P to FS, its wholly owned Country F 
subsidiary, in exchange for FS stock under section 351 (a). FS has not 
made a section 897(i) election. Under the rules of paragraph (a)(1) of 
this section, FC must recognize gain of 350x under section 897 (a) 
because the FS stock received in the exchange is not a U.S. real 
property interest. No exception to the recognition rule of paragraph 
(a)(1) is provided under this paragraph (b) for a transfer under section 
351 (a) of a U.S. real property interest (that is not stock in a U.S. 
real property holding corporation) by a foreign corporation to another 
foreign corporation in exchange for stock to the transferee corporation.
    Example 2. (i) FC is a Country F corporation that has not made a 
section 897(i) election. FC owns several U.S. real property interests 
that have appreciated in value since FC purchased the interests. FP, a 
Country F corporation, owns all of the outstanding stock of FC. Country 
F maintains an income tax treaty with the United States.
    (ii) For valid business purposes, FC transferred substantially all 
of its assets including all of its U.S. real property interests to FS in 
1989 under section 361(a) in a reorganization in exchange for FS stock. 
FS is a newly formed Country F corporation that is owned by FC. The 
transfer qualifies as a reorganization under section 368(a)(1)(D). FC 
immediately distributes the FS stock to FP in exchange for the FC stock 
and FC dissolves. FP has no gain or loss on the exchange of the FC stock 
for the FS stock under section 354(a).
    (iii) Under the rules of paragraph (b)(1)(i) of this section, FC 
does not recognize any gain on the transfer of the U.S. real property 
interests to FS under section 361(a) in the reorganization under section 
368(a)(1)(D) because FS would be subject to U.S. taxation on a 
subsequent disposition of the interests, as required by paragraph (b)(1) 
of this section; there is an exchange of stock under section 354(a), as 
required by paragraph (b)(1)(i); and FC and FS are incorporated in 
Country F which maintains an income tax treaty with the United States, 
as required by paragraph (b)(2)(iv).

    (5) Contributions of property. A foreign person that contributes a 
U.S. real property interest to a foreign corporation as paid in surplus 
or as a contribution to capital (including a contribution provided in 
section 304(a)) shall be treated, for purposes of section 897(j) and 
this section, as exchanging the U.S. real property interest for stock in 
the foreign corporation.
    (c) Denial of nonrecognition with respect to certain tax avoidance 
transfers--(1) In general. The provisions of Sec.  1.897-5T and 
paragraphs (a) and (b) of this section are subject to the rules of this 
paragraph (c).
    (2) Certain transfers to domestic corporations--(i) General rule. If 
a foreign person transfers property, that is not a U.S. real property 
interest, to a domestic corporation in a nonrecognition exchange, 
where--

[[Page 652]]

    (A) The adjusted basis of such property transferred exceeded its 
fair market value on the date of the transfer to the domestic 
corporation;
    (B) The property transferred will not immediately be used in, or 
held by the domestic corporation for use in, the conduct of a trade or 
business as defined in Sec.  1.897-1(f); and
    (C) Within two years of the transfer to the domestic corporation, 
the property transferred is sold at a loss;


then, it will be presumed, absent clear and convincing evidence to the 
contrary, that the purpose for transferring the loss property was the 
avoidance of taxation on the disposition of U.S. real property interests 
by the domestic corporation. Any loss recognized by the domestic 
corporation on the sale or exchange of such property shall not be used 
by the domestic corporation, either by direct offset or as part of a net 
operating loss or capital loss carryback or carryover to offset any gain 
recognized from the sale or exchange of a U.S. real property interest by 
the domestic corporation.
    (ii) Example. The rules of paragraph (c)(2)(i) of this section may 
be illustrated by the following example.

    Example. A is an individual citizen and resident of country F, which 
does not have an income tax treaty with the U.S. On January 1, 1987, A 
transfers a U.S. real property interest with a basis of $100,000 and a 
fair market value of $600,000 to domestic corporation DC in exchange for 
all of the stock of DC. On October 20, 1987, A transfers stock of a 
publicly traded domestic corporation with a basis in his hands of 
$900,000 and a fair market value of $500,000, in exchange for additional 
stock of DC. The stock of the publicly traded domestic corporation does 
not constitute an asset used or held for use in DC's trade or business. 
If DC sells the stock of the publicly traded domestic corporation before 
October 20, 1989 and recognizes a loss, the loss may not be used to 
offset any gain recognized on the sale of the U.S. real property 
interests by DC.

    (3) Basis adjustment for certain related person transactions. In the 
case of any disposition after December 31, 1979, of a U.S. real property 
interest to a related person (within the meaning of section 453(f)(1)), 
the basis of the interest in the hands of the person acquiring such 
interest shall be reduced by the amount of any gain which is not subject 
to taxation under section 871(b)(1) or 882(a)(1) because the disposition 
occurred before June 19, 1980 or because of any treaty obligation of the 
United States. If a foreign corporation makes an election under section 
897(i), and the stock of such corporation was transferred between 
related persons after December 31, 1979 and before June 19, 1980, then 
such stock shall be treated as a U.S. real property interest solely for 
purposes of this paragraph (c)(3).
    (4) Rearrangement of ownership to gain treaty benefit. A foreign 
person who directly or indirectly owns a U.S. real property interest may 
not directly or indirectly rearrange the incidents of ownership of the 
U.S. real property interest through the use of nonrecognition provisions 
in order to gain the benefit of a treaty exemption from taxation. Such 
nonrecognition will not apply to the foreign transferor. The transferor 
will recognize gain but not loss on the transfer under section 897(a).
    (d) Effective date. Except as specifically provided otherwise in the 
text of the regulations, paragraphs (a) through (c) shall be effective 
for transfers, exchanges and other dispositions occurring after June 18, 
1980. Paragraph (a)(5)(ii) of this section shall be effective for 
exchanges and elections occurring after June 6, 1988.

[T.D. 8198, 53 FR 16224, May 5, 1988; 53 FR 18022, May 19, 1988; T.D. 
9082, 68 FR 46084, Aug. 5, 2003]



Sec.  1.897-7T  Treatment of certain partnership interests as entirely 
U.S. real property interests under sections 897(g) and 1445(e) (temporary).

    (a) Rule. Pursuant to section 897(g), an interest in a partnership 
in which, directly or indirectly, fifty percent or more of the value of 
the gross assets consist of U.S. real property interests, and ninety 
percent or more of the value of the gross assets consist of U.S. real 
property interests plus any cash or cash equivalents shall, for purposes 
of section 1445, be treated as entirely a U.S. real property interest. 
For purposes of section 897(g), such interest shall be treated as a U.S. 
real property interest only to the extent that the gain on the 
disposition is attributable

[[Page 653]]

to U.S. real property interests (and not cash, cash equivalents or other 
property). Consequently, a disposition of any portion of such 
partnership interest shall be subject to partial taxation under section 
897(a) and full withholding under section 1445(a). For purposes of this 
paragraph, cash equivalent means any asset readily convertible into cash 
(whether or not denominated in U.S. dollars) including, but not limited 
to, bank accounts, certificates of deposit, money market accounts, 
commercial paper, U.S. and foreign treasury obligations and bonds, 
corporate obligations and bonds, precious metals or commodities, and 
publicly traded instruments.
    (b) Effective date. Section 1.897-7T shall be effective for 
transfers, exchanges, distributions and other dispositions occurring 
after June 6, 1988.

[T.D. 8198, 53 FR 16228, May 5, 1988]



Sec.  1.897-8T  Status as a U.S. real property holding corporation 
as a condition for electing section 897(i) pursuant to 
Sec.  1.897-3 (temporary).

    (a) Purpose and scope. This section provides a temporary regulation 
that if and when adopted as a final regulation, will be added to 
paragraph (b) of Sec.  1.897-3. Paragraph (b) of this section would then 
appear as paragraph (b)(4) of Sec.  1.897-3.
    (b) General conditions. The foreign corporation upon making an 
election under section 897(i) (including any retroactive election) must 
qualify as a U.S. real property holding corporation as defined in 
paragraph (b)(1) of Sec.  1.897-2.
    (c) Effective Date. Section 1.897-8T shall be effective as of June 
6, 1988, with respect to foreign corporations making an election under 
section 897(i) after May 5, 1988.

[T.D. 8198, 53 FR 16229, May 5, 1988]



Sec.  1.897-9T  Treatment of certain interest in publicly traded corporations, 
definition of foreign person, and foreign governments 
and international organizations (temporary).

    (a) Purpose and scope. This section provides a temporary regulation 
that, if and when adopted as a final regulation will be added as new 
paragraphs (c)(2)(iii)(B), (k), (n) and (q) of Sec.  1.897-1. Paragraph 
(b) of this section would then appear as paragraph (c)(2)(iii)(B) of 
Sec.  1.897-1. Paragraph (c) of this section would then appear as 
paragraph (k) of Sec.  1.897-1. Paragraph (d) of this section would then 
appear as paragraph (n) of Sec.  1.897-1. Paragraph (e) of this section 
would then appear as paragraph (q) of Sec.  1.897-1.
    (b) Any other interest in the corporation (other than an interest 
solely as a creditor) if on the date such interest was acquired by its 
present holder it had a fair market value greater than the fair market 
value on that date of 5 percent of the regularly traded class of the 
corporation's stock with the lowest fair market value. However, if a 
non-regularly traded class of interests in the corporation is 
convertible into a regularly traded class of interests in the 
corporation, an interest in such non-regularly traded class shall be 
treated as a U.S. real property interest if on the date it was acquired 
by its present holder it had a fair market value greater than the fair 
market value on that date of 5 percent of the regularly traded class of 
the corporation's stock into which it is convertible. If a person holds 
interests in a corporation of a class that is not regularly traded, and 
subsequently acquires additional interests of the same class, then all 
such interests must be aggregated and valued as of the date of the 
subsequent acquisition. If the subsequent acquisition causes that 
person's interests to exceed the applicable limitation, then all such 
interests shall be treated as U.S. real property interests, regardless 
of when acquired. In addition, if a person holds interests in a 
corporation of separate classes that are not regularly traded, and if 
such interests were separately acquired for a principal purpose of 
avoiding the applicable 5 percent limitation of this paragraph, then 
such interests shall be aggregated for purposes of applying that 
limitation. This rule shall not apply to interests of separate classes 
acquired in transactions more than three years apart. For purposes of 
paragraph (c)(2)(iii) of Sec.  1.897-1, section 318(a) shall apply 
(except that section 318(a)(2)(C) and (3)(C) shall each be applied by 
substituting ``5 percent'' for ``50 percent'').

[[Page 654]]

    (c) Foreign person. The term ``foreign person'' means a nonresident 
alien individual (including an individual subject to the provisions of 
section 877), a foreign corporation as defined in paragraph (1) of this 
section, a foreign partnership, a foreign trust or a foreign estate, as 
such persons are defined respectively by Sec.  1.871-2 and by 7701 and 
the regulations thereunder. A resident alien individual, including a 
nonresident alien with respect to whom there is in effect an election 
under section 6013(g) or (h) to be treated as United States resident, is 
not a foreign person. With respect to the status of foreign governments 
and international organizations, see paragraph (e) of this section.
    (d) Regularly traded--(1) General rule--(i) Trading requirements. A 
class of interests that is traded on one or more established securities 
markets is considered to be regularly traded on such market or markets 
for any calendar quarter during which--
    (A) Trades in such class are effected, other than in de minimis 
quantities, on at least 15 days during the calendar quarter;
    (B) The aggregate number of the interests in such class traded is at 
least 7.5 percent or more of the average number of interests in such 
class outstanding during the calendar quarter; and
    (C) The requirements of paragraph (d)(3) of this section are met.
    (ii) Exceptions--(A) in the case of the class of interests which is 
held by 2,500 or more record shareholders, the requirements of paragraph 
(d)(1)(i)(B) of this section shall be applied by substituting ``2.5 
percent'' for ``7.5 percent''.
    (B) If at any time during the calendar quarter 100 or fewer persons 
own 50 percent or more of the outstanding shares of a class of 
interests, such class shall not be considered to be regularly traded for 
purposes of sections 897, 1445 and 6039C. Related persons shall be 
treated as one person for purposes of this paragraph (d)(1)(ii)(B).
    (iii) Anti-abuse rule. Trades between related persons shall be 
disregarded. In addition, a class of interests shall not be treated as 
regularly traded if there is an arrangement or a pattern of trades 
designed to meet the requirements of this paragraph (d)(1). For example, 
trades between two persons that occur several times during the calendar 
quarter may be treated as an arrangement or a pattern of trades designed 
to meet the requirements of this paragraph (d)(1).
    (2) Interests traded on domestic established securities markets. For 
purposes of sections 897, 1445 and 6039C, a class of interests that is 
traded on an established securities market located in the United States 
is considered to be regularly traded for any calendar quarter during 
which it is regularly quoted by brokers or dealers making a market in 
such interests. A broker or dealer makes a market in a class of 
interests only if the broker or dealer holds himself out to buy or sell 
interests in such class at the quoted price. Stock of a corporation that 
is described in section 851(a)(1) and units of a unit investment trust 
registered under the Investment Company Act of 1940 (15 U.S.C. sections 
80a-1 to 80a-2) shall be treated as regularly traded within the meaning 
of this paragraph.
    (3) Reporting requirement for interests traded on foreign securities 
markets. A class of interests in a domestic corporation that is traded 
on one or more established securities markets located outside the United 
States shall not be considered to be regularly traded on such market or 
markets unless such class is traded in registered form, and--
    (i) The corporation registers such class of interests pursuant to 
section 12 of the Securities Exchange Act of 1934, 15 U.S.C. section 78, 
or
    (ii) The corporation attaches to its Federal income tax return a 
statement providing the following:
    (A) A caption which states ``The following information concerning 
certain shareholders of this corporation is provided in accordance with 
the requirements of Sec.  1.897-9T.''
    (B) The name under which the corporation is incorporated, the state 
in which such corporation is incorporated, the principal place of 
business of the corporation, and its employer identification number, if 
any;
    (C) The identity of each person who, at any time during the 
corporation's taxable year, was the beneficial owner

[[Page 655]]

of more than 5 percent of any class of interests of the corporation to 
which this paragraph (d)(3) applies;
    (D) The title, and the total number of shares issued, of any class 
of interests so owned; and
    (E) With respect to each beneficial owner of more than 5 percent of 
any class of interests of the corporation, the number of shares owned, 
the percentage of the class represented thereby, and the nature of the 
beneficial ownership of each class of shares so owned.


Interests in a domestic corporation which has filed a report pursuant to 
this paragraph (d)(3)(ii) shall be considered to be regularly traded on 
an established securities market only for the taxable year of the 
corporation with respect to which such a report is filed.
    (4) Coordination with section 1445. For purposes of section 1445, a 
class of interests in a corporation shall be presumed to be regularly 
traded during a calendar quarter if such interests were regularly traded 
within the meaning of this paragraph during the previous calendar 
quarter.
    (e) Foreign governments and international organizations. A foreign 
government shall be treated as a foreign person with respect to U.S. 
real property interests, and shall be subject to sections 897, 1445, and 
6039C on the disposition of a U.S. real property interest except to the 
extent specifically otherwise provided in the regulations issued under 
section 892. An international organization (as defined in section 
7701(a)(18)) is not a foreign person with respect to U.S. real property 
interests, and is not subject to sections 897, 1445, and 6039C on the 
disposition of a U.S. real property interest. Buildings or parts of 
buildings and the land ancillary thereto (including the residence of the 
head of the diplomatic mission) used by the foreign government for a 
diplomatic mission shall not be a U.S. real property interest in the 
hands of the respective foreign government.
    (f) Effective date. Section 1.897-9T with the exception of paragraph 
(e) shall be effective for transfers, exchanges, distributions and other 
dispositions occurring on or after June 6, 1988. Paragraph (e) of this 
section shall be effective for transfers, exchanges, distributions and 
other dispositions occurring on or after July 1, 1986.

[T.D. 8198, 53 FR 16229, May 5, 1988]

              Income From Sources Without the United States

                           foreign tax credit



Sec.  1.901-1  Allowance of credit for taxes.

    (a) In general. Citizens of the United States, domestic 
corporations, and certain aliens resident in the United States or Puerto 
Rico may choose to claim a credit, as provided in section 901, against 
the tax imposed by chapter 1 of the Internal Revenue Code (Code) for 
taxes paid or accrued to foreign countries and possessions of the United 
States, subject to the conditions prescribed in paragraphs (a)(1) 
through (a)(3) and paragraph (b) of this section.
    (1) Citizen of the United States. A citizen of the United States, 
whether resident or nonresident, may claim a credit for--
    (i) The amount of any income, war profits, and excess profits taxes 
paid or accrued during the taxable year to any foreign country or to any 
possession of the United States; and
    (ii) His share of any such taxes of a partnership of which he is a 
member, or of an estate or trust of which he is a beneficiary.
    (2) Domestic corporation. A domestic corporation may claim a credit 
for--
    (i) The amount of any income, war profits, and excess profits taxes 
paid or accrued during the taxable year to any foreign country or to any 
possession of the United States;
    (ii) Its share of any such taxes of a partnership of which it is a 
member, or of an estate or trust of which it is a beneficiary; and
    (iii) The taxes deemed to have been paid under section 902 or 960.
    (3) Alien resident of the United States or Puerto Rico. Except as 
provided in a Presidential proclamation described in section 901(c), an 
alien resident of the United States, or an alien individual who is a 
bona fide resident of Puerto Rico during the entire taxable year, may 
claim a credit for--
    (i) The amount of any income, war profits, and excess profits taxes 
paid or accrued during the taxable year to any

[[Page 656]]

foreign country or to any possession of the United States; and
    (ii) His distributive share of any such taxes of a partnership of 
which he is a member, or of an estate or trust of which he is a 
beneficiary.
    (b) Limitations. Certain Code sections, including sections 814, 
901(e) through (m), 904, 906, 907, 908, 909, 911, 999, and 6038, limit 
the credit against the tax imposed by chapter 1 of the Code for certain 
foreign taxes.
    (c) Deduction denied if credit claimed. If a taxpayer chooses with 
respect to any taxable year to claim a credit for taxes to any extent, 
such choice will be considered to apply to income, war profits, and 
excess profits taxes paid or accrued in such taxable year to all foreign 
countries and possessions of the United States, and no portion of any 
such taxes shall be allowed as a deduction from gross income in such 
taxable year or any succeeding taxable year. See section 275(a)(4).
    (d) Period during which election can be made or changed. The 
taxpayer may, for a particular taxable year, claim the benefits of 
section 901 (or claim a deduction in lieu of a foreign tax credit) at 
any time before the expiration of the period prescribed by section 
6511(d)(3)(A) (or section 6511(c) if the period is extended by 
agreement).
    (e) Joint return. In the case of a husband and wife making a joint 
return, credit for taxes paid or accrued to any foreign country or to 
any possession of the United States shall be computed upon the basis of 
the total taxes so paid by or accrued against the spouses.
    (f) Taxes against which credit not allowed-- The credit for taxes 
shall be allowed only against the tax imposed by chapter 1 of the Code, 
but it shall not be allowed against the following taxes imposed under 
that chapter:
    (1) The minimum tax for tax preferences imposed by section 56;
    (2) The 10 percent tax on premature distributions to owner-employees 
imposed by section 72(m)(5)(B);
    (3) The tax on lump sum distributions imposed by section 402(e);
    (4) The additional tax on income from certain retirement accounts 
imposed by section 408(f);
    (5) The tax on accumulated earnings imposed by section 531;
    (6) The personal holding company tax imposed by section 541;
    (7) The additional tax relating to war loss recoveries imposed by 
section 1333; and
    (8) The additional tax relating to recoveries of foreign 
expropriation losses imposed by section 1351.
    (g) Taxpayers to whom credit not allowed. Among those to whom the 
credit for taxes is not allowed are the following:
    (1) Except as provided in section 906, a foreign corporation.
    (2) Except as provided in section 906, a nonresident alien 
individual who is not described in section 876 (see sections 874(c) and 
901(b)(4)).
    (3) A nonresident alien individual described in section 876 other 
than a bona fide resident (as defined in section 937(a) and the 
regulations under that section) of Puerto Rico during the entire taxable 
year (see sections 901(b)(3) and (4)).
    (4) A U.S. citizen or resident alien individual who is a bona fide 
resident of a section 931 possession (as defined in Sec.  1.931-
1(c)(1)), the U.S. Virgin Islands, or Puerto Rico, and who excludes 
certain income from U.S. gross income to the extent of taxes allocable 
to the income so excluded (see sections 931(b)(2), 933(1), and 
932(c)(4)).
    (h) Taxpayers denied credit in a particular taxable year. Taxpayers 
who are denied the credit for taxes for particular taxable years are the 
following:
    (1) An individual who elects to pay the optional tax imposed by 
section 3, or one who elects under section 144 to take the standard 
deduction (see section 36);
    (2) A taxpayer who elects to deduct taxes paid or accrued to any 
foreign country or possession of the United States (see sections 164 and 
275);
    (3) A regulated investment company which has exercised the election 
under section 853.
    (i) Dividends from a DISC treated as foreign. For purposes of 
sections 901 through 906 and the regulations thereunder, any amount 
treated as a dividend from a corporation which is a DISC or former DISC 
(as defined in section 992(a) (1) or (3) as the case may be) will be 
treated as a dividend from a foreign corporation to the extent such

[[Page 657]]

dividend is treated under section 861(a)(2)(D) as income from sources 
without the United States.
    (j) Effective/applicability date. Paragraph (g) of this section 
applies to taxable years ending after April 9, 2008. Paragraphs (a) and 
(b) of this section apply to taxable years ending after July 13, 2011.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960]

    Editorial Note: For Federal Register citations affecting Sec.  
1.901-1, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.901-2  Income, war profits, or excess profits tax paid or accrued.

    (a) Definition of income, war profits, or excess profits tax--(1) In 
general. Section 901 allows a credit for the amount of income, war 
profits or excess profits tax (referred to as ``income tax'' for 
purposes of this section and Sec. Sec.  1.901-2A and 1.903-1) paid to 
any foreign country. Whether a foreign levy is an income tax is 
determined independently for each separate foreign levy. A foreign levy 
is an income tax if and only if--
    (i) It is a tax; and
    (ii) The predominant character of that tax is that of an income tax 
in the U.S. sense.


Except to the extent otherwise provided in paragraphs (a)(3)(ii) and (c) 
of this section, a tax either is or is not an income tax, in its 
entirety, for all persons subject to the tax. Paragraphs (a), (b) and 
(c) of this section define an income tax for purposes of section 901. 
Paragraph (d) of this section contains rules describing what constitutes 
a separate foreign levy. Paragraph (e) of this section contains rules 
for determining the amount of tax paid by a person. Paragraph (f) of 
this section contains rules for determining by whom foreign tax is paid. 
Paragraph (g) of this section contains definitions of the terms ``paid 
by,'' ``foreign country,'' and ``foreign levy.'' Paragraph (h) of this 
section states the effective date of this section.
    (2) Tax--(i) In general. A foreign levy is a tax if it requires a 
compulsory payment pursuant to the authority of a foreign country to 
levy taxes. A penalty, fine, interest, or similar obligation is not a 
tax, nor is a customs duty a tax. Whether a foreign levy requires a 
compulsory payment pursuant to a foreign country's authority to levy 
taxes is determined by principles of U.S. law and not by principles of 
law of the foreign country. Therefore, the assertion by a foreign 
country that a levy is pursuant to the foreign country's authority to 
levy taxes is not determinative that, under U.S. principles, it is 
pursuant thereto. Notwithstanding any assertion of a foreign country to 
the contrary, a foreign levy is not pursuant to a foreign country's 
authority to levy taxes, and thus is not a tax, to the extent a person 
subject to the levy receives (or will receive), directly or indirectly, 
a specific economic benefit (as defined in paragraph (a)(2)(ii)(B) of 
this section) from the foreign country in exchange for payment pursuant 
to the levy. Rather, to that extent, such levy requires a compulsory 
payment in exchange for such specific economic benefit. If, applying 
U.S. principles, a foreign levy requires a compulsory payment pursuant 
to the authority of a foreign country to levy taxes and also requires a 
compulsory payment in exchange for a specific economic benefit, the levy 
is considered to have two distinct elements: A tax and a requirement of 
compulsory payment in exchange for such specific economic benefit. In 
such a situation, these two distinct elements of the foreign levy (and 
the amount paid pursuant to each such element) must be separated. No 
credit is allowable for a payment pursuant to a foreign levy by a dual 
capacity taxpayer (as defined in paragraph (a)(2)(ii)(A) of this 
section) unless the person claiming such credit establishes the amount 
that is paid pursuant to the distinct element of the foreign levy that 
is a tax. See paragraph (a)(2)(ii) of this section and Sec.  1.901-2A.
    (ii) Dual capacity taxpayers--(A) In general. For purposes of this 
section and Sec. Sec.  1.901-2A and 1.903-1, a person who is subject to 
a levy of a foreign state or of a possession of the United States or of 
a political subdivision of such a

[[Page 658]]

state or possession and who also, directly or indirectly (within the 
meaning of paragraph (a)(2)(ii)(E) of this section) receives (or will 
receive) a specific economic benefit from the state or possession or 
from a political subdivision of such state or possession or from an 
agency or instrumentality of any of the foregoing is referred to as a 
``dual capacity taxpayer.'' Dual capacity taxpayers are subject to the 
special rules of Sec.  1.901-2A.
    (B) Specific economic benefit. For purposes of this section and 
Sec. Sec.  1.901-2A and 1.903-1, the term ``specific economic benefit'' 
means an economic benefit that is not made available on substantially 
the same terms to substantially all persons who are subject to the 
income tax that is generally imposed by the foreign country, or, if 
there is no such generally imposed income tax, an economic benefit that 
is not made available on substantially the same terms to the population 
of the country in general. Thus, a concession to extract government-
owned petroleum is a specific economic benefit, but the right to travel 
or to ship freight on a government-owned airline is not, because the 
latter, but not the former, is made generally available on substantially 
the same terms. An economic benefit includes property; a service; a fee 
or other payment; a right to use, acquire or extract resources, patents 
or other property that a foreign country owns or controls (within the 
meaning of paragraph (a)(2)(ii)(D) of this section); or a reduction or 
discharge of a contractual obligation. It does not include the right or 
privilege merely to engage in business generally or to engage in 
business in a particular form.
    (C) Pension, unemployment, and disability fund payments. A foreign 
levy imposed on individuals to finance retirement, old-age, death, 
survivor, unemployment, illness, or disability benefits, or for some 
substantially similar purpose, is not a requirement of compulsory 
payment in exchange for a specific economic benefit, as long as the 
amounts required to be paid by the individuals subject to the levy are 
not computed on a basis reflecting the respective ages, life 
expectancies or similar characteristics of such individuals.
    (D) Control of property. A foreign country controls property that it 
does not own if the country exhibits substantial indicia of ownership 
with respect to the property, for example, by both regulating the 
quantity of property that may be extracted and establishing the minimum 
price at which it may be disposed of.
    (E) Indirect receipt of a benefit. A person is considered to receive 
a specific economic benefit indirectly if another person receives a 
specific economic benefit and that other person--
    (1) Owns or controls, directly or indirectly, the first person or is 
owned or controlled, directly or indirectly, by the first person or by 
the same persons that own or control, directly or indirectly, the first 
person; or
    (2) Engages in a transaction with the first person under terms and 
conditions such that the first person receives, directly or indirectly, 
all or part of the value of the specific economic benefit.
    (3) Predominant character. The predominant character of a foreign 
tax is that of an income tax in the U.S. sense--
    (i) If, within the meaning of paragraph (b)(1) of this section, the 
foreign tax is likely to reach net gain in the normal circumstances in 
which it applies,
    (ii) But only to the extent that liability for the tax is not 
dependent, within the meaning of paragraph (c) of this section, by its 
terms or otherwise, on the availability of a credit for the tax against 
income tax liability to another country.
    (b) Net gain--(1) In general. A foreign tax is likely to reach net 
gain in the normal circumstances in which it applies if and only if the 
tax, judged on the basis of its predominant character, satisfies each of 
the realization, gross receipts, and net income requirements set forth 
in paragraphs (b)(2), (b)(3) and (b)(4), respectively, of this section.
    (2) Realization--(i) In general. A foreign tax satisfies the 
realization requirement if, judged on the basis of its predominant 
character, it is imposed--
    (A) Upon or subsequent to the occurrence of events (``realization 
events'') that would result in the realization of income under the 
income tax provisions of the Internal Revenue Code;

[[Page 659]]

    (B) Upon the occurrence of an event prior to a realization event (a 
``prerealization event'') provided the consequence of such event is the 
recapture (in whole or part) of a tax deduction, tax credit or other tax 
allowance previously accorded to the taxpayer; or
    (C) Upon the occurrence of a prerealization event, other than one 
described in paragraph (b)(2)(i)(B) of this section, but only if the 
foreign country does not, upon the occurrence of a later event (other 
than a distribution or a deemed distribution of the income), impose tax 
(``second tax'') with respect to the income on which tax is imposed by 
reason of such prerealization event (or, if it does impose a second tax, 
a credit or other comparable relief is available against the liability 
for such a second tax for tax paid on the occurrence of the 
prerealization event) and--
    (1) The imposition of the tax upon such prerealization event is 
based on the difference in the values of property at the beginning and 
end of a period; or
    (2) The prerealization event is the physical transfer, processing, 
or export of readily marketable property (as defined in paragraph 
(b)(2)(iii) of this section).


A foreign tax that, judged on the basis of its predominant character, is 
imposed upon the occurrence of events described in this paragraph 
(b)(2)(i) satisfies the realization requirement even if it is also 
imposed in some situations upon the occurrence of events not described 
in this paragraph (b)(2)(i). For example, a foreign tax that, judged on 
the basis of its predominant character, is imposed upon the occurrence 
of events described in this paragraph (b)(2)(i) satisfies the 
realization requirement even though the base of that tax also includes 
imputed rental income from a personal residence used by the owner and 
receipt of stock dividends of a type described in section 305(a) of the 
Internal Revenue Code. As provided in paragraph (a)(1) of this section, 
a tax either is or is not an income tax, in its entirety, for all 
persons subject to the tax; therefore, a foreign tax described in the 
immediately preceding sentence satisfies the realization requirement 
even though some persons subject to the tax will on some occasions not 
be subject to the tax except with respect to such imputed rental income 
and such stock dividends. However, a foreign tax based only or 
predominantly on such imputed rental income or only or predominantly on 
receipt of such stock dividends does not satisfy the realization 
requirement.
    (ii) Certain deemed distributions. A foreign tax that does not 
satisfy the realization requirement under paragraph (b)(2)(i) of this 
section is nevertheless considered to meet the realization requirement 
if it is imposed with respect to a deemed distribution (e.g., by a 
corporation to a shareholder) of amounts that meet the realization 
requirement in the hands of the person that, under foreign law, is 
deemed to distribute such amount, but only if the foreign country does 
not, upon the occurrence of a later event (e.g., an actual 
distribution), impose tax (``second tax'') with respect to the income on 
which tax was imposed by reason of such deemed distribution (or, if it 
does impose a second tax, a credit or other comparable relief is 
available against the liability for such a second tax for tax paid with 
respect to the deemed distribution).
    (iii) Readily marketable property. Property is readily marketable 
if--
    (A) It is stock in trade or other property of a kind that properly 
would be included in inventory if on hand at the close of the taxable 
year or if it is held primarily for sale to customers in the ordinary 
course of business, and
    (B) It can be sold on the open market without further processing or 
it is exported from the foreign country.
    (iv) Examples. The provisions of paragraph (b)(2) of this section 
may be illustrated by the following examples:

    Example 1. Residents of country X are subject to a tax of 10 percent 
on the aggregate net appreciation in fair market value during the 
calendar year of all shares of stock held by them at the end of the 
year. In addition, all such residents are subject to a country X tax 
that qualifies as an income tax within the meaning of paragraph (a)(1) 
of this section. Included in the base of the income tax are gains and 
losses realized on the sale of stock, and the basis of stock for 
purposes of determining such gain or loss is its cost. The operation of 
the stock appreciation tax and the income tax as applied to sales of 
stock is

[[Page 660]]

exemplified as follows: A, a resident of country X, purchases stock in 
June, 1983 for 100u (units of country X currency) and sells it in May, 
1985 for 160u. On December 31, 1983, the stock is worth 120u and on 
December 31, 1984, it is worth 155u. Pursuant to the stock appreciation 
tax, A pays 2u for 1983 (10 percent of (120u-100u)), 3.5u for 1984 (10 
percent of (155u-120u)), and nothing in 1985 because no stock was held 
at the end of that year. For purposes of the income tax, A must include 
60u (160u-100u) in his income for 1985, the year of sale. Pursuant to 
paragraph (b)(2)(i)(C) of this section, the stock appreciation tax does 
not satisfy the realization requirement because country X imposes a 
second tax upon the occurrence of a later event (i.e., the sale of 
stock) with respect to the income that was taxed by the stock 
appreciation tax and no credit or comparable relief is available against 
such second tax for the stock appreciation tax paid.
    Example 2. The facts are the same as in example 1 except that if 
stock was held on the December 31 last preceding the date of its sale, 
the basis of such stock for purposes of computing gain or loss under the 
income tax is the value of the stock on such December 31. Thus, in 1985, 
A includes only 5u (160u--155u) as income from the sale for purposes of 
the income tax. Because the income tax imposed upon the occurrence of a 
later event (the sale) does not impose a tax with respect to the income 
that was taxed by the stock appreciation tax, the stock appreciation tax 
satisfies the realization requirement. The result would be the same if, 
instead of a basis adjustment to reflect taxation pursuant to the stock 
appreciation tax, the country X income tax allowed a credit (or other 
comparable relief) to take account of the stock appreciation tax. If a 
credit mechanism is used, see also paragraph (e)(4)(i) of this section.
    Example 3. Country X imposes a tax on the realized net income of 
corporations that do business in country X. Country X also imposes a 
branch profits tax on corporations organized under the law of a country 
other than country X that do business in country X. The branch profits 
tax is imposed when realized net income is remitted or deemed to be 
remitted by branches in country X to home offices outside of country X. 
The branch profits tax is imposed subsequent to the occurrence of events 
that would result in realization of income (i.e., by corporations 
subject to such tax) under the income tax provisions of the Internal 
Revenue Code; thus, in accordance with paragraph (b)(2)(i)(A) of this 
section, the branch profits tax satisfies the realization requirement.
    Example 4. Country X imposes a tax on the realized net income of 
corporations that do business in country X (the ``country X corporate 
tax''). Country X also imposes a separate tax on shareholders of such 
corporations (the ``country X shareholder tax''). The country X 
shareholder tax is imposed on the sum of the actual distributions 
received during the taxable year by such a shareholder from the 
corporation's realized net income for that year (i.e., income from past 
years is not taxed in a later year when it is actually distributed) plus 
the distributions deemed to be received by such a shareholder. Deemed 
distributions are defined as (A) a shareholder's pro rata share of the 
corporation's realized net income for the taxable year, less (B) such 
shareholder's pro rata share of the corporation's country X corporate 
tax for that year, less (C) actual distributions made by such 
corporation to such shareholder from such net income. A shareholder's 
receipt of actual distributions is a realization event within the 
meaning of paragraph (b)(2)(i)(A) of this section. The deemed 
distributions are not realization events, but they are described in 
paragraph (b)(2)(ii) of this section. Accordingly, the country X 
shareholder tax satisfies the realization requirement.

    (3) Gross receipts--(i) In general. A foreign tax satisfies the 
gross receipts requirement if, judged on the basis of its predominant 
character, it is imposed on the basis of--
    (A) Gross receipts; or
    (B) Gross receipts computed under a method that is likely to produce 
an amount that is not greater than fair market value.


A foreign tax that, judged on the basis of its predominant character, is 
imposed on the basis of amounts described in this paragraph (b)(3)(i) 
satisfies the gross receipts requirement even if it is also imposed on 
the basis of some amounts not described in this paragraph (b)(3)(i).
    (ii) Examples. The provisions of paragraph (b)(3)(i) of this section 
may be illustrated by the following examples:

    Example 1. Country X imposes a ``headquarters company tax'' on 
country X corporations that serve as regional headquarters for 
affiliated nonresident corporations, and this tax is a separate tax 
within the meaning of paragraph (d) of this section. A headquarters 
company for purposes of this tax is a corporation that performs 
administrative, management or coordination functions solely for 
nonresident affiliated entities. Due to the difficulty of determining on 
a case-by-case basis the arm's length gross receipts that headquarters 
companies would charge affiliates for such services, gross receipts of a 
headquarters company are deemed, for purposes of this tax, to equal 110

[[Page 661]]

percent of the business expenses incurred by the headquarters company. 
It is established that this formula is likely to produce an amount that 
is not greater than the fair market value of arm's length gross receipts 
from such transactions with affiliates. Pursuant to paragraph 
(b)(3)(i)(B) of this section, the headquarters company tax satisfies the 
gross receipts requirement.
    Example 2. The facts are the same as in Example 1, with the added 
fact that in the case of a particular taxpayer, A, the formula actually 
produces an amount that is substantially greater than the fair market 
value of arm's length gross receipts from transactions with affiliates. 
As provided in paragraph (a)(1) of this section, the headquarters 
company tax either is or is not an income tax, in its entirety, for all 
persons subject to the tax. Accordingly, the result is the same as in 
example 1 for all persons subject to the headquarters company tax, 
including A.
    Example 3. Country X imposes a separate tax (within the meaning of 
paragraph (d) of this section) on income from the extraction of 
petroleum. Under that tax, gross receipts from extraction income are 
deemed to equal 105 percent of the fair market value of petroleum 
extracted. This computation is designed to produce an amount that is 
greater than the fair market value of actual gross receipts; therefore, 
the tax on extraction income is not likely to produce an amount that is 
not greater than fair market value. Accordingly, the tax on extraction 
income does not satisfy the gross receipts requirement. However, if the 
tax satisfies the criteria of Sec.  1.903-1(a), it is a tax in lieu of 
an income tax.

    (4) Net income--(i) In general. A foreign tax satisfies the net 
income requirement if, judged on the basis of its predominant character, 
the base of the tax is computed by reducing gross receipts (including 
gross receipts as computed under paragraph (b)(3)(i)(B) of this section) 
to permit--
    (A) Recovery of the significant costs and expenses (including 
significant capital expenditures) attributable, under reasonable 
principles, to such gross receipts; or
    (B) Recovery of such significant costs and expenses computed under a 
method that is likely to produce an amount that approximates, or is 
greater than, recovery of such significant costs and expenses.


A foreign tax law permits recovery of significant costs and expenses 
even if such costs and expenses are recovered at a different time than 
they would be if the Internal Revenue Code applied, unless the time of 
recovery is such that under the circumstances there is effectively a 
denial of such recovery. For example, unless the time of recovery is 
such that under the circumstances there is effectively a denial of such 
recovery, the net income requirement is satisfied where items deductible 
under the Internal Revenue Code are capitalized under the foreign tax 
system and recovered either on a recurring basis over time or upon the 
occurrence of some future event or where the recovery of items 
capitalized under the Internal Revenue Code occurs less rapidly under 
the foreign tax system. A foreign tax law that does not permit recovery 
of one or more significant costs or expenses, but that provides 
allowances that effectively compensate for nonrecovery of such 
significant costs or expenses, is considered to permit recovery of such 
costs or expenses. Principles used in the foreign tax law to attribute 
costs and expenses to gross receipts may be reasonable even if they 
differ from principles that apply under the Internal Revenue Code (e.g., 
principles that apply under section 265, 465 or 861(b) of the Internal 
Revenue Code). A foreign tax whose base, judged on the basis of its 
predominant character, is computed by reducing gross receipts by items 
described in paragraph (b)(4)(i)(A) or (B) of this section satisfies the 
net income requirement even if gross receipts are not reduced by some 
such items. A foreign tax whose base is gross receipts or gross income 
does not satisfy the net income requirement except in the rare situation 
where that tax is almost certain to reach some net gain in the normal 
circumstances in which it applies because costs and expenses will almost 
never be so high as to offset gross receipts or gross income, 
respectively, and the rate of the tax is such that after the tax is paid 
persons subject to the tax are almost certain to have net gain. Thus, a 
tax on the gross receipts or gross income of businesses can satisfy the 
net income requirement only if businesses subject to the tax are almost 
certain never to incur a loss (after payment of the tax). In determining 
whether a foreign tax satisfies

[[Page 662]]

the net income requirement, it is immaterial whether gross receipts are 
reduced, in the base of the tax, by another tax, provided that other tax 
satisfies the realization, gross receipts and net income requirements.
    (ii) Consolidation of profits and losses. In determining whether a 
foreign tax satisfies the net income requirement, one of the factors to 
be taken into account is whether, in computing the base of the tax, a 
loss incurred in one activity (e.g., a contract area in the case of oil 
and gas exploration) in a trade or business is allowed to offset profit 
earned by the same person in another activity (e.g., a separate contract 
area) in the same trade or business. If such an offset is allowed, it is 
immaterial whether the offset may be made in the taxable period in which 
the loss is incurred or only in a different taxable period, unless the 
period is such that under the circumstances there is effectively a 
denial of the ability to offset the loss against profit. In determining 
whether a foreign tax satisfies the net income requirement, it is 
immaterial that no such offset is allowed if a loss incurred in one such 
activity may be applied to offset profit earned in that activity in a 
different taxable period, unless the period is such that under the 
circumstances there is effectively a denial of the ability to offset 
such loss against profit. In determining whether a foreign tax satisfies 
the net income requirement, it is immaterial whether a person's profits 
and losses from one trade or business (e.g., oil and gas extraction) are 
allowed to offset its profits and losses from another trade or business 
(e. g., oil and gas refining and processing), or whether a person's 
business profits and losses and its passive investment profits and 
losses are allowed to offset each other in computing the base of the 
foreign tax. Moreover, it is immaterial whether foreign law permits or 
prohibits consolidation of profits and losses of related persons, unless 
foreign law requires separate entities to be used to carry on separate 
activities in the same trade or business. If foreign law requires that 
separate entities carry on such separate activities, the determination 
whether the net income requirement is satisfied is made by applying the 
same considerations as if such separate activities were carried on by a 
single entity.
    (iii) Carryovers. In determining whether a foreign tax satisfies the 
net income requirement, it is immaterial, except as otherwise provided 
in paragraph (b)(4)(ii) of this section, whether losses incurred during 
one taxable period may be carried over to offset profits incurred in 
different taxable periods.
    (iv) Examples. The provisions of this paragraph (b)(4) may be 
illustrated by the following examples:

    Example 1. Country X imposes an income tax on corporations engaged 
in business in country X; however, that income tax is not applicable to 
banks. Country X also imposes a tax (the ``bank tax'') of 1 percent on 
the gross amount of interest income derived by banks from branches in 
country X; no deductions are allowed. Banks doing business in country X 
incur very substantial costs and expenses (e.g., interest expense) 
attributable to their interest income. The bank tax neither provides for 
recovery of significant costs and expenses nor provides any allowance 
that significantly compensates for the lack of such recovery. Since such 
banks are not almost certain never to incur a loss on their interest 
income from branches in country X, the bank tax does not satisfy the net 
income requirement. However, if the tax on corporations is generally 
imposed, the bank tax satisfies the criteria of Sec.  1.903-1(a) and 
therefore is a tax in lieu of an income tax.
    Example 2. Country X law imposes an income tax on persons engaged in 
business in country X. The base of that tax is realized net income 
attributable under reasonable principles to such business. Under the tax 
law of country X, a bank is not considered to be engaged in business in 
country X unless it has a branch in country X and interest income earned 
by a bank from a loan to a resident of country X is not considered 
attributable to business conducted by the bank in country X unless a 
branch of the bank in country X performs certain significant enumerated 
activities, such as negotiating the loan. Country X also imposes a tax 
(the ``bank tax'') of 1 percent on the gross amount of interest income 
earned by banks from loans to residents of country X if such banks do 
not engage in business in country X or if such interest income is not 
considered attributable to business conducted in country X. For the same 
reasons as are set forth in example 1, the bank tax does not satisfy the 
net income requirement. However, if the tax on persons engaged in 
business in country X is generally imposed, the bank tax satisfies

[[Page 663]]

the criteria of Sec.  1.903-1(a) and therefore is a tax in lieu of an 
income tax.
    Example 3. A foreign tax is imposed at the rate of 40 percent on the 
amount of gross wages realized by an employee; no deductions are 
allowed. Thus, the tax law neither provides for recovery of costs and 
expenses nor provides any allowance that effectively compensates for the 
lack of such recovery. Because costs and expenses of employees 
attributable to wage income are almost always insignificant compared to 
the gross wages realized, such costs and expenses will almost always not 
be so high as to offset the gross wages and the rate of the tax is such 
that, under the circumstances, after the tax is paid, employees subject 
to the tax are almost certain to have net gain.


Accordingly, the tax satisfies the net income requirement.
    Example 4. Country X imposes a tax at the rate of 48 percent of the 
``taxable income'' of nonresidents of country X who furnish specified 
types of services to customers who are residents of country X. ``Taxable 
income'' for purposes of the tax is defined as gross receipts received 
from residents of country X (regardless of whether the services to which 
the receipts relate are performed within or outside country X) less 
deductions that permit recovery of the significant costs and expenses 
(including significant capital expenditures) attributable under 
reasonable principles to such gross receipts. The country X tax 
satisfies the net income requirement.
    Example 5. Each of country X and province Y (a political subdivision 
of country X) imposes a tax on corporations, called the ``country X 
income tax'' and the ``province Y income tax,'' respectively. Each tax 
has an identical base, which is computed by reducing a corporation's 
gross receipts by deductions that, based on the predominant character of 
the tax, permit recovery of the significant costs and expenses 
(including significant capital expenditures) attributable under 
reasonable principles to such gross receipts. The country X income tax 
does not allow a deduction for the province Y income tax for which a 
taxpayer is liable, nor does the province Y income tax allow a deduction 
for the country X income tax for which a taxpayer is liable. As provided 
in paragraph (d)(1) of this section, each of the country X income tax 
and the province Y income tax is a separate levy. Both of these levies 
satisfy the net income requirement; the fact that neither levy's base 
allows a deduction for the other levy is immaterial in reaching that 
determination.

    (c) Soak-up taxes--(1) In general. Pursuant to paragraph (a)(3)(ii) 
of this section, the predominant character of a foreign tax that 
satisfies the requirement of paragraph (a)(3)(i) of this section is that 
of an income tax in the U.S. sense only to the extent that liability for 
the foreign tax is not dependent (by its terms or otherwise) on the 
availability of a credit for the tax against income tax liability to 
another country. Liability for foreign tax is dependent on the 
availability of a credit for the foreign tax against income tax 
liability to another country only if and to the extent that the foreign 
tax would not be imposed on the taxpayer but for the availability of 
such a credit. See also Sec.  1.903-1(b)(2).
    (2) Examples. The provisions of paragraph (c)(1) of this section may 
be illustrated by the following examples:

    Example 1. Country X imposes a tax on the receipt of royalties from 
sources in country X by nonresidents of country X. The tax is 15 percent 
of the gross amount of such royalties unless the recipient is a resident 
of the United States or of country A, B, C, or D, in which case the tax 
is 20 percent of the gross amount of such royalties. Like the United 
States, each of countries A, B, C, and D allows its residents a credit 
against the income tax otherwise payable to it for income taxes paid to 
other countries. Because the 20 percent rate applies only to residents 
of countries which allow a credit for taxes paid to other countries and 
the 15 percent rate applies to residents of countries which do not allow 
such a credit, one-fourth of the country X tax would not be imposed on 
residents of the United States but for the availability of such a 
credit. Accordingly, one-fourth of the country X tax imposed on 
residents of the United States who receive royalties from sources in 
country X is dependent on the availability of a credit for the country X 
tax against income tax liability to another country.
    Example 2. Country X imposes a tax on the realized net income 
derived by all nonresidents from carrying on a trade or business in 
country X. Although country X law does not prohibit other nonresidents 
from carrying on business in country X, United States persons are the 
only nonresidents of country X that carry on business in country X in 
1984. The country X tax would be imposed in its entirety on a 
nonresident of country X irrespective of the availability of a credit 
for country X tax against income tax liability to another country. 
Accordingly, no portion of that tax is dependent on the availability of 
such a credit.
    Example 3. Country X imposes tax on the realized net income of all 
corporations incorporated in country X. Country X allows a tax holiday 
to qualifying corporations incorporated in country X that are owned by 
nonresidents of country X, pursuant to which no

[[Page 664]]

country X tax is imposed on the net income of a qualifying corporation 
for the first ten years of its operations in country X. A corporation 
qualifies for the tax holiday if it meets certain minimum investment 
criteria and if the development office of country X certifies that in 
its opinion the operations of the corporation will be consistent with 
specified development goals of country X. The development office will 
not so certify to any corporation owned by persons resident in countries 
that allow a credit (such as that available under section 902 of the 
Internal Revenue Code) for country X tax paid by a corporation 
incorporated in country X. In practice, tax holidays are granted to a 
large number of corporations, but country X tax is imposed on a 
significant number of other corporations incorporated in country X 
(e.g., those owned by country X persons and those which have had 
operations for more than 10 years) in addition to corporations denied a 
tax holiday because their shareholders qualify for a credit for the 
country X tax against income tax liability to another country. In the 
case of corporations denied a tax holiday because they have U.S. 
shareholders, no portion of the country X tax during the period of the 
denied 10-year tax holiday is dependent on the availability of a credit 
for the country X tax against income tax liability to another country.
    Example 4. The facts are the same as in example 3, except that 
corporations owned by persons resident in countries that will allow a 
credit for country X tax at the time when dividends are distributed by 
the corporations are granted a provisional tax holiday. Under the 
provisional tax holiday, instead of relieving such a corporation from 
country X tax for 10 years, liability for such tax is deferred until the 
corporation distributes dividends. The result is the same as in example 
3.

    (d) Separate levies--(1) In general. For purposes of sections 901 
and 903, whether a single levy or separate levies are imposed by a 
foreign country depends on U.S. principles and not on whether foreign 
law imposes the levy or levies in a single or separate statutes. A levy 
imposed by one taxing authority (e.g., the national government of a 
foreign country) is always separate for purposes of sections 901 and 903 
from a levy imposed by another taxing authority (e.g., a political 
subdivision of that foreign country). Levies are not separate merely 
because different rates apply to different taxpayers. For example, a 
foreign levy identical to the tax imposed on U.S. citizens and resident 
alien individuals by section 1 of the Internal Revenue Code is a single 
levy notwithstanding the levy has graduated rates and applies different 
rate schedules to unmarried individuals, married individuals who file 
separate returns and married individuals who file joint returns. In 
general, levies are not separate merely because some provisions 
determining the base of the levy apply, by their terms or in practice, 
to some, but not all, persons subject to the levy. For example, a 
foreign levy identical to the tax imposed by section 11 of the Internal 
Revenue Code is a single levy even though some provisions apply by their 
terms to some but not all corporations subject to the section 11 tax 
(e.g., section 465 is by its terms applicable to corporations described 
in sections 465(a)(1)(B) and 465(a)(1)(C), but not to other 
corporations), and even though some provisions apply in practice to some 
but not all corporations subject to the section 11 tax (e.g., section 
611 does not, in practice, apply to any corporation that does not have a 
qualifying interest in the type of property described in section 
611(a)). However, where the base of a levy is different in kind, and not 
merely in degree, for different classes of persons subject to the levy, 
the levy is considered for purposes of sections 901 and 903 to impose 
separate levies for such classes of persons. For example, regardless of 
whether they are contained in a single or separate foreign statutes, a 
foreign levy identical to the tax imposed by section 871(b) of the 
Internal Revenue Code is a separate levy from a foreign levy identical 
to the tax imposed by section 1 of the Internal Revenue Code as it 
applies to persons other than those described in section 871(b), and 
foreign levies identical to the taxes imposed by sections 11, 541, 881, 
882, 1491 and 3111 of the Internal Revenue Code are each separate 
levies, because the base of each of those levies differs in kind, and 
not merely in degree, from the base of each of the others. Accordingly, 
each such levy must be analyzed separately to determine whether it is an 
income tax within the meaning of paragraph (a)(1) of this section and 
whether it is a tax in lieu of an income tax within the meaning of 
paragraph (a) of Sec.  1.903-1. Where foreign law imposes a levy that is 
the sum of two or more separately computed amounts, and each such amount 
is

[[Page 665]]

computed by reference to a separate base, separate levies are 
considered, for purposes of sections 901 and 903, to be imposed. A 
separate base may consist, for example, of a particular type of income 
or of an amount unrelated to income, e.g., wages paid. Amounts are not 
separately computed if they are computed separately merely for purposes 
of a preliminary computation and are then combined as a single base. In 
the case of levies that apply to dual capacity taxpayers, see also Sec.  
1.901-2A(a).
    (2) Contractual modifications. Notwithstanding paragraph (d)(1) of 
this section, if foreign law imposing a levy is modified for one or more 
persons subject to the levy by a contract entered into by such person or 
persons and the foreign country, then foreign law is considered for 
purposes of sections 901 and 903 to impose a separate levy for all 
persons to whom such contractual modification of the levy applies, as 
contrasted to the levy as applied to all persons to whom such 
contractual modification does not apply. In applying the provisions of 
paragraph (c) of this section to a tax as modified by such a contract, 
the provisions of Sec.  1.903-1(b)(2) shall apply.
    (3) Examples. The provisions of paragraph (d)(1) of this section may 
be illustrated by the following examples:

    Example 1. A foreign statute imposes a levy on corporations equal to 
the sum of 15% of the corporation's realized net income plus 3% of its 
net worth. As the levy is the sum of two separately computed amounts, 
each of which is computed by reference to a separate base, each of the 
portion of the levy based on income and the portion of the levy based on 
net worth is considered, for purposes of sections 901 and 903, to be a 
separate levy.
    Example 2. A foreign statute imposes a levy on nonresident alien 
individuals analogous to the taxes imposed by section 871 of the 
Internal Revenue Code. For the same reasons as set forth in example 1, 
each of the portion of the foreign levy analogous to the tax imposed by 
section 871(a) and the portion of the foreign levy analogous to the tax 
imposed by sections 871 (b) and 1, is considered, for purposes of 
sections 901 and 903, to be a separate levy.
    Example 3. A single foreign statute or separate foreign statutes 
impose a foreign levy that is the sum of the products of specified rates 
applied to specified bases, as follows:

------------------------------------------------------------------------
                                                                 Rate
                            Base                              (percent)
------------------------------------------------------------------------
Net income from mining.....................................           45
Net income from manufacturing..............................           50
Net income from technical services.........................           50
Net income from other services.............................           45
Net income from investments................................           15
All other net income.......................................           50
------------------------------------------------------------------------


In computing each such base, deductible expenditures are allocated to 
the type of income they generate. If allocated deductible expenditures 
exceed the gross amount of a specified type of income, the excess may 
not be applied against income of a different specified type. 
Accordingly, the levy is the sum of several separately computed amounts, 
each of which is computed by reference to a separate base. Each of the 
levies on mining net income, manufacturing net income, technical 
services net income, other services net income, investment net income 
and other net income is, therefore, considered, for purposes of sections 
901 and 903, to be a separate levy.
    Example 4. The facts are the same as in example 3, except that 
excess deductible expenditures allocated to one type of income are 
applied against other types of income to which the same rate applies. 
The levies on mining net income and other services net income together 
are considered, for purposes of sections 901 and 903, to be a single 
levy since, despite a separate preliminary computation of the bases, by 
reason of the permitted application of excess allocated deductible 
expenditures, the bases are not separately computed. For the same 
reason, the levies on manufacturing net income, technical services net 
income and other net income together are considered, for purposes of 
sections 901 and 903, to be a single levy. The levy on investment net 
income is considered, for purposes of sections 901 and 903, to be a 
separate levy. These results are not dependent on whether the 
application of excess allocated deductible expenditures to a different 
type of income, as described above, is permitted in the same taxable 
period in which the expenditures are taken into account for purposes of 
the preliminary computation, or only in a different (e.g., later) 
taxable period.
    Example 5. The facts are the same as in example 3, except that 
excess deductible expenditures allocated to any type of income other 
than investment income are applied against the other types of income 
(including investment income) according to a specified set of priorities 
of application. Excess deductible expenditures allocated to investment 
income are not applied against any other type of income. For the reason 
expressed in example 4, all of the levies are together considered, for 
purposes of sections 901 and 903, to be a single levy.


[[Page 666]]


    (e) Amount of income tax that is creditable--(1) In general. Credit 
is allowed under section 901 for the amount of income tax (within the 
meaning of paragraph (a)(1) of this section) that is paid to a foreign 
country by the taxpayer. The amount of income tax paid by the taxpayer 
is determined separately for each taxpayer.
    (2) Refunds and credits--(i) In general. An amount is not tax paid 
to a foreign country to the extent that it is reasonably certain that 
the amount will be refunded, credited, rebated, abated, or forgiven. It 
is not reasonably certain that an amount will be refunded, credited, 
rebated, abated, or forgiven if the amount is not greater than a 
reasonable approximation of final tax liability to the foreign country.
    (ii) Examples. The provisions of paragraph (e)(2)(i) of this section 
may be illustrated by the following examples:

    Example 1. The internal law of country X imposes a 25 percent tax on 
the gross amount of interest from sources in country X that is received 
by a nonresident of country X. Country X law imposes the tax on the 
nonresident recipient and requires any resident of country X that pays 
such interest to a nonresident to withhold and pay over to country X 25 
percent of such interest, which is applied to offset the recipient's 
liability for the 25 percent tax. A tax treaty between the United States 
and country X overrides internal law of country X and provides that 
country X may not tax interest received by a resident of the United 
States from a resident of country X at a rate in excess of 10 percent of 
the gross amount of such interest. A resident of the United States may 
claim the benefit of the treaty only by applying for a refund of the 
excess withheld amount (15 percent of the gross amount of interest 
income) after the end of the taxable year. A, a resident of the United 
States, receives a gross amount of 100u (units of country X currency) of 
interest income from a resident of country X from sources in country X 
in the taxable year 1984, from which 25u of country X tax is withheld. A 
files a timely claim for refund of the 15u excess withheld amount. 15u 
of the amount withheld (25u-10u) is reasonably certain to be refunded; 
therefore 15u is not considered an amount of tax paid to country X.
    Example 2. A's initial income tax liability under country X law is 
100u (units of country X currency). However, under country X law A's 
initial income tax liability is reduced in order to compute its final 
tax liability by an investment credit of 15u and a credit for charitable 
contributions of 5u. The amount of income tax paid by A is 80u.
    Example 3. A computes his income tax liability in country X for the 
taxable year 1984 as 100u (units of country X currency), files a tax 
return on that basis, and pays 100u of tax. The day after A files that 
return, A files a claim for refund of 90u. The difference between the 
100u of liability reflected in A's original return and the 10u of 
liability reflected in A's refund claim depends on whether a particular 
expenditure made by A is nondeductible or deductible, respectively. 
Based on an analysis of the country X tax law, A's country X tax 
advisors have advised A that it is not clear whether or not that 
expenditure is deductible. In view of the uncertainty as to the proper 
treatment of the item in question under country X tax law, no portion of 
the 100u paid by A is reasonably certain to be refunded. If A receives a 
refund, A must treat the refund as required by section 905(c) of the 
Internal Revenue Code.
    Example 4. A levy of country X, which qualifies as an income tax 
within the meaning of paragraph (a)(1) of this section, provides that 
each person who makes payment to country X pursuant to the levy will 
receive a bond to be issued by country X with an amount payable at 
maturity equal to 10 percent of the amount paid pursuant to the levy. A 
pays 38,000u (units of country X currency) to country X and is entitled 
to receive a bond with an amount payable at maturity of 3800u. It is 
reasonably certain that a refund in the form of property (the bond) will 
be made. The amount of that refund is equal to the fair market value of 
the bond. Therefore, only the portion of the 38,000u payment in excess 
of the fair market value of the bond is an amount of tax paid.

    (3) Subsidies--(i) General rule. An amount of foreign income tax is 
not an amount of income tax paid or accrued by a taxpayer to a foreign 
country to the extent that--
    (A) The amount is used, directly or indirectly, by the foreign 
country imposing the tax to provide a subsidy by any means (including, 
but not limited to, a rebate, a refund, a credit, a deduction, a 
payment, a discharge of an obligation, or any other method) to the 
taxpayer, to a related person (within the meaning of section 482), to 
any party to the transaction, or to any party to a related transaction; 
and
    (B) The subsidy is determined, directly or indirectly, by reference 
to the amount of the tax or by reference to the base used to compute the 
amount of the tax.

[[Page 667]]

    (ii) Subsidy. The term ``subsidy'' includes any benefit conferred, 
directly or indirectly, by a foreign country to one of the parties 
enumerated in paragraph (e)(3)(i)(A) of this section. Substance and not 
form shall govern in determining whether a subsidy exists. The fact that 
the U.S. taxpayer may derive no demonstrable benefit from the subsidy is 
irrelevant in determining whether a subsidy exists.
    (iii) Official exchange rate. A subsidy described in paragraph 
(e)(3)(i)(B) of this section does not include the actual use of an 
official foreign government exchange rate converting foreign currency 
into dollars where a free exchange rate also exists if--
    (A) The economic benefit represented by the use of the official 
exchange rate is not targeted to or tied to transactions that give rise 
to a claim for a foreign tax credit;
    (B) The economic benefit of the official exchange rate applies to a 
broad range of international transactions, in all cases based on the 
total payment to be made without regard to whether the payment is a 
return of principal, gross income, or net income, and without regard to 
whether it is subject to tax; and
    (C) Any reduction in the overall cost of the transaction is merely 
coincidental to the broad structure and operation of the official 
exchange rate.


In regard to foreign taxes paid or accrued in taxable years beginning 
before January 1, 1987, to which the Mexican Exchange Control Decree, 
effective as of December 20, 1982, applies, see Rev. Rul. 84-143, 1984-2 
C.B. 127.
    (iv) Examples. The provisions of this paragraph (e)(3) may be 
illustrated by the following examples:

    Example 1. (i) Country X imposes a 30 percent tax on nonresident 
lenders with respect to interest which the nonresident lenders receive 
from borrowers who are residents of Country X, and it is established 
that this tax is a tax in lieu of an income tax within the meaning of 
Sec.  1.903-1(a). Country X provides the nonresident lenders with 
receipts upon their payment of the 30 percent tax. Country X remits to 
resident borrowers an incentive payment for engaging in foreign loans, 
which payment is an amount equal to 20 percent of the interest paid to 
nonresident lenders.
    (ii) Because the incentive payment is based on the interest paid, it 
is determined by reference to the base used to compute the tax that is 
imposed on the nonresident lender. The incentive payment is considered a 
subsidy under this paragraph (e)(3) since it is provided to a party (the 
borrower) to the transaction and is based on the amount of tax that is 
imposed on the lender with respect to the transaction. Therefore, two-
thirds (20 percent/30 percent) of the amount withheld by the resident 
borrower from interest payments to the nonresidential lender is not an 
amount of income tax paid or accrued for purposes of section 901(b).
    Example 2. (i) A U.S. bank lends money to a development bank in 
Country X. The development bank relends the money to companies resident 
in Country X. A withholding tax is imposed by Country X on the U.S. bank 
with respect to the interest that the development bank pays to the U.S. 
bank, and appropriate receipts are provided. On the date that the tax is 
withheld, fifty percent of the tax is credited by Country X to an 
account of the development bank. Country X requires the development bank 
to transfer the amount credited to the borrowing companies.
    (ii) The amount successively credited to the account of the 
development bank and then to the account of the borrowing companies is 
determined by reference to the amount of the tax and the tax base. Since 
the amount credited to the borrowing companies is a subsidy provided to 
a party (the borrowing companies) to a related transaction and is based 
on the amount of tax and the tax base, it is not an amount paid or 
accrued as an income tax for purposes of section 901(b).
    Example 3. (i) A U.S. bank lends dollars to a Country X borrower. 
Country X imposes a withholding tax on the lender with respect to the 
interest. The tax is to be paid in Country X currency, although the 
interest is payable in dollars. Country X has a dual exchange rate 
system, comprised of a controlled official exchange rate and a free 
exchange rate. Priority transactions such as exports of merchandise, 
imports of merchandise, and payments of principal and interest on 
foreign currency loans payable abroad to foreign lenders are governed by 
the official exchange rate which yields more dollars per unit of Country 
X currency than the free exchange rate. The Country X borrower remits 
the net amount of dollar interest due to the U.S. bank (interest due 
less withholding tax), pays the tax withheld in Country X currency to 
the Country X government, and provides to the U.S. bank a receipt for 
payment of the Country X taxes.
    (ii) The use of the official exchange rate by the U.S. bank to 
determine foreign taxes with respect to interest is not a subsidy 
described in paragraph (e)(3)(i)(B) of this section. The official 
exchange rate is not targeted to or tied to transactions that give rise

[[Page 668]]

to a claim for a foreign tax credit. The use of the official exchange 
rate applies to the interest paid and to the principal paid. Any benefit 
derived by the U.S. bank through the use of the official exchange rate 
is merely coincidental to the broad structure and operation of the 
official exchange rate.
    Example 4. (i) B, a U.S. corporation, is engaged in the production 
of oil and gas in Country X pursuant to a production sharing agreement 
between B, Country X, and the state petroleum authority of Country X. 
The agreement is approved and enacted into law by the Legislature of 
Country X. Both B and the petroleum authority are subject to the Country 
X income tax. Each entity files an annual income tax return and pays, to 
the tax authority of Country X, the amount of income tax due on its 
annual income. B is a dual capacity taxpayer as defined in Sec.  1.901-
2(a)(2)(ii)(A). Country X has agreed to return to the petroleum 
authority one-half of the income taxes paid by B by allowing it a credit 
in calculating its own tax liability to Country X.
    (ii) The petroleum authority is a party to a transaction with B and 
the amount returned by Country X to the petroleum authority is 
determined by reference to the amount of the tax imposed on B. 
Therefore, the amount returned is a subsidy as described in this 
paragraph (e)(3) and one-half the tax imposed on B is not an amount of 
income tax paid or accrued.
    Example 5. Assume the same facts as in Example 4, except that the 
state petroleum authority of Country X does not receive amounts from 
Country X related to tax paid by B. Instead, the authority of Country X 
receives a general appropriation from Country X which is not calculated 
with reference to the amount of tax paid by B. The general appropriation 
is therefore not a subsidy described in this paragraph (e)(3).
    (v) Effective Date. This paragraph (e)(3) shall apply to foreign 
taxes paid or accrued in taxable years beginning after December 31, 
1986.

    (4) Multiple levies--(i) In general. If, under foreign law, a 
taxpayer's tentative liability for one levy (the ``first levy'') is or 
can be reduced by the amount of the taxpayer's liability for a different 
levy (the ``second levy''), then the amount considered paid by the 
taxpayer to the foreign country pursuant to the second levy is an amount 
equal to its entire liability for that levy, and the remainder of the 
amount paid is considered paid pursuant to the first levy. This rule 
applies regardless of whether it is or is not likely that liability for 
one such levy will always exceed liability for the other such levy. For 
an example of the application of this rule, see example 5 of Sec.  
1.903-1(b)(3). If, under foreign law, the amount of a taxpayer's 
liability is the greater or lesser of amounts computed pursuant to two 
levies, then the entire amount paid to the foreign country by the 
taxpayer is considered paid pursuant to the levy that imposes such 
greater or lesser amount, respectively, and no amount is considered paid 
pursuant to such other levy.
    (ii) Integrated tax systems. [Reserved]
    (5) Noncompulsory amounts--(i) In general. An amount paid is not a 
compulsory payment, and thus is not an amount of tax paid, to the extent 
that the amount paid exceeds the amount of liability under foreign law 
for tax. An amount paid does not exceed the amount of such liability if 
the amount paid is determined by the taxpayer in a manner that is 
consistent with a reasonable interpretation and application of the 
substantive and procedural provisions of foreign law (including 
applicable tax treaties) in such a way as to reduce, over time, the 
taxpayer's reasonably expected liability under foreign law for tax, and 
if the taxpayer exhausts all effective and practical remedies, including 
invocation of competent authority procedures available under applicable 
tax treaties, to reduce, over time, the taxpayer's liability for foreign 
tax (including liability pursuant to a foreign tax audit adjustment). 
Where foreign tax law includes options or elections whereby a taxpayer's 
tax liability may be shifted, in whole or part, to a different year or 
years, the taxpayer's use or failure to use such options or elections 
does not result in a payment in excess of the taxpayer's liability for 
foreign tax. An interpretation or application of foreign law is not 
reasonable if there is actual notice or constructive notice (e.g., a 
published court decision) to the taxpayer that the interpretation or 
application is likely to be erroneous. In interpreting foreign tax law, 
a taxpayer may generally rely on advice obtained in good faith from 
competent foreign tax advisors to whom the taxpayer has disclosed the 
relevant facts. A remedy is effective and practical only if the cost 
thereof (including the risk of offsetting or additional tax liability) 
is

[[Page 669]]

reasonable in light of the amount at issue and the likelihood of 
success. A settlement by a taxpayer of two or more issues will be 
evaluated on an overall basis, not on an issue-by-issue basis, in 
determining whether an amount is a compulsory amount. A taxpayer is not 
required to alter its form of doing business, its business conduct, or 
the form of any business transaction in order to reduce its liability 
under foreign law for tax.
    (ii) Examples. The provisions of paragraph (e)(5)(i) of this section 
may be illustrated by the following examples:

    Example 1. A, a corporation organized and doing business solely in 
the United States, owns all of the stock of B, a corporation organized 
in country X. In 1984 A buys merchandise from unrelated persons for 
$1,000,000, shortly thereafter resells that merchandise to B for 
$600,000, and B later in 1984 resells the merchandise to unrelated 
persons for $1,200,000. Under the country X income tax, which is an 
income tax within the meaning of paragraph (a)(1) of this section, all 
corporations organized in country X are subject to a tax equal to 3 
percent of their net income. In computing its 1984 country X income tax 
liability B reports $600,000 ($1,200,000--$600,000) of profit from the 
purchase and resale of the merchandise referred to above. The country X 
income tax law requires that transactions between related persons be 
reported at arm's length prices, and a reasonable interpretation of this 
requirement, as it has been applied in country X, would consider B's 
arm's length purchase price of the merchandise purchased from A to be 
$1,050,000. When it computes its country X tax liability B is aware that 
$600,000 is not an arm's length price (by country X standards). B's 
knowing use of a non-arm's length price (by country X standards) of 
$600,000, instead of a price of $1,050,000 (an arm's length price under 
country X's law), is not consistent with a reasonable interpretation and 
application of the law of country X, determined in such a way as to 
reduce over time B's reasonably expected liability for country X income 
tax. Accordingly, $13,500 (3 percent of $450,000 ($1,050,000--
$600,000)), the amount of country X income tax paid by B to country X 
that is attributable to the purchase of the merchandise from B's parent 
at less than an arm's length price, is in excess of the amount of B's 
liability for country X tax, and thus is not an amount of tax.
    Example 2. A, a corporation organized and doing business solely in 
the United States, owns all of the stock of B, a corporation organized 
in country X. Country X has in force an income tax treaty with the 
United States. The treaty provides that the profits of related persons 
shall be determined as if the persons were not related. A and B deal 
extensively with each other. A and B, with respect to a series of 
transactions involving both of them, treat A as having $300,000 of 
income and B as having $700,000 of income for purposes of A's United 
States income tax and B's country X income tax, respectively. B has no 
actual or constructive notice that its treatment of these transactions 
under country X law is likely to be erroneous. Subsequently, the 
Internal Revenue Service reallocates $200,000 of this income from B to A 
under the authority of section 482 and the treaty. This reallocation 
constitutes actual notice to A and constructive notice to B that B's 
interpretation and application of country X's law and the tax treaty is 
likely to be erroneous. B does not exhaust all effective and practical 
remedies to obtain a refund of the amount of country X income tax paid 
by B to country X that is attributable to the reallocated $200,000 of 
income. This amount is in excess of the amount of B's liability for 
country X tax and thus is not an amount of tax.
    Example 3. The facts are the same as in example 2, except that B 
files a claim for refund (an administrative proceeding) of country X tax 
and A or B invokes the competent authority procedures of the treaty, the 
cost of which is reasonable in view of the amount at issue and the 
likelihood of success, Nevertheless, B does not obtain any refund of 
country X tax. The cost of pursuing any judicial remedy in country X 
would be unreasonable in light of the amount at issue and the likelihood 
of B's success, and B does not pursue any such remedy. The entire amount 
paid by B to country X is a compulsory payment and thus is an amount of 
tax paid by B.
    Example 4. The facts are the same as in example 2, except that, when 
the Internal Revenue Service makes the reallocation, the country X 
statute of limitations on refunds has expired; and neither the internal 
law of country X nor the treaty authorizes the country X tax authorities 
to pay a refund that is barred by the statute of limitations. B does not 
file a claim for refund, and neither A nor B invokes the competent 
authority procedures of the treaty. Because the country X tax 
authorities would be barred by the statute of limitations from paying a 
refund, B has no effective and practicable remedies. The entire amount 
paid by B to country X is a compulsory payment and thus is an amount of 
tax paid by B.
    Example 5. A is a U.S. person doing business in country X. In 
computing its income tax liability to country X, A is permitted, at its 
election, to recover the cost of machinery used in its business either 
by deducting that cost in the year of acquisition or by depreciating 
that cost on the straight line method over a period of 2, 4, 6 or 10 
years. A elects to depreciate machinery over 10 years. This

[[Page 670]]

election merely shifts A's tax liability to different years (compared to 
the timing of A's tax liability under a different depreciation period); 
it does not result in a payment in excess of the amount of A's liability 
for country X income tax in any year since the amount of country X tax 
paid by A is consistent with a reasonable interpretation of country X 
law in such a way as to reduce over time A's reasonably expected 
liability for country X tax. Because the standard of paragraph (e)(5(i) 
of this section refers to A's reasonably expected liability, not its 
actual liability, events actually occurring in subsequent years (e.g. 
whether A has sufficient profit in such years so that such depreciation 
deductions actually reduce A's country X tax liability or whether the 
country X tax rates change) are immaterial.
    Example 6. The internal law of country X imposes a 25 percent tax on 
the gross amount of interest from sources in country X that is received 
by a nonresident of country X. Country X law imposes the tax on the 
nonresident recipient and requires any resident of country X that pays 
such interest to a nonresident to withhold and pay over to country X 25 
percent of such interest, which is applied to offset the recipient's 
liability for the 25 percent tax. A tax treaty between the United States 
and country X overrides internal law of country X and provides that 
country X may not tax interest received by a resident of the United 
States from a resident of country X at a rate in excess of 10 percent of 
the gross amount of such interest. A resident of the United States may 
claim the benefit of the treaty only by applying for a refund of the 
excess withheld amount (15 percent of the gross amount of interest 
income) after the end of the taxable year. A, a resident of the United 
States, receives a gross amount of 100u (units of country X currency) of 
interest income from a resident of country X from sources in country X 
in the taxable year 1984, from which 25u of country X tax is withheld. A 
does not file a timely claim for refund. 15u of the amount withheld 
(25u-10u) is not a compulsory payment and hence is not an amount of tax.

    (iii) [Reserved]
    (iv) Structured passive investment arrangements--(A) In general. 
Notwithstanding paragraph (e)(5)(i) of this section, an amount paid to a 
foreign country (a ``foreign payment'') is not a compulsory payment, and 
thus is not an amount of tax paid, if the foreign payment is 
attributable (within the meaning of paragraph (e)(5)(iv)(B)(1)(ii) of 
this section) to a structured passive investment arrangement (as 
described in paragraph (e)(5)(iv)(B) of this section).
    (B) Conditions. An arrangement is a structured passive investment 
arrangement if all of the following conditions are satisfied:
    (1) Special purpose vehicle (SPV). An entity that is part of the 
arrangement meets the following requirements:
    (i) Substantially all of the gross income (for U.S. tax purposes) of 
the entity, if any, is passive investment income, and substantially all 
of the assets of the entity are assets held to produce such passive 
investment income.
    (ii) There is a foreign payment attributable to income of the entity 
(as determined under the laws of the foreign country to which such 
foreign payment is made), including the entity's share of income of a 
lower-tier entity that is a branch or pass-through entity under the laws 
of such foreign country, that, if the foreign payment were an amount of 
tax paid, would be paid or accrued in a U.S. taxable year in which the 
entity meets the requirements of paragraph (e)(5)(iv)(B)(1)(i) of this 
section. A foreign payment attributable to income of an entity includes 
a foreign payment attributable to income that is required to be taken 
into account by an owner of the entity, if the entity is a branch or 
pass-through entity under the laws of such foreign country. A foreign 
payment attributable to income of the entity also includes a withholding 
tax (within the meaning of section 901(k)(1)(B)) imposed on a dividend 
or other distribution (including distributions made by a pass-through 
entity or an entity that is disregarded as an entity separate from its 
owner for U.S. tax purposes) with respect to the equity of the entity.
    (2) U.S. party. A person would be eligible to claim a credit under 
section 901(a) (including a credit for foreign taxes deemed paid under 
section 902 or 960) for all or a portion of the foreign payment 
described in paragraph (e)(5)(iv)(B)(1)(ii) of this section if the 
foreign payment were an amount of tax paid.
    (3) Direct investment. The U.S. party's proportionate share of the 
foreign payment or payments described in paragraph (e)(5)(iv)(B)(1)(ii) 
of this section is (or is expected to be) substantially greater than the 
amount of credits, if

[[Page 671]]

any, that the U.S. party reasonably would expect to be eligible to claim 
under section 901(a) for foreign taxes attributable to income generated 
by the U.S. party's proportionate share of the assets owned by the SPV 
if the U.S. party directly owned such assets. For this purpose, direct 
ownership shall not include ownership through a branch, a permanent 
establishment or any other arrangement (such as an agency arrangement or 
dual resident status) that would result in the income generated by the 
U.S. party's proportionate share of the assets being subject to tax on a 
net basis in the foreign country to which the payment is made. A U.S. 
party's proportionate share of the assets of the SPV shall be determined 
by reference to such U.S. party's proportionate share of the total value 
of all of the outstanding interests in the SPV that are held by its 
equity owners and creditors. A U.S. party's proportionate share of the 
assets of the SPV, however, shall not include any assets that produce 
income subject to gross basis withholding tax.
    (4) Foreign tax benefit. The arrangement is reasonably expected to 
result in a credit, deduction, loss, exemption, exclusion or other tax 
benefit under the laws of a foreign country that is available to a 
counterparty or to a person that is related to the counterparty 
(determined under the principles of paragraph (e)(5)(iv)(C)(7) of this 
section by applying the tax laws of a foreign country in which the 
counterparty is subject to tax on a net basis). However, a foreign tax 
benefit in the form of a credit is described in this paragraph 
(e)(5)(iv)(B)(4) only if the amount of any such credit corresponds to 10 
percent or more of the amount of the U.S. party's share (for U.S. tax 
purposes) of the foreign payment referred to in paragraph 
(e)(5)(iv)(B)(1)(ii) of this section. In addition, a foreign tax benefit 
in the form of a deduction, loss, exemption, exclusion or other tax 
benefit is described in this paragraph (e)(5)(iv)(B)(4) only if such 
amount corresponds to 10 percent or more of the foreign base with 
respect to which the U.S. party's share (for U.S. tax purposes) of the 
foreign payment is imposed. For purposes of the preceding two sentences, 
if an arrangement involves more than one U.S. party or more than one 
counterparty or both, the aggregate amount of foreign tax benefits 
available to all of the counterparties and persons related to such 
counterparties is compared to the aggregate amount of all of the U.S. 
parties' shares of the foreign payment or foreign base, as the case may 
be. Where a U.S. party indirectly owns interests in an SPV that are 
treated as equity interests for both U.S. and foreign tax purposes, a 
foreign tax benefit available to a foreign entity in the chain of 
ownership that begins with the SPV and ends with the first-tier entity 
in the chain does not correspond to the U.S. party's share of the 
foreign payment attributable to income of the SPV to the extent that 
such benefit relates to earnings of the SPV that are distributed with 
respect to equity interests in the SPV that are owned directly or 
indirectly by the U.S. party for purposes of both U.S. and foreign tax 
law.
    (5) Counterparty. The arrangement involves a counterparty. A 
counterparty is a person that, under the tax laws of a foreign country 
in which the person is subject to tax on the basis of place of 
management, place of incorporation or similar criterion or otherwise 
subject to a net basis tax, directly or indirectly owns or acquires 
equity interests in, or assets of, the SPV. However, a counterparty does 
not include the SPV or a person with respect to which for U.S. tax 
purposes the same domestic corporation, U.S. citizen or resident alien 
individual directly or indirectly owns more than 80 percent of the total 
value of the stock (or equity interests) of each of the U.S. party and 
such person. A counterparty also does not include a person with respect 
to which for U.S. tax purposes the U.S. party directly or indirectly 
owns more than 80 percent of the total value of the stock (or equity 
interests), but only if the U.S. party is a domestic corporation, a U.S. 
citizen or a resident alien individual. In addition, a counterparty does 
not include an individual who is a U.S. citizen or resident alien.
    (6) Inconsistent treatment. The United States and an applicable 
foreign country treat one or more of the aspects of the arrangement 
listed in paragraph

[[Page 672]]

(e)(5)(iv)(B)(6)(i) through (e)(5)(iv)(B)(6)(iv) of this section 
differently under their respective tax systems, and for one or more tax 
years when the arrangement is in effect one or both of the following two 
conditions applies; either the amount of income attributable to the SPV 
that is recognized for U.S. tax purposes by the SPV, the U.S. party or 
parties, and persons related to a U.S. party or parties is materially 
less than the amount of income that would be recognized if the foreign 
tax treatment controlled for U.S. tax purposes; or the amount of credits 
claimed by the U.S. party or parties (if the foreign payment described 
in paragraph (e)(5)(iv)(B)(1)(ii) of this section were an amount of tax 
paid) is materially greater than it would be if the foreign tax 
treatment controlled for U.S. tax purposes:
    (i) The classification of the SPV (or an entity that has a direct or 
indirect ownership interest in the SPV) as a corporation or other entity 
subject to an entity-level tax, a partnership or other flow-through 
entity or an entity that is disregarded for tax purposes.
    (ii) The characterization as debt, equity or an instrument that is 
disregarded for tax purposes of an instrument issued by the SPV (or an 
entity that has a direct or indirect ownership interest in the SPV) to a 
U.S. party, a counterparty or a person related to a U.S. party or a 
counterparty.
    (iii) The proportion of the equity of the SPV (or an entity that 
directly or indirectly owns the SPV) that is considered to be owned 
directly or indirectly by a U.S. party and a counterparty.
    (iv) The amount of taxable income that is attributable to the SPV 
for one or more tax years during which the arrangement is in effect.
    (C) Definitions. The following definitions apply for purposes of 
paragraph (e)(5)(iv) of this section.
    (1) Applicable foreign country. An applicable foreign country means 
each foreign country to which a foreign payment described in paragraph 
(e)(5)(iv)(B)(1)(ii) of this section is made or which confers a foreign 
tax benefit described in paragraph (e)(5)(iv)(B)(4) of this section.
    (2) Counterparty. The term counterparty means a person described in 
paragraph (e)(5)(iv)(B)(5) of this section.
    (3) Entity. The term entity includes a corporation, trust, 
partnership or disregarded entity described in Sec.  301.7701-
2(c)(2)(i).
    (4) Indirect ownership. Indirect ownership of stock or another 
equity interest (such as an interest in a partnership) shall be 
determined in accordance with the principles of section 958(a)(2), 
regardless of whether the interest is owned by a U.S. or foreign entity.
    (5) Passive investment income--(i) In general. The term passive 
investment income means income described in section 954(c), as modified 
by this paragraph (e)(5)(iv)(C)(5)(i) and paragraph (e)(5)(iv)(C)(5)(ii) 
of this section. In determining whether income is described in section 
954(c), paragraphs (c)(1)(H), (c)(3), and (c)(6) of that section shall 
be disregarded. Sections 954(c), 954(h), and 954(i) shall be applied at 
the entity level as if the entity (as defined in paragraph 
(e)(5)(iv)(C)(3) of this section) were a controlled foreign corporation 
(as defined in section 957(a)). For purposes of determining if sections 
954(h) and 954(i) apply for purposes of this paragraph 
(e)(5)(iv)(C)(5)(i) and paragraph (e)(5)(iv)(C)(5)(ii) of this section, 
any income of an entity attributable to transactions that, assuming the 
entity is an SPV, are with a person that is a counterparty, or with 
persons that are related to a counterparty within the meaning of 
paragraph (e)(5)(iv)(B)(4) of this section, shall not be treated as 
qualified banking or financing income or as qualified insurance income, 
and shall not be taken into account in applying sections 954(h) and 
954(i) for purposes of determining whether other income of the entity is 
excluded from section 954(c)(1) under section 954(h) or 954(i), but only 
if any such person (or a person that is related to such person within 
the meaning of paragraph (e)(5)(iv)(B)(4) of this section) is eligible 
for a foreign tax benefit described in paragraph (e)(5)(iv)(B)(4) of 
this section. In addition, in applying section 954(h) for purposes of 
this paragraph (e)(5)(iv)(C)(5)(i) and paragraph (e)(5)(iv)(C)(5)(ii) of 
this section, section 954(h)(3)(E) shall not

[[Page 673]]

apply, section 954(h)(2)(A)(ii) shall be satisfied only if the entity 
conducts substantial activity with respect to its business through its 
own employees, and the term ``any foreign country'' shall be substituted 
for ``home country'' wherever it appears in section 954(h).
    (ii) Income attributable to lower-tier entities; holding company 
exception. Income of an upper-tier entity that is attributable to an 
equity interest in a lower-tier entity, including dividends, an 
allocable share of partnership income, and income attributable to the 
ownership of an interest in an entity that is disregarded as an entity 
separate from its owner is passive investment income unless 
substantially all of the upper-tier entity's assets consist of qualified 
equity interests in one or more lower-tier entities, each of which is 
engaged in the active conduct of a trade or business and derives more 
than 50 percent of its gross income from such trade or business, and 
substantially all of the upper-tier entity's opportunity for gain and 
risk of loss with respect to each such interest in a lower-tier entity 
is shared by the U.S. party (or persons that are related to a U.S. 
party) and, assuming the entity is an SPV, a counterparty (or persons 
that are related to a counterparty) (``holding company exception''). If 
an arrangement involves more than one U.S. party or more than one 
counterparty or both, then substantially all of the upper-tier entity's 
opportunity for gain and risk of loss with respect to its interest in 
any lower-tier entity must be shared (directly or indirectly) by one or 
more U.S. parties (or persons related to such U.S. parties) and, 
assuming the upper-tier entity is an SPV, one or more counterparties (or 
persons related to such counterparties). Substantially all of the upper-
tier entity's opportunity for gain and risk of loss with respect to its 
interest in any lower-tier entity is not shared if the opportunity for 
gain and risk of loss is borne (directly or indirectly) by one or more 
U.S. parties (or persons related to such U.S. party or parties) or, 
assuming the upper-tier entity is an SPV, by one or more counterparties 
(or persons related to such counterparty or counterparties). Whether and 
the extent to which a person is considered to share in an upper-tier 
entity's opportunity for gain and risk of loss is determined based on 
all the facts and circumstances, provided, however, that a person does 
not share in an upper-tier entity's opportunity for gain and risk of 
loss if its equity interest in the upper-tier entity was acquired in a 
sale-repurchase transaction or if its interest is treated as debt for 
U.S. tax purposes. If a U.S. party owns an interest in an entity 
indirectly through a chain of entities, the application of the holding 
company exception begins with the lowest-tier entity in the chain that 
may satisfy the holding company exception and proceeds upward; provided, 
however, that the opportunity for gain and risk of loss borne by any 
upper-tier entity in the chain that is a counterparty shall be 
disregarded to the extent borne indirectly by a U.S. party. An upper-
tier entity that satisfies the holding company exception is itself 
considered to be engaged in the active conduct of a trade or business 
and to derive more than 50 percent of its gross income from such trade 
or business for purposes of applying the holding company exception to 
the owners of such entity. A lower-tier entity that is engaged in a 
banking, financing, or similar business shall not be considered to be 
engaged in the active conduct of a trade or business unless the income 
derived by such entity would be excluded from section 954(c)(1) under 
section 954(h) or 954(i) as modified by paragraph (e)(5)(iv)(C)(5)(i) of 
this section.
    (6) Qualified equity interest. With respect to an interest in a 
corporation, the term qualified equity interest means stock representing 
10 percent or more of the total combined voting power of all classes of 
stock entitled to vote and 10 percent or more of the total value of the 
stock of the corporation or disregarded entity, but does not include any 
preferred stock (as defined in section 351(g)(3)). Similar rules shall 
apply to determine whether an interest in an entity other than a 
corporation is a qualified equity interest.
    (7) Related person. Two persons are related if--

[[Page 674]]

    (i) One person directly or indirectly owns stock (or an equity 
interest) possessing more than 50 percent of the total value of the 
other person; or
    (ii) The same person directly or indirectly owns stock (or an equity 
interest) possessing more than 50 percent of the total value of both 
persons.
    (8) Special purpose vehicle (SPV). The term SPV means the entity 
described in paragraph (e)(5)(iv)(B)(1) of this section.
    (9) U.S. party. The term U.S. party means a person described in 
paragraph (e)(5)(iv)(B)(2) of this section.
    (D) Examples. The following examples illustrate the rules of 
paragraph (e)(5)(iv) of this section. No inference is intended as to 
whether a taxpayer would be eligible to claim a credit under section 
901(a) if a foreign payment were an amount of tax paid. The examples set 
forth below do not limit the application of other principles of existing 
law to determine the proper tax consequences of the structures or 
transactions addressed in the regulations.

    Example 1. U.S. borrower transaction. (i) Facts. A domestic 
corporation (USP) forms a country M corporation (Newco), contributing 
$1.5 billion in exchange for 100% of the stock of Newco. Newco, in turn, 
loans the $1.5 billion to a second country M corporation (FSub) wholly 
owned by USP. USP then sells its entire interest in Newco to a country M 
corporation (FP) for the original purchase price of $1.5 billion, 
subject to an obligation to repurchase the interest in five years for 
$1.5 billion. The sale has the effect of transferring ownership of the 
Newco stock to FP for country M tax purposes. Assume the sale-repurchase 
transaction is structured in a way that qualifies as a collateralized 
loan for U.S. tax purposes. Therefore, USP remains the owner of the 
Newco stock for U.S. tax purposes. In year 1, FSub pays Newco $120 
million of interest. Newco pays $36 million to country M with respect to 
such interest income and distributes the remaining $84 million to FP. 
Under country M law, the $84 million distribution is excluded from FP's 
income. None of FP's stock is owned, directly or indirectly, by USP or 
any shareholders of USP that are domestic corporations, U.S. citizens, 
or resident alien individuals. Under an income tax treaty between 
country M and the United States, country M does not impose country M tax 
on interest received by U.S. residents from sources in country M.
    (ii) Result. The $36 million payment by Newco to country M is not a 
compulsory payment, and thus is not an amount of tax paid because the 
foreign payment is attributable to a structured passive investment 
arrangement. First, Newco is an SPV because all of Newco's income is 
passive investment income described in paragraph (e)(5)(iv)(C)(5) of 
this section; Newco's only asset, a note, is held to produce such 
income; the payment to country M is attributable to such income; and if 
the payment were an amount of tax paid it would be paid or accrued in a 
U.S. taxable year in which Newco meets the requirements of paragraph 
(e)(5)(iv)(B)(1)(i) of this section. Second, if the foreign payment were 
treated as an amount of tax paid, USP would be deemed to pay the foreign 
payment under section 902(a) and, therefore, would be eligible to claim 
a credit for such payment under section 901(a). Third, USP would not pay 
any country M tax if it directly owned Newco's loan receivable. Fourth, 
the distribution from Newco to FP is exempt from tax under country M 
law, and the exempt amount corresponds to more than 10% of the foreign 
base with respect to which USP's share (which is 100% under U.S. tax 
law) of the foreign payment was imposed. Fifth, FP is a counterparty 
because FP owns stock of Newco under country M law and none of FP's 
stock is owned by USP or shareholders of USP that are domestic 
corporations, U.S. citizens, or resident alien individuals. Sixth, FP is 
the owner of 100% of Newco's stock for country M tax purposes, while USP 
is the owner of 100% of Newco's stock for U.S. tax purposes, and the 
amount of credits claimed by USP if the payment to country M were an 
amount of tax paid is materially greater than it would be if country M 
tax treatment controlled for U.S. tax purposes such that FP, rather than 
USP, owned 100% of Newco's stock. Because the payment to country M is 
not an amount of tax paid, USP is not deemed to pay any country M tax 
under section 902(a). USP has dividend income of $84 million and also 
has interest expense of $84 million. FSub's post-1986 undistributed 
earnings are reduced by $120 million of interest expense.
    Example 2. U.S. borrower transaction. (i) Facts. The facts are the 
same as in Example 1, except that FSub is a wholly-owned subsidiary of 
Newco. In addition, assume FSub is engaged in the active conduct of 
manufacturing and selling widgets and derives more than 50% of its gross 
income from such business.
    (ii) Result. The results are the same as in Example 1. Although 
Newco wholly owns FSub, which is engaged in the active conduct of 
manufacturing and selling widgets and derives more than 50% of its 
income from such business, Newco's income that is attributable to 
Newco's equity interest in FSub is passive investment income because the 
sale-repurchase transaction limits FP's interest in Newco and its assets 
to that of a creditor,

[[Page 675]]

so that substantially all of Newco's opportunity for gain and risk of 
loss with respect to its stock in FSub is borne by USP. See paragraph 
(e)(5)(iv)(C)(5)(ii) of this section. Accordingly, Newco's stock in FSub 
is held to produce passive investment income. Thus, Newco is an SPV 
because all of Newco's income is passive investment income described in 
paragraph (e)(5)(iv)(C)(5) of this section, Newco's assets are held to 
produce such income, the payment to country M is attributable to such 
income, and if the payment were an amount of tax paid it would be paid 
or accrued in a U.S. taxable year in which Newco meets the requirements 
of paragraph (e)(5)(iv)(B)(1)(i) of this section.
    Example 3. U.S. borrower transaction. (i) Facts. (A) A domestic 
corporation (USP) loans $750 million to its wholly-owned domestic 
subsidiary (Sub). USP and Sub form a country M partnership (Partnership) 
to which each contributes $750 million. Partnership loans all of its 
$1.5 billion of capital to Issuer, a wholly-owned country M affiliate of 
USP, in exchange for a note and coupons providing for the payment of 
interest at a fixed rate over a five-year term. Partnership sells all of 
the coupons to Coupon Purchaser, a country N partnership owned by a 
country M corporation (Foreign Bank) and a wholly-owned country M 
subsidiary of Foreign Bank, for $300 million. At the time of the coupon 
sale, the fair market value of the coupons sold is $290 million and, 
pursuant to section 1286(b)(3), Partnership's basis allocated to the 
coupons sold is $290 million. Several months later and prior to any 
interest payments on the note, Foreign Bank and its subsidiary sell all 
of their interests in Coupon Purchaser to an unrelated country O 
corporation for $280 million. None of Foreign Bank's stock or its 
subsidiary's stock is owned, directly or indirectly, by USP or Sub or by 
any shareholders of USP or Sub that are domestic corporations, U.S. 
citizens, or resident alien individuals.
    (B) Assume that both the United States and country M respect the 
sale of the coupons for tax law purposes. In the year of the coupon 
sale, for country M tax purposes USP's and Sub's shares of Partnership's 
profits total $300 million, a payment of $60 million to country M is 
made with respect to those profits, and Foreign Bank and its subsidiary, 
as partners of Coupon Purchaser, are entitled to deduct the $300 million 
purchase price of the coupons from their taxable income. For U.S. tax 
purposes, USP and Sub recognize their distributive shares of the $10 
million premium income and claim a direct foreign tax credit for their 
shares of the $60 million payment to country M. Country M imposes no 
additional tax when Foreign Bank and its subsidiary sell their interests 
in Coupon Purchaser. Country M also does not impose country M tax on 
interest received by U.S. residents from sources in country M.
    (ii) Result. The payment to country M is not a compulsory payment, 
and thus is not an amount of tax paid, because the foreign payment is 
attributable to a structured passive investment arrangement. First, 
Partnership is an SPV because all of Partnership's income is passive 
investment income described in paragraph (e)(5)(iv)(C)(5) of this 
section; Partnership's only asset, Issuer's note, is held to produce 
such income; the payment to country M is attributable to such income; 
and if the payment were an amount of tax paid, it would be paid or 
accrued in a U.S. taxable year in which Partnership meets the 
requirements of paragraph (e)(5)(iv)(B)(1)(i) of this section. Second, 
if the foreign payment were an amount of tax paid, USP and Sub would be 
eligible to claim a credit for such payment under section 901(a). Third, 
USP and Sub would not pay any country M tax if they directly owned 
Issuer's note. Fourth, for country M tax purposes, Foreign Bank and its 
subsidiary deduct the $300 million purchase price of the coupons and are 
exempt from country M tax on the $280 million received upon the sale of 
Coupon Purchaser, and the deduction and exemption correspond to more 
than 10% of the $300 million base with respect to which USP's and Sub's 
100% share of the foreign payments was imposed. Fifth, Foreign Bank and 
its subsidiary are counterparties because they indirectly acquired 
assets of Partnership, the interest coupons on Issuer's note, and are 
not directly or indirectly owned by USP or Sub or shareholders of USP or 
Sub that are domestic corporations, U.S. citizens, or resident alien 
individuals. Sixth, the amount of taxable income of Partnership for one 
or more years is different for U.S. and country M tax purposes, and the 
amount of income attributable to USP and Sub for U.S. tax purposes is 
materially less than the amount of income they would recognize if the 
country M tax treatment of the coupon sale controlled for U.S. tax 
purposes. Because the payment to country M is not an amount of tax paid, 
USP and Sub are not considered to pay tax under section 901. USP and Sub 
have income of $10 million in the year of the coupon sale.
    Example 4. Active business; no SPV. (i) Facts. A, a domestic 
corporation, wholly owns B, a country X corporation engaged in the 
manufacture and sale of widgets. On January 1, year 1, C, also a country 
X corporation, loans $400 million to B in exchange for an instrument 
that is debt for U.S. tax purposes and equity in B for country X tax 
purposes. As a result, C is considered to own stock of B for country X 
tax purposes. B loans $55 million to D, a country Y corporation wholly 
owned by A. In year 1, B has $166 million of net income attributable to 
its sales of widgets and $3.3 million of interest income attributable

[[Page 676]]

to the loan to D. Substantially all of B's assets are used in its widget 
business. Country Y does not impose tax on interest paid to 
nonresidents. B makes a payment of $50.8 million to country X with 
respect to B's net income. Country X does not impose tax on dividend 
payments between country X corporations. None of C's stock is owned, 
directly or indirectly, by A or by any shareholders of A that are 
domestic corporations, U.S. citizens, or resident alien individuals.
    (ii) Result. B is not an SPV within the meaning of paragraph 
(e)(5)(iv)(B)(1) of this section because the amount of interest income 
received from D does not constitute substantially all of B's income and 
the $55 million note from D does not constitute substantially all of B's 
assets. Accordingly, the $50.8 million payment to country X is not 
attributable to a structured passive investment arrangement.
    Example 5. U.S. lender transaction. (i) Facts. (A) A country X 
corporation (Foreign Bank) contributes $2 billion to a newly-formed 
country X company (Newco) in exchange for 90% of the common stock of 
Newco and securities that are treated as debt of Newco for U.S. tax 
purposes and preferred stock of Newco for country X tax purposes. A 
domestic corporation (USP) contributes $1 billion to Newco in exchange 
for 10% of Newco's common stock and securities that are treated as 
preferred stock of Newco for U.S. tax purposes and debt of Newco for 
country X tax purposes. Newco loans the $3 billion to a wholly-owned, 
country X subsidiary of Foreign Bank (FSub) in return for a $3 billion, 
seven-year note paying interest currently. The Newco securities held by 
USP entitle the holder to fixed distributions of $4 million per year, 
and the Newco securities held by Foreign Bank entitle the holder to 
receive $82 million per year, payable only on maturity of the $3 billion 
FSub note in year 7. At the end of year 5, pursuant to a prearranged 
plan, Foreign Bank acquires USP's Newco stock and securities for a 
prearranged price of $1 billion. Country X does not impose tax on 
dividends received by one country X corporation from a second country X 
corporation. Under an income tax treaty between country X and the United 
States, country X does not impose country X tax on interest received by 
U.S. residents from sources in country X. None of Foreign Bank's stock 
is owned, directly or indirectly, by USP or any shareholders of USP that 
are domestic corporations, U.S. citizens, or resident alien individuals.
    (B) In each of years 1 through 7, FSub pays Newco $124 million of 
interest on the $3 billion note. Newco distributes $4 million to USP in 
each of years 1 through 5. The distributions are deductible for country 
X tax purposes, and Newco pays country X $36 million with respect to 
$120 million of taxable income from the FSub note in each year. For U.S. 
tax purposes, in each year Newco's post-1986 undistributed earnings are 
increased by $124 million of interest income and reduced by accrued 
interest expense with respect to the Newco securities held by Foreign 
Bank.
    (ii) Result. The $36 million payment to country X is not a 
compulsory payment, and thus is not an amount of tax paid, because the 
foreign payment is attributable to a structured passive investment 
arrangement. First, Newco is an SPV because all of Newco's income is 
passive investment income described in paragraph (e)(5)(iv)(C)(5) of 
this section; Newco's only asset, a note of FSub, is held to produce 
such income; the payment to country X is attributable to such income; 
and if the payment were an amount of tax paid it would be paid or 
accrued in a U.S. taxable year in which Newco meets the requirements of 
paragraph (e)(5)(iv)(B)(1)(i) of this section. Second, if the foreign 
payment were an amount of tax paid, USP would be deemed to pay its pro 
rata share of the foreign payment under section 902(a) in each of years 
1 through 5 and, therefore, would be eligible to claim a credit under 
section 901(a). Third, USP would not pay any country X tax if it 
directly owned its proportionate share of Newco's assets, a note of 
FSub. Fourth, for country X tax purposes, Foreign Bank is eligible to 
receive a tax-free distribution of $82 million attributable to each of 
years 1 through 5, and that amount corresponds to more than 10% of the 
foreign base with respect to which USP's share of the foreign payment 
was imposed. Fifth, Foreign Bank is a counterparty because it owns stock 
of Newco for country X tax purposes and none of Foreign Bank's stock is 
owned, directly or indirectly, by USP or shareholders of USP that are 
domestic corporations, U.S. citizens, or resident alien individuals. 
Sixth, the United States and country X treat various aspects of the 
arrangement differently, including whether the Newco securities held by 
Foreign Bank and USP are debt or equity. The amount of credits claimed 
by USP if the payment to country X were an amount of tax paid is 
materially greater than it would be if the country X tax treatment 
controlled for U.S. tax purposes such that the securities held by USP 
were treated as debt or the securities held by Foreign Bank were treated 
as equity, and the amount of income recognized by Newco for U.S. tax 
purposes is materially less than the amount of income recognized for 
country X tax purposes. Because the payment to country X is not an 
amount of tax paid, USP is not deemed to pay any country X tax under 
section 902(a). USP has dividend income of $4 million in each of years 1 
through 5.
    Example 6. Holding company; no SPV. (i) Facts. A, a country X 
corporation, and B, a domestic corporation, each contribute $1 billion 
to a newly-formed country X entity (C)

[[Page 677]]

in exchange for 50% of the common stock of C. C is treated as a 
corporation for country X purposes and a partnership for U.S. tax 
purposes. C contributes $1.95 billion to a newly-formed country X 
corporation (D) in exchange for 100% of D's common stock. C loans its 
remaining $50 million to D. Accordingly, C's sole assets are stock and 
debt of D. D uses the entire $2 billion to engage in the business of 
manufacturing and selling widgets. In year 1, D derives $300 million of 
income from its widget business and derives $2 million of interest 
income. Also in year 1, C has dividend income of $200 million and 
interest income of $3.2 million with respect to its investment in D. 
Country X does not impose tax on dividends received by one country X 
corporation from a second country X corporation. C makes a payment of 
$960,000 to country X with respect to C's net income.
    (ii) Result. C qualifies for the holding company exception described 
in paragraph (e)(5)(iv)(C)(5)(ii) of this section because C holds a 
qualified equity interest in D, D is engaged in an active trade or 
business and derives more than 50% of its gross income from such trade 
or business, C's interest in D constitutes substantially all of C's 
assets, and A and B share in substantially all of C's opportunity for 
gain and risk of loss with respect to D. As a result, C's dividend 
income from D is not passive investment income and C's stock in D is not 
held to produce such income. Accordingly, C is not an SPV within the 
meaning of paragraph (e)(5)(iv)(B)(1) of this section, and the $960,000 
payment to country X is not attributable to a structured passive 
investment arrangement.
    Example 7. Holding company; no SPV. (i) Facts. The facts are the 
same as in Example 6, except that instead of loaning $50 million to D, C 
contributes the $50 million to E in exchange for 10% of the stock of E. 
E is a country Y corporation that is not engaged in the active conduct 
of a trade or business. Also in year 1, D pays no dividends to C, E pays 
$3.2 million in dividends to C, and C makes a payment of $960,000 to 
country X with respect to C's net income.
    (ii) Result. C qualifies for the holding company exception described 
in paragraph (e)(5)(iv)(C)(5)(ii) of this section because C holds a 
qualified equity interest in D, D is engaged in an active trade or 
business and derives more than 50% of its gross income from such trade 
or business, C's interest in D constitutes substantially all of C's 
assets, and A and B share in substantially all of C's opportunity for 
gain and risk of loss with respect to D. As a result, less than 
substantially all of C's assets are held to produce passive investment 
income. Accordingly, C is not an SPV because it does not meet the 
requirements of paragraph (e)(5)(iv)(B)(1) of this section, and the 
$960,000 payment to country X is not attributable to a structured 
passive investment arrangement.
    Example 8. Holding company; no SPV. (i) Facts. The facts are the 
same as in Example 6, except that B's $1 billion investment in C 
consists of 30% of C's common stock and 100% of C's preferred stock. A's 
$1 billion investment in C consists of 70% of C's common stock. B sells 
its preferred stock to F, a country X corporation, subject to a 
repurchase obligation. Assume that under country X tax law, but not U.S. 
tax law, F is treated as the owner of the preferred shares and receives 
a distribution in year 1 of $50 million. The remaining earnings are 
distributed 70% to A and 30% to B.
    (ii) Result. C qualifies for the holding company exception described 
in paragraph (e)(5)(iv)(C)(5)(ii) of this section because C holds a 
qualified equity interest in D, D is engaged in an active trade or 
business and derives more than 50% of its gross income from such trade 
or business, and C's interest in D constitutes substantially all of C's 
assets. Additionally, although F does not share in C's opportunity for 
gain and risk of loss with respect to C's interest in D because F 
acquired its interest in C in a sale-repurchase transaction, B (the U.S. 
party) and in the aggregate A and F (who would be counterparties 
assuming C were an SPV) share in substantially all of C's opportunity 
for gain and risk of loss with respect to D and such opportunity for 
gain and risk of loss is not borne exclusively either by B or by A and F 
in the aggregate. Accordingly, C's shares in D are not held to produce 
passive investment income and the $200 million dividend from D is not 
passive investment income. C is not an SPV within the meaning of 
paragraph (e)(5)(iv)(B)(1) of this section, and the $960,000 payment to 
country X is not attributable to a structured passive investment 
arrangement.
    Example 9. Asset holding transaction. (i) Facts. (A) A domestic 
corporation (USP) contributes $6 billion of country Z debt obligations 
to a country Z entity (DE) in exchange for all of the class A and class 
B stock of DE. DE is a disregarded entity for U.S. tax purposes and a 
corporation for country Z tax purposes. A corporation unrelated to USP 
and organized in country Z (FC) contributes $1.5 billion to DE in 
exchange for all of the class C stock of DE. DE uses the $1.5 billion 
contributed by FC to redeem USP's class B stock. The terms of the class 
C stock entitle its holder to all income from DE, but FC is obligated 
immediately to contribute back to DE all distributions on the class C 
stock. USP and FC enter into--
    (1) A contract under which USP agrees to buy after five years the 
class C stock for $1.5 billion; and
    (2) An agreement under which USP agrees to pay FC periodic payments 
on $1.5 billion.
    (B) The transaction is structured in such a way that, for U.S. tax 
purposes, there is a loan of $1.5 billion from FC to USP, and USP

[[Page 678]]

is the owner of the class C stock and the class A stock. In year 1, DE 
earns $400 million of interest income on the country Z debt obligations. 
DE makes a payment to country Z of $100 million with respect to such 
income and distributes the remaining $300 million to FC. FC contributes 
the $300 million back to DE. None of FC's stock is owned, directly or 
indirectly, by USP or shareholders of USP that are domestic 
corporations, U.S. citizens, or resident alien individuals. Assume that 
country Z imposes a withholding tax on interest income derived by U.S. 
residents.
    (C) Country Z treats FC as the owner of the class C stock. Pursuant 
to country Z tax law, FC is required to report the $400 million of 
income with respect to the $300 million distribution from DE, but is 
allowed to claim credits for DE's $100 million payment to country Z. For 
country Z tax purposes, FC is entitled to current deductions equal to 
the $300 million contributed back to DE.
    (ii) Result. The payment to country Z is not a compulsory payment, 
and thus is not an amount of tax paid because the payment is 
attributable to a structured passive investment arrangement. First, DE 
is an SPV because all of DE's income is passive investment income 
described in paragraph (e)(5)(iv)(C)(5) of this section; all of DE's 
assets are held to produce such income; the payment to country Z is 
attributable to such income; and if the payment were an amount of tax 
paid it would be paid or accrued in a U.S. taxable year in which DE 
meets the requirements of paragraph (e)(5)(iv)(B)(1)(i) of this section. 
Second, if the payment were an amount of tax paid, USP would be eligible 
to claim a credit for such amount under section 901(a). Third, USP's 
proportionate share of DE's foreign payment of $100 million is 
substantially greater than the amount of credits USP would be eligible 
to claim if it directly held its proportionate share of DE's assets, 
excluding any assets that would produce income subject to gross basis 
withholding tax if directly held by USP. Fourth, FC is entitled to claim 
a credit under country Z tax law for the payment and recognizes a 
deduction for the $300 million contributed to DE under country Z law. 
The credit claimed by FC corresponds to more than 10% of USP's share 
(for U.S. tax purposes) of the foreign payment and the deductions 
claimed by FC correspond to more than 10% of the base with respect to 
which USP's share of the foreign payment was imposed. Fifth, FC is a 
counterparty because FC is considered to own equity of DE under country 
Z law and none of FC's stock is owned, directly or indirectly, by USP or 
shareholders of USP that are domestic corporations, U.S. citizens, or 
resident alien individuals. Sixth, the United States and country X treat 
certain aspects of the transaction differently, including the proportion 
of equity owned in DE by USP and FC, and the amount of credits claimed 
by USP if the country Z payment were an amount of tax paid is materially 
greater than it would be if the country X tax treatment controlled for 
U.S. tax purposes such that FC, rather than USP, owned the class C 
stock. Because the payment to country Z is not an amount of tax paid, 
USP is not considered to pay tax under section 901. USP has $400 million 
of interest income.
    Example 10. Loss surrender. (i) Facts. The facts are the same as in 
Example 9, except that the deductions attributable to the arrangement 
contribute to a loss recognized by FC for country Z tax purposes, and 
pursuant to a group relief regime in country Z FC elects to surrender 
the loss to its country Z subsidiary.
    (ii) Result. The results are the same as in Example 9. The surrender 
of the loss to a related party is a foreign tax benefit that corresponds 
to the base with respect to which USP's share of the foreign payment was 
imposed.
    Example 11. Joint venture; no foreign tax benefit. (i) Facts. FC, a 
country X corporation, and USC, a domestic corporation, each contribute 
$1 billion to a newly-formed country X entity (C) in exchange for stock 
of C. FC and U.S.C. are entitled to equal 50% shares of all of C's 
income, gain, expense and loss. C is treated as a corporation for 
country X purposes and a partnership for U.S. tax purposes. In year 1, C 
earns $200 million of net passive investment income, makes a payment to 
country X of $60 million with respect to that income, and distributes 
$70 million to each of FC and USC. Country X does not impose tax on 
dividends received by one country X corporation from a second country X 
corporation.
    (ii) Result. FC's tax-exempt receipt of $70 million, or its 50% 
share of C's profits, is not a foreign tax benefit within the meaning of 
paragraph (e)(5)(iv)(B)(4) of this section because it does not 
correspond to any part of the foreign base with respect to which USC's 
share of the foreign payment was imposed. Accordingly, the $60 million 
payment to country X is not attributable to a structured passive 
investment arrangement.
    Example 12. Joint venture; no foreign tax benefit. (i) Facts. The 
facts are the same as in Example 11, except that C in turn contributes 
$2 billion to a wholly-owned and newly-formed country X entity (D) in 
exchange for stock of D. D is treated as a corporation for country X 
purposes and disregarded as an entity separate from its owner for U.S. 
tax purposes. C has no other assets and earns no other income. In year 
1, D earns $200 million of passive investment income, makes a payment to 
country X of $60 million with respect to that income, and distributes 
$140 million to C.
    (ii) Result. C's tax-exempt receipt of $140 million is not a foreign 
tax benefit within the meaning of paragraph (e)(5)(iv)(B)(4) of this 
section because it does not correspond

[[Page 679]]

to any part of the foreign base with respect to which USC's share of the 
foreign payment was imposed. Fifty percent of C's foreign tax exemption 
is not a foreign tax benefit within the meaning of paragraph 
(e)(5)(iv)(B)(4) because it relates to earnings of D that are 
distributed with respect to an equity interest in D that is owned 
indirectly by U.S.C. under both U.S. and foreign tax law. The remaining 
50% of C's foreign tax exemption, as well as FC's tax-exempt receipt of 
$70 million from C, is also not a foreign tax benefit because it does 
not correspond to any part of the foreign base with respect to which 
USC's share of the foreign payment was imposed. Accordingly, the $60 
million payment to country X is not attributable to a structured passive 
investment arrangement.

    (f) Taxpayer--(1) In general. The person by whom tax is considered 
paid for purposes of sections 901 and 903 is the person on whom foreign 
law imposes legal liability for such tax, even if another person (e.g., 
a withholding agent) remits such tax. For purposes of this section, 
Sec.  1.901-2A and Sec.  1.903-1, the person on whom foreign law imposes 
such liability is referred to as the ``taxpayer.'' A foreign tax of a 
type described in paragraph (a)(2)(ii)(C) of this section is considered 
to be imposed on the recipients of wages if such tax is deducted from 
such wages under provisions that are comparable to section 3102 (a) and 
(b) of the Internal Revenue Code.
    (2) Party undertaking tax obligation as part of transaction--(i) In 
general. Tax is considered paid by the taxpayer even if another party to 
a direct or indirect transaction with the taxpayer agrees, as a part of 
the transaction, to assume the taxpayer's foreign tax liability. The 
rules of the foregoing sentence apply notwithstanding anything to the 
contrary in paragraph (e)(3) of this section. See Sec.  1.901-2A for 
additional rules regarding dual capacity taxpayers.
    (ii) Examples. The provisions of paragraphs (f)(1) and (2)(i) of 
this section may be illustrated by the following examples:

    Example 1. Under a loan agreement between A, a resident of country 
X, and B, a United States person, A agrees to pay B a certain amount of 
interest net of any tax that country X may impose on B with respect to 
its interest income. Country X imposes a 10 percent tax on the gross 
amount of interest income received by nonresidents of country X from 
sources in country X, and it is established that this tax is a tax in 
lieu of an income tax within the meaning of Sec.  1.903-1(a). Under the 
law of country X this tax is imposed on the nonresident recipient, and 
any resident of country X that pays such interest to a nonresident is 
required to withhold and pay over to country X 10 percent of the amount 
of such interest, which is applied to offset the recipient's liability 
for the tax. Because legal liability for the tax is imposed on the 
recipient of such interest income, B is the taxpayer with respect to the 
country X tax imposed on B's interest income from B's loan to A. 
Accordingly, B's interest income for federal income tax purposes 
includes the amount of country X tax that is imposed on B with respect 
to such interest income and that is paid on B's behalf by A pursuant to 
the loan agreement, and, under paragraph (f)(2)(i) of this section, such 
tax is considered for purposes of section 903 to be paid by B.
    Example 2. The facts are the same as in example 1, except that in 
collecting and receiving the interest B is acting as a nominee for, or 
agent of, C, who is a United States person. Because C (not B) is the 
beneficial owner of the interest, legal liability for the tax is imposed 
on C, not B (C's nominee or agent). Thus, C is the taxpayer with respect 
to the country X tax imposed on C's interest income from C's loan to A. 
Accordingly, C's interest income for federal income tax purposes 
includes the amount of country X tax that is imposed on C with respect 
to such interest income and that is paid on C's behalf by A pursuant to 
the loan agreement. Under paragraph (f)(2)(i) of this section, such tax 
is considered for purposes of section 903 to be paid by C. No such tax 
is considered paid by B.
    Example 3. Country X imposes a tax called the ``country X income 
tax.'' A, a United States person engaged in construction activities in 
country X, is subject to that tax. Country X has contracted with A for A 
to construct a naval base. A is a dual capacity taxpayer (as defined in 
paragraph (a)(2)(ii)(A) of this section) and, in accordance with 
paragraphs (a)(1) and (c)(1) of Sec.  1.901-2A, A has established that 
the country X income tax as applied to dual capacity persons and the 
country X income tax as applied to persons other than dual capacity 
persons together constitute a single levy. A has also established that 
that levy is an income tax within the meaning of paragraph (a)(1) of 
this section. Pursuant to the terms of the contract, country X has 
agreed to assume any country X tax liability that A may incur with 
respect to A's income from the contract. For federal income tax 
purposes, A's income from the contract includes the amount of tax 
liability that is imposed by country X on A with respect to its income 
from the contract and that is assumed by country X; and for purposes of 
section 901 the amount of such tax liability assumed by country X is 
considered

[[Page 680]]

to be paid by A. By reason of paragraph (f)(2)(i) of this section, 
country X is not considered to provide a subsidy, within the meaning of 
paragraph (e)(3) of this section, to A.

    (3) Taxes imposed on combined income of two or more persons--(i) In 
general. If foreign tax is imposed on the combined income of two or more 
persons (for example, a husband and wife or a corporation and one or 
more of its subsidiaries), foreign law is considered to impose legal 
liability on each such person for the amount of the tax that is 
attributable to such person's portion of the base of the tax. Therefore, 
if foreign tax is imposed on the combined income of two or more persons, 
such tax is allocated among, and considered paid by, such persons on a 
pro rata basis in proportion to each person's portion of the combined 
income, as determined under foreign law and paragraph (f)(3)(iii) of 
this section. Combined income with respect to each foreign tax that is 
imposed on a combined basis is computed separately, and the tax on that 
combined income is allocated separately under this paragraph (f)(3)(i). 
If foreign law exempts from tax, or provides for specific rates of tax 
with respect to, certain types of income, or if certain expenses, 
deductions or credits are taken into account only with respect to a 
particular type of income, combined income with respect to such portions 
of the combined income is also computed separately, and the tax on that 
combined income is allocated separately under this paragraph (f)(3)(i). 
The rules of this paragraph (f)(3) apply regardless of which person is 
obligated to remit the tax, which person actually remits the tax, or 
which person the foreign country could proceed against to collect the 
tax in the event all or a portion of the tax is not paid. For purposes 
of this paragraph (f)(3), the term person means an individual or an 
entity (including a disregarded entity described in Sec.  301.7701-
2(c)(2)(i) of this chapter) that is subject to tax in a foreign country 
as a corporation (or otherwise at the entity level). In determining the 
amount of tax paid by an owner of a partnership or a disregarded entity, 
this paragraph (f)(3) first applies to determine the amount of tax paid 
by the partnership or disregarded entity, and then paragraph (f)(4) of 
this section applies to allocate the amount of such tax to the owner.
    (ii) Combined income. For purposes of this paragraph (f)(3), foreign 
tax is imposed on the combined income of two or more persons if such 
persons compute their taxable income on a combined basis under foreign 
law and foreign tax would otherwise be imposed on each such person on 
its separate taxable income. For example, income is computed on a 
combined basis if two or more persons add their items of income, gain, 
deduction, and loss to compute a single consolidated taxable income 
amount for foreign tax purposes. Foreign tax is considered to be imposed 
on the combined income of two or more persons even if the combined 
income is computed under foreign law by attributing to one such person 
(for example, the foreign parent of a foreign consolidated group) the 
income of other such persons or by treating persons that would otherwise 
be subject to tax as separate entities as unincorporated branches of a 
single corporation for purposes of computing the foreign tax on the 
combined income of the group. However, foreign tax is not considered to 
be imposed on the combined income of two or more persons if, because one 
or more persons is a fiscally transparent entity (under the principles 
of Sec.  1.894-1(d)(3)) under foreign law, only one of such persons is 
subject to tax under foreign law (even if two or more of such persons 
are corporations for U.S. Federal income tax purposes). Therefore, 
foreign tax is not considered to be imposed on the combined income of 
two or more persons solely because foreign law:
    (A) Permits one person to surrender a loss to another person 
pursuant to a group relief or other loss-sharing regime described in 
Sec.  1.909-2T(b)(2)(vi);
    (B) Requires a shareholder of a corporation to include in income 
amounts attributable to taxes imposed on the corporation with respect to 
distributed earnings, pursuant to an integrated tax system that allows 
the shareholder a credit for such taxes;
    (C) Requires a shareholder to include, pursuant to an anti-deferral 
regime (similar to subpart F of the Internal

[[Page 681]]

Revenue Code (sections 951 through 965)), income attributable to the 
shareholder's interest in the corporation;
    (D) Reallocates income from one person to a related person under 
foreign transfer pricing rules;
    (E) Requires a person to take into account a distributive share of 
income of an entity that is a partnership or other fiscally transparent 
entity for foreign tax law purposes; or
    (F) Requires a person to take all or part of the income of an entity 
that is a corporation for U.S. Federal income tax purposes into account 
because foreign law treats the entity as a branch or fiscally 
transparent entity (a reverse hybrid). A reverse hybrid does not include 
an entity that is treated under foreign law as a branch or fiscally 
transparent entity solely for purposes of calculating combined income of 
a foreign consolidated group.
    (iii) Portion of combined income--(A) In general. Each person's 
portion of the combined income is determined by reference to any return, 
schedule or other document that must be filed or maintained with respect 
to a person showing such person's income for foreign tax purposes, as 
properly amended or adjusted for foreign tax purposes. If no such 
return, schedule or other document must be filed or maintained with 
respect to a person for foreign tax purposes, then, for purposes of this 
paragraph (f)(3), such person's income is determined from the books of 
account regularly maintained by or on behalf of the person for purposes 
of computing its income for foreign tax purposes. Each person's portion 
of the combined income is determined by adjusting such person's income 
determined under this paragraph (f)(3)(iii)(A) as provided in paragraph 
(f)(3)(iii)(B) and (f)(3)(iii)(C) of this section.
    (B) Effect of certain payments--(1) Each person's portion of the 
combined income is determined by giving effect to payments and accrued 
amounts of interest, rents, royalties, and other amounts between persons 
whose income is included in the combined base to the extent such amounts 
would be taken into account in computing the separate taxable incomes of 
such persons under foreign law if they did not compute their income on a 
combined basis. Each person's portion of the combined income is 
determined without taking into account any payments from other persons 
whose income is included in the combined base that are treated as 
dividends or other non-deductible distributions with respect to equity 
under foreign law, and without taking into account deemed dividends or 
any similar attribution of income made for purposes of computing the 
combined income under foreign law, regardless of whether any such deemed 
dividend or attribution of income results in a deduction or inclusion 
under foreign law.
    (2) For purposes of determining each person's portion of the 
combined income, the treatment of a payment is determined under foreign 
law. Thus, for example, interest accrued by one group member with 
respect to an instrument held by another member that is treated as debt 
for foreign tax purposes but as equity for U.S. Federal income tax 
purposes would be considered income of the holder and would reduce the 
income of the issuer. See also Sec.  1.909-2T(b)(3)(i) for rules 
requiring suspension of foreign income taxes paid or accrued by the 
owner of a U.S. equity hybrid instrument.
    (C) Net losses. If tax is considered to be imposed on the combined 
income of three or more persons and one or more of such persons has a 
net loss for the taxable year for foreign tax purposes, the following 
rules apply. If foreign law provides mandatory rules for allocating the 
net loss among the other persons, then the rules that apply for foreign 
tax purposes apply for purposes of this paragraph (f)(3). If foreign law 
does not provide mandatory rules for allocating the net loss, the net 
loss is allocated among all other such persons on a pro rata basis in 
proportion to the amount of each person's income, as determined under 
paragraphs (f)(3)(iii)(A) and (f)(3)(iii)(B) of this section. For 
purposes of this paragraph (f)(3)(iii)(C), foreign law is not considered 
to provide mandatory rules for allocating a net loss solely because such 
loss is attributed from one person to a second person for purposes of 
computing combined income, as described in paragraph (f)(3)(ii) of this 
section.

[[Page 682]]

    (iv) Collateral consequences. U.S. tax principles apply to determine 
the tax consequences if one person remits a tax that is the legal 
liability of, and thus is considered paid by, another person.
    (4) Taxes imposed on partnerships and disregarded entities--(i) 
Partnerships. If foreign law imposes tax at the entity level on the 
income of a partnership, the partnership is considered to be legally 
liable for such tax under foreign law and therefore is considered to pay 
the tax for U.S. Federal income tax purposes. The rules of this 
paragraph (f)(4)(i) apply regardless of which person is obligated to 
remit the tax, which person actually remits the tax, or which person the 
foreign country could proceed against to collect the tax in the event 
all or a portion of the tax is not paid. See Sec. Sec.  1.702-1(a)(6) 
and 1.704-1(b)(4)(viii) for rules relating to the determination of a 
partner's distributive share of such tax. If the U.S. taxable year of a 
partnership closes for all partners due to a termination of the 
partnership under section 708(b)(1)(A) and the regulations under that 
section and the foreign taxable year of the partnership does not close, 
then foreign tax paid or accrued with respect to the foreign taxable 
year in which the termination occurs is allocated between the 
terminating partnership and its successors or assigns. For example, if, 
as a result of a change in ownership during a partnership's foreign 
taxable year, the partnership becomes a disregarded entity and the 
entity's foreign taxable year does not close, foreign tax paid or 
accrued by the owner of the disregarded entity with respect to the 
foreign taxable year is allocated between the partnership and the owner 
of the disregarded entity. If the U.S. taxable year of a partnership 
closes for all partners due to a termination of the partnership under 
section 708(b)(1)(B) and the regulations under that section and the 
foreign taxable year of the partnership does not close, then foreign tax 
paid or accrued by the new partnership with respect to the foreign 
taxable year in which the termination occurs is allocated between the 
terminating partnership and the new partnership. If multiple 
terminations under section 708(b)(1)(B) occur within the foreign taxable 
year, foreign tax paid or accrued with respect to that foreign taxable 
year by a new partnership is allocated among all terminating and new 
partnerships. In the case of any termination under section 708(b)(1), 
the allocation of foreign tax is made based on the respective portions 
of the taxable income (as determined under foreign law) for the foreign 
taxable year that are attributable under the principles of Sec.  1.1502-
76(b) to the period of existence of each terminating and new 
partnership, or successor or assign of a terminating partnership, during 
the foreign taxable year. Foreign tax allocated to a terminating 
partnership under this paragraph (f)(4)(i) is treated as paid or accrued 
by such partnership as of the close of the last day of its final U.S. 
taxable year. In the case of a change in any partner's interest in the 
partnership (a variance), except as otherwise provided in section 
706(d)(2) (relating to certain cash basis items) or 706(d)(3) (relating 
to tiered partnerships), foreign tax paid or accrued by the partnership 
during its U.S. taxable year in which the variance occurs is allocated 
between the portion of the U.S. taxable year ending on, and the portion 
of the U.S. taxable year beginning on the day after, the day of the 
variance. The allocation is made under the principles of this paragraph 
(f)(4)(i) as if the variance were a termination under section 708(b)(1).
    (ii) Disregarded entities. If foreign law imposes tax at the entity 
level on the income of an entity described in Sec.  301.7701-2(c)(2)(i) 
of this chapter (a disregarded entity), the person (as defined in 
section 7701(a)(1)) who is treated as owning the assets of the 
disregarded entity for U.S. Federal income tax purposes is considered to 
be legally liable for such tax under foreign law. Such person is 
considered to pay the tax for U.S. Federal income tax purposes. The 
rules of this paragraph (f)(4)(ii) apply regardless of which person is 
obligated to remit the tax, which person actually remits the tax, or 
which person the foreign country could proceed against to collect the 
tax in the event all or a portion of the tax is not paid. If there is a 
change in the ownership of such disregarded entity during the entity's 
foreign taxable year and such change does

[[Page 683]]

not result in a closing of the disregarded entity's foreign taxable 
year, foreign tax paid or accrued with respect to such foreign taxable 
year is allocated between the transferor and the transferee. If there is 
more than one change in the ownership of a disregarded entity during the 
entity's foreign taxable year, foreign tax paid or accrued with respect 
to that foreign taxable year is allocated among all transferors and 
transferees. The allocation is made based on the respective portions of 
the taxable income of the disregarded entity (as determined under 
foreign law) for the foreign taxable year that are attributable under 
the principles of Sec.  1.1502-76(b) to the period of ownership of each 
transferor and transferee during the foreign taxable year. If, as a 
result of a change in ownership, the disregarded entity becomes a 
partnership and the entity's foreign taxable year does not close, 
foreign tax paid or accrued by the partnership with respect to the 
foreign taxable year is allocated between the owner of the disregarded 
entity and the partnership under the principles of this paragraph 
(f)(4)(ii). If the person who owns a disregarded entity is a partnership 
for U.S. Federal income tax purposes, see Sec.  1.704-1(b)(4)(viii) for 
rules relating to the allocation of such tax among the partners of the 
partnership.
    (5) Allocation of foreign taxes in connection with elections under 
section 336(e) or 338. For rules relating to the allocation of foreign 
taxes in connection with elections made pursuant to section 336(e), see 
Sec.  1.336-2(g)(3)(ii). For rules relating to the allocation of foreign 
taxes in connection with elections made pursuant to section 338, see 
Sec.  1.338-9(d).
    (6) Examples. The following examples illustrate the rules of 
paragraphs (f)(3) and (f)(4) of this section:

    Example 1. (i) Facts. A, a United States person, owns 100 percent of 
B, an entity organized in country X. B owns 100 percent of C, also an 
entity organized in country X. B and C are corporations for U.S. and 
foreign tax purposes that use the ``u'' as their functional currency. 
Pursuant to a consolidation regime, country X imposes an income tax 
described in (a)(1) of this section on the combined income of B and C 
within the meaning of paragraph (f)(3)(ii) of this section. In year 1, C 
pays 25u of interest to B. If B and C did not report their income on a 
combined basis for country X tax purposes, the interest paid from C to B 
would result in 25u of interest income to B and 25u of deductible 
interest expense to C. For purposes of reporting the combined income of 
B and C, country X first requires B and C to determine their own income 
(or loss) on a separate schedule. For this purpose, however, neither B 
nor C takes into account the 25u of interest paid from C to B because 
the income of B and C is included in the same combined base. The 
separate income of B and C reported on their country X schedules for 
year 1, which do not reflect the 25u intercompany payment, is 100u and 
200u, respectively. The combined income reported for country X purposes 
is 300u (the sum of the 100u separate income of B and 200u separate 
income of C).
    (ii) Result. On the separate schedules described in paragraph 
(f)(3)(iii)(A) of this section, B's separate income is 100u and C's 
separate income is 200u. Under paragraph (f)(3)(iii)(B)(1) of this 
section, the 25u interest payment from C to B is taken into account for 
purposes of determining B's and C's portions of the combined income 
under paragraph (f)(3)(iii) of this section, because B and C would have 
taken the items into account if they did not compute their income on a 
combined basis. Thus, B's portion of the combined income is 125u (100u 
plus 25u) and C's portion of the combined income is 175u (200u less 
25u). The result is the same regardless of whether the 25u interest 
payment from C to B is deductible for U.S. Federal income tax purposes. 
See paragraph (f)(3)(iii)(B)(2) of this section.
    Example 2. (i) Facts. A, a United States person, owns 100 percent of 
B, an entity organized in country X. B is a corporation for country X 
tax purposes, and a disregarded entity for U.S. income tax purposes. B 
owns 100 percent of C and D, entities organized in country X that are 
corporations for both U.S. and country X tax purposes. B, C, and D use 
the ``u'' as their functional currency and file on a combined basis for 
country X income tax purposes. Country X imposes an income tax described 
in paragraph (a)(1) of this section at the rate of 30 percent on the 
taxable income of corporations organized in country X. Under the country 
X combined reporting regime, income (or loss) of C and D is attributed 
to, and treated as income (or loss) of, B. B has the sole obligation to 
pay country X income tax imposed with respect to income of B and income 
of C and D that is attributed to, and treated as income of, B. Under the 
law of country X, country X may proceed against B, but not C or D, if B 
fails to pay over to country X all or any portion of the country X 
income tax imposed with respect to such income. In year 1, B has income 
of 100u, C has income of 200u, and D has a net loss of (60u). Under the 
law of country X, B is considered to have 240u of taxable income with 
respect to which 72u of country X

[[Page 684]]

income tax is imposed. Country X does not provide mandatory rules for 
allocating D's loss.
    (ii) Result. Under paragraph (f)(3)(ii) of this section, the 72u of 
country X tax is considered to be imposed on the combined income of B, 
C, and D. Because country X law does not provide mandatory rules for 
allocating D's loss between B and C, under paragraph (f)(3)(iii)(C) of 
this section D's (60u) loss is allocated pro rata: 20u to B ((100u/300u) 
x 60u) and 40u to C ((200u/300u) x 60u). Under paragraph (f)(3)(i) of 
this section, the 72u of country X tax must be allocated pro rata among 
B, C, and D. Because D has no income for country X tax purposes, no 
country X tax is allocated to D. Accordingly, 24u (72u x (80u/240u)) of 
the country X tax is allocated to B, and 48u (72u x (160u/240u)) of such 
tax is allocated to C. Under paragraph (f)(4)(ii) of this section, A is 
considered to have legal liability for the 24u of country X tax 
allocated to B under paragraph (f)(3) of this section.
    Example 3. (i) Facts. A, B, and C are U.S. persons that each use the 
calendar year as their taxable year. A and B each own 50 percent of the 
capital and profits of D, an entity organized in country M. D is a 
partnership for U.S. tax purposes, but is a corporation for country M 
tax purposes. D uses the ``u'' as its functional currency and the 
calendar year as its taxable year for both U.S. tax purposes and country 
M tax purposes. Country M imposes an income tax described in paragraph 
(a)(1) of this section at a rate of 30 percent at the entity level on 
the taxable income of D. On September 30 of Year 1, A sells its 50 
percent interest in D to C. A's sale of its partnership interest results 
in a termination of the partnership under section 708(b)(1)(B) for U.S. 
tax purposes. As a result of the termination, ``old'' D's taxable year 
closes on September 30 of Year 1 for U.S. tax purposes. New D also has a 
short U.S. taxable year, beginning on October 1 and ending on December 
31 of Year 1. The sale of A's interest does not close D's taxable year 
for country M tax purposes. D has 400u of taxable income for its foreign 
taxable year ending December 31, Year 1 with respect to which country M 
imposes 120u of income tax, equal to $120 as translated in accordance 
with section 986(a).
    (ii) Result. Under paragraph (f)(4)(i) of this section, partnership 
D is legally liable for the $120 of country M income tax imposed on its 
foreign taxable income. Because D's taxable year closes on September 30, 
Year 1, for U.S. tax purposes, but does not close for country M tax 
purposes, under paragraph (f)(4)(i) of this section the $120 of country 
M tax must be allocated under the principles of Sec.  1.1502-76(b) 
between terminating D and new D. See Sec.  1.704-1(b)(4)(viii) for rules 
relating to the allocation of terminating D's country M taxes between A 
and B and the allocation of new D's country M taxes between B and C.
    (g) Definitions. For purposes of this section and Sec. Sec.  1.901-
2A and 1.903-1, the following definitions apply:
    (1) The term paid means ``paid or accrued''; the term payment means 
``payment or accrual''; and the term paid by means ``paid or accrued by 
or on behalf of.''
    (2) The term foreign country means any foreign state, any possession 
of the United States, and any political subdivision of any foreign state 
or of any possession of the United States. The term ``possession of the 
United States'' includes Puerto Rico, the Virgin Islands, Guam, the 
Northern Mariana Islands and American Samoa.
    (3) The term foreign levy means a levy imposed by a foreign country.
    (h) Effective/applicability date--(1) In general. This section and 
Sec. Sec.  1.901-2A and 1.903-1 apply to taxable years beginning after 
November 14, 1983.
    (2) Except as provided in paragraph (h)(3) of this section, 
paragraph (e)(5)(iv) of this section applies to foreign payments that, 
if such payments were an amount of tax paid, would be considered paid or 
accrued under Sec.  1.901-2(f) on or after July 13, 2011. See 26 CFR 
1.901-2T(e)(5)(iv) (revised as of April 1, 2011), for rules applicable 
to foreign payments that, if such payments were an amount of tax paid, 
would be considered paid or accrued before July 13, 2011.
    (3) The last sentence of paragraph (e)(5)(iv)(B)(1)(ii) of this 
section applies to foreign payments that, if such payments were an 
amount of tax paid, would be considered paid or accrued under Sec.  
1.901-2(f) on or after September 4, 2013. See 26 CFR 1.901-
2T(e)(5)(iv)(B)(1)(iii) (revised as of April 1, 2013) for rules 
applicable to foreign payments that, if such payments were an amount of 
tax paid, would be considered paid or accrued under Sec.  1.901-2(f) 
before September 4, 2013.
    (4) Paragraphs (f)(3), (f)(4), and (f)(6) of this section apply to 
foreign taxes paid or accrued in taxable years beginning after February 
14, 2012. However, if an amount of tax is paid or accrued in a taxable 
year of any person beginning on or before February 14, 2012, and the tax 
is treated as paid or accrued by

[[Page 685]]

such person under 26 CFR 1.901-2(f) (revised as of April 1, 2011), then 
paragraph (f)(4) of this section will not apply, and 26 CFR 1.901-2(f) 
(revised as of April 1, 2011) will apply, to determine the person with 
legal liability for that tax. No other person will be treated as legally 
liable for such tax, even if the tax is paid or accrued on a date that 
falls within a taxable year of such other person beginning after 
February 14, 2012. Taxpayers may choose to apply paragraph (f)(3) of 
this section to foreign taxes paid or accrued in taxable years beginning 
after December 31, 2010, and on or before February 14, 2012.

(Approved by the Office of Management and Budget under control number 
1545-0746)

[T.D. 7918, 48 FR 46276, Oct. 12, 1983, as amended by T.D. 8372, 56 FR 
56008, Oct. 31, 1991; T.D. 9416, 73 FR 40733, July 16, 2008; T.D. 9536, 
76 FR 42037, July 18, 2011, T.D. 9535, 76 FR 42043, July 18, 2011; T.D. 
9536, 76 FR 53819, Aug. 30, 2011; T.D. 9576, 77 FR 8125, Feb. 14, 2012; 
T.D. 9619, 78 FR 28489, May 15, 2013; T.D. 9634, 78 FR 54391, Sept. 4, 
2013]



Sec.  1.901-2A  Dual capacity taxpayers.

    (a) Application of separate levy rules as applied to dual capacity 
taxpayers--(1) In general. If the application of a foreign levy (as 
defined in Sec.  1.901-2(g)(3)) is different, either by the terms of the 
levy or in practice, for dual capacity taxpayers (as defined in Sec.  
1.901-2(a)(2)(ii)(A)) from its application to other persons, then, 
unless the only such difference is that a lower rate (but the same base) 
applies to dual capacity taxpayers, such difference is considered to be 
related to the fact that dual capacity taxpayers receive, directly or 
indirectly, a specific economic benefit (as defined in Sec.  1.901-
2(a)(2)(ii)(B)) from the foreign country and thus to be a difference in 
kind, and not merely of degree. In such a case, notwithstanding any 
contrary provision of Sec.  1.901-2(d), the levy as applicable to such 
dual capacity taxpayers is a separate levy (within the meaning of Sec.  
1.901-2(d)) from the levy as applicable to such other persons, 
regardless of whether such difference is in the base of the levy, in the 
rate of the levy, or both. In such a case, each of the levy as applied 
to dual capacity taxpayers and the levy as applied to other persons must 
be analyzed separately to determine whether it is an income tax within 
the meaning of Sec.  1.901-2(a)(1) and whether it is a tax in lieu of an 
income tax within the meaning of Sec.  1.903-1(a). However, if the 
application of the levy is neither different by its terms nor different 
in practice for dual capacity taxpayers from its application to other 
persons, or if the only difference is that a lower rate (but the same 
base) applies to dual capacity taxpayers, then, in accordance with Sec.  
1.901-2(d), such foreign levy as applicable to dual capacity taxpayers 
and such levy as applicable to other persons together constitute a 
single levy. In such a case, no amount paid (as defined in Sec.  1.901-
2(g)(1)) pursuant to such levy by any such dual capacity taxpayer is 
considered to be paid in exchange for a specific economic benefit, and 
such levy, as applicable in the aggregate to such dual capacity 
taxpayers and to such other persons, is analyzed to determine whether it 
is an income tax within the meaning of Sec.  1.901-2(a)(1) or a tax in 
lieu of an income tax within the meaning of Sec.  1.903-1(a). 
Application of a foreign levy to dual capacity taxpayers will be 
considered to be different in practice from application of that levy to 
other persons, even if no such difference is apparent from the terms of 
the levy, unless it is established that application of that levy to dual 
capacity taxpayers does not differ in practice from its application to 
other persons.
    (2) Examples. The provisions of paragraph (a)(1) of this section may 
be illustrated by the following examples:

    Example 1. Under a levy of country X called the country X income 
tax, every corporation that does business in country X is required to 
pay to country X 40 percent of its income from its business in country 
X. Income for purposes of the country X income tax is computed by 
subtracting specified deductions from the corporation's gross income 
derived from its business in country X. The specified deductions include 
the corporation's expenses attributable to such gross income and 
allowances for recovery of the cost of capital expenditures attributable 
to such gross income, except that under the terms of the country X 
income tax a corporation engaged in the exploitation of minerals K, L or 
M in

[[Page 686]]

country X is not permitted to recover, currently or in the future, 
expenditures it incurs in exploring for those minerals. In practice, the 
only corporations that engage in exploitation of the specified minerals 
in country X are dual capacity taxpayers. Thus, the application of the 
country X income tax to dual capacity taxpayers is different from its 
application to other corporations. The country X income tax as applied 
to corporations that engage in the exploitation of minerals K, L or M 
(dual capacity taxpayers) is, therefore, a separate levy from the 
country X income tax as applied to other corporations. Accordingly, each 
of (i) the country X income tax as applied to such dual capacity 
taxpayers and (ii) the country X income tax as applied to such other 
persons, must be analyzed separately to determine whether it is an 
income tax within the meaning of Sec.  1.901-2(a)(1) and whether it is a 
tax in lieu of an income tax within the meaning of Sec.  1.903-1(a).
    Example 2. The facts are the same as in example 1, except that it is 
demonstrated that corporations that engage in exploitation of the 
specified minerals in country X and that are subject to the levy include 
both dual capacity taxpayers and other persons. The country X income tax 
as applied to all corporations is, therefore, a single levy. 
Accordingly, no amount paid pursuant to the country X income tax by a 
dual capacity taxpayer is considered to be paid in exchange for a 
specific economic benefit; and, if the country X income tax is an income 
tax within the meaning of Sec.  1.901-2(a)(1) or a tax in lieu of an 
income tax within the meaning of Sec.  1.903-1(a), it will be so 
considered in its entirety for all corporations subject to it.
    Example 3. Under a levy of country Y called the country Y income 
tax, each corporation incorporated in country Y is required to pay to 
country Y a percentage of its worldwide income. The applicable 
percentage is greater for such corporations that earn more than a 
specified amount of income than for such corporations that earn less 
than that amount. Income for purposes of the levy is computed by 
deducting from gross income specified types of expenses and specified 
allowances for capital expenditures. The expenses for which deductions 
are permitted differ depending on the type of business in which the 
corporation subject to the levy is engaged, e.g., a deduction for 
interest paid to a related party is not allowed for corporations engaged 
in enumerated types of activities. In addition, carryover of losses from 
one taxable period to another is permitted for corporations engaged in 
specified types of activities, but not for corporations engaged in other 
activities. By its terms, the foreign levy makes no distinction between 
dual capacity taxpayers and other persons. It is established that in 
practice the higher rate of the country Y income tax applies to both 
dual capacity taxpayers and other persons and that in practice the 
differences in the base of the country Y income tax (e.g., the lack of a 
deduction for interest paid to related parties for some corporations 
subject to the levy and the lack of a carryover provision for some 
corporations subject to the levy) apply to both dual capacity taxpayers 
and other persons. The country Y income tax as applied to all 
corporations incorporated in country Y is therefore a single levy. 
Accordingly, no amount paid pursuant to the country Y income tax by a 
dual capacity taxpayer is considered to be paid in exchange for a 
specific economic benefit; and if the country Y income tax is an income 
tax within the meaning of Sec.  1.901-2(a)(1) or a tax in lieu of an 
income tax within the meaning of Sec.  1.903-1(a), it will be so 
considered in its entirety for all persons subject to it.
    Example 4. The facts are the same as in example 3, except that it is 
not established that in practice the higher rate does not apply only to 
dual capacity taxpayers. By reason of such higher rate, application of 
the country Y income tax to dual capacity taxpayers is different in 
practice from application of the country Y income tax to other persons 
subject to it. The country Y income tax as applied to dual capacity 
taxpayers is therefore a separate levy from the country Y income tax as 
applied to other corporations incorporated in country Y. Accordingly, 
each of (i) the country Y income tax as applied to dual capacity 
taxpayers and (ii) the country Y income tax as applied to other 
corporations incorporated in country Y, must be analyzed separately to 
determine whether it is an income tax within the meaning of Sec.  1.901-
2(a)(1) and whether it is a tax in lieu of an income tax within the 
meaning of Sec.  1.903-1(a).
    Example 5. Under a levy of country X called the country X tax, all 
persons who do not engage in business in country X and who receive 
interest income from residents of country X are required to pay to 
country X 25 percent of the gross amount of such interest income. It is 
established that the country X tax applies by its terms and in practice 
to certain banks that are dual capacity taxpayers and to persons who are 
not dual capacity taxpayers and that application to such dual capacity 
taxpayers does not differ by its terms or in practice from application 
to such other persons. The country X tax as applied to all such persons 
(both the dual capacity taxpayers and the other persons) is, therefore, 
a single levy. Accordingly, no amount paid pursuant to the country X tax 
by such a dual capacity taxpayer is considered to be paid in exchange 
for a specific economic benefit; and, if the country X tax is a tax in 
lieu of an income tax within the meaning of Sec.  1.903-1(a), it will be 
so considered in its entirety for all persons subject to it.

[[Page 687]]

    Example 6. Under a levy of country X called the country X tax, every 
corporation incorporated outside of country X (``foreign corporation'') 
that maintains a branch in country X is required annually to pay to 
country X 52 percent of its net income attributable to that branch. It 
is established that the application of the country X tax is neither 
different by its terms nor different in practice for certain banks that 
are dual capacity taxpayers from its application to persons (which may, 
but do not necessarily, include other banks) that are not dual capacity 
taxpayers. The country X tax as applied to all foreign corporations with 
branches in country X (i.e., both those banks that are dual capacity 
taxpayers and the foreign corporations that are not dual capacity 
taxpayers) is, therefore, a single levy. Accordingly, no amount paid 
pursuant to the country X tax by a bank that is a dual capacity taxpayer 
is considered to be paid in exchange for a specific economic benefit; 
and, if the country X tax is an income tax within the meaning of Sec.  
1.901-2(a)(1) or a tax in lieu of an income tax within the meaning of 
Sec.  1.903-1(a), it will be so considered in its entirety for all 
persons subject to it.
    Example 7. Under a levy of country H called the country H tax, all 
corporations that are organized outside country H and that do not engage 
in business in country H are required to pay to country H a percentage 
of the gross amount of interest income derived from residents of country 
H. The percentage is 30 percent, except that it is 15 percent for a 
specified category of corporations. All corporations in that category 
are dual capacity taxpayers. It is established that the country H tax 
applies by its terms and in practice to dual capacity taxpayers and to 
persons that are not dual capacity taxpayers and that the only 
difference in application between such dual capacity taxpayers and such 
other persons is that a lower rate (but the same base) applies to such 
dual capacity taxpayers. The country H tax as applied to all such 
persons (both the dual capacity taxpayers and the other persons) is, 
therefore, a single levy. Accordingly, no amount paid pursuant to the 
country H tax by such a dual capacity taxpayer is considered to be paid 
in exchange for a specific economic benefit, and if the country H tax is 
a tax in lieu of an income tax within the meaning of Sec.  1.903-1(a), 
it will be so considered in its entirety for all persons subject to it.

    (b) Burden of proof for dual capacity taxpayers--(1) In general. For 
credit to be allowable under section 901 or 903, the person claiming 
credit must establish that the foreign levy with respect to which credit 
is claimed is an income tax within the meaning of Sec.  1.901-2(a)(1) or 
a tax in lieu of an income tax within the meaning of Sec.  1.903-1(a), 
respectively. Thus, such person must establish, among other things, that 
such levy is a tax. See Sec.  1.901-2(a)(2)(i) and Sec.  1.903-1(a). 
Where a person claims credit under section 901 or 903 for an amount paid 
by a dual capacity taxpayer pursuant to a foreign levy, Sec.  1.901-
2(a)(2)(i) and Sec.  1.903-1(a), respectively, require such person to 
establish the amount, if any, that is paid pursuant to the distinct 
element of the levy that is a tax. If, pursuant to paragraph (a)(1) of 
this section and Sec.  1.901-2(d), such levy as applicable to dual 
capacity taxpayers and such levy as applicable to other persons together 
constitute a single levy, then no amount paid pursuant to that levy by 
any such dual capacity taxpayer is considered to be paid in exchange for 
a specific economic benefit. Accordingly, such levy has only one 
distinct element, and the levy either is or is not, in its entirety, a 
tax. If, however, such levy as applicable to dual capacity taxpayers is 
a separate levy from such levy as applicable to other persons, then a 
person claiming credit under section 901 or 903 for an amount paid by a 
dual capacity taxpayer pursuant to such separate levy may establish the 
amount, if any, that is paid pursuant to the distinct element of the 
levy that is a tax only by the facts and circumstances method or the 
safe harbor method described in paragraph (c) of this section. If such 
person fails to so establish such amount, no portion of the amount that 
is paid pursuant to the separate levy by the dual capacity taxpayer to 
such foreign country shall be treated as an amount of tax. Any amount 
that, either by reason of application of the methods of paragraph (c) of 
this section or by reason of the immediately preceding sentence, is not 
treated as an amount of tax shall (i) be considered to have been paid in 
exchange for a specific economic benefit; (ii) be characterized (e.g., 
as royalty, purchase price, cost of sales, reduction of the proceeds of 
a sale, or reduction of interest income) according to the nature of the 
transaction and of the specific economic benefit received; and (iii) be 
treated according to such characterization for all purposes of chapter 1 
of the Internal Revenue Code, except that any

[[Page 688]]

determination that an amount is not tax for purposes of section 901 or 
903 by reason of application of the safe harbor method shall not be 
taken into account in determining whether or not such an amount is to be 
characterized and treated as tax for purposes of computing an allowance 
for percentage depletion under sections 611 and 613.
    (2) Effect of certain treaties. If, irrespective of whether such 
credit would be allowable under section 901 or 903 in the absence of a 
treaty, the United States has in force a treaty with a foreign country 
that treats a foreign levy as an income tax for purposes of allowing 
credit for United States tax and if the person claiming credit is 
entitled to the benefit of such treaty, then, unless such person claims 
credit not under the treaty but under section 901 or 903, and except to 
the extent the treaty provides otherwise and subject to all terms, 
conditions and limitations provided in the treaty, no portion of an 
amount paid with respect to such levy by a dual capacity taxpayer shall 
be considered to be paid in exchange for a specific economic benefit. 
If, however, such person claims credit not under such treaty but rather 
under section 901 or 903 (e.g., so as not to be subject to a limitation 
contained in such treaty), the provisions of this section apply to such 
levy.
    (c) Satisfaction of burden of proof--(1) In general. This paragraph 
(c) sets out the methods by which a person who claims credit under 
section 901 or 903 for an amount paid by a dual capacity taxpayer 
pursuant to a foreign levy that satisfies all of the criteria of section 
901 or 903 other than the determination of the distinct element of the 
levy that is a tax and of the amount that is paid pursuant to that 
distinct element (a ``qualifying levy'') may establish such distinct 
element and amount. Such person must establish the amount paid pursuant 
to a qualifying levy that is paid pursuant to the distinct element of 
the levy that is a tax (which amount therefore is an amount of income 
tax within the meaning of Sec.  1.901-2(a)(1) or an amount of tax in 
lieu of income tax within the meaning of Sec.  1.903-1(a) (a 
``qualifying amount'')) only by the facts and circumstances method set 
forth in paragraph (c)(2) of this section or the safe harbor method set 
forth in paragraph (c)(3) of this section. A levy is not a qualifying 
levy, and neither the facts and circumstances method nor the safe harbor 
method applies to an amount paid by a dual capacity taxpayer pursuant to 
a foreign levy, if it has been established pursuant to Sec.  1.901-2(d) 
and paragraph (a)(1) of this section that that levy as applied to that 
dual capacity taxpayer and that levy as applied to persons other than 
dual capacity taxpayers together constitute a single levy, or if it has 
been established in accordance with the first sentence of paragraph 
(b)(2) of this section that credit is allowable by reason of a treaty 
for an amount paid with respect to such levy.
    (2) Facts and circumstances method--(i) In general. If the person 
claiming credit establishes, based on all of the relevant facts and 
circumstances, the amount, if any, paid by the dual capacity taxpayer 
pursuant to the qualifying levy that is not paid in exchange for a 
specific economic benefit, such amount is the qualifying amount with 
respect to such qualifying levy. In determining the qualifying amount 
with respect to a qualifying levy under the facts and circumstances 
method, neither the methodology nor the results that would have obtained 
if a person had elected to apply the safe harbor method to such 
qualifying levy is a relevant fact or circumstance. Accordingly, neither 
such methodology nor such results shall be taken into account in 
applying the facts and circumstances method.
    (ii) Examples. The application of the facts and circumstances method 
is illustrated by the following examples:

    Example 1. Country A, which does not have a generally imposed income 
tax, imposes a levy, called the country A income tax, on corporations 
that carry on the banking business through a branch in country A. All 
such corporations lend money to the government of country A, and the 
consideration (interest) paid by the government of country A for the 
loans is not made available by the government on substantially the same 
terms to the population of country A in general. Thus, the country A 
income tax is imposed only on dual capacity taxpayers. L, a corporation 
that carries on the banking business through a branch in country A and 
that is a dual capacity taxpayer, establishes that all of the criteria 
of section 901 are satisfied

[[Page 689]]

by the country A income tax, except for the determination of the 
distinct element of the levy that is a tax and of L's qualifying amount 
with respect thereto. The country A income tax is, therefore, a 
qualifying levy. L establishes that, although all persons subject to the 
country A income tax are dual capacity taxpayers, the country A income 
tax applies in the same manner to income from such persons' transactions 
with the government of country A as it does to income from their 
transactions with private persons; that there are significant 
transactions (either in volume or in amount) with private persons; and 
that the portion of such persons' income that is derived from 
transactions with the government of country A on the one hand or private 
persons on the other varies greatly among persons subject to the country 
A income tax. By making this showing, L has demonstrated that no portion 
of the amount paid by it to country A pursuant to the levy is paid in 
exchange for a specific economic benefit (the interest income). 
Accordingly, L has demonstrated under the facts and circumstances method 
that the entire amount it has paid pursuant to the country A income tax 
is a qualifying amount.
    Example 2. A, a domestic corporation that is a dual capacity 
taxpayer subject to a qualifying levy of country X, pays 1000u (units of 
country X currency) to country X in 1986 pursuant to the qualifying 
levy. A does not elect to apply the safe harbor method to country X, but 
if it had so elected, 800u would have been A's qualifying amount with 
respect to the levy. Based on all of the relevant facts and 
circumstances (which do not include either the methodology of the safe 
harbor method or the qualifying amount that would have obtained under 
that method), A establishes that 628u of such 1000u is not paid in 
exchange for a specific economic benefit. A has demonstrated under the 
facts and circumstances method that 628u is a qualifying amount. 
Pursuant to paragraph (b)(1) of this section, 372u (1000u-628u) is 
considered to have been paid by A in exchange for a specific economic 
benefit. That amount is characterized and treated as provided in 
paragraph (b)(1) of this section.
    Example 3. The facts are the same as in example 2 except that under 
the safe harbor method 580u would have been A's qualifying amount with 
respect to the levy. That amount is not a relevant fact or circumstance 
and the result is the same as in example 2.

    (3) Safe harbor method. Under the safe harbor method, the person 
claiming credit makes an election as provided in paragraph (d) of this 
section and, pursuant to such election, applies the safe harbor formula 
described in paragraph (e) of this section to the qualifying levy or 
levies to which the election applies.
    (d) Election to use the safe harbor method--(1) Scope of election. 
An election to use the safe harbor method is made with respect to one or 
more foreign states and possessions of the United States with respect to 
a taxable year of the person making the election (the ``electing 
person''). Such election applies to such taxable year and to all 
subsequent taxable years of the electing person (``election years''), 
unless the election is revoked in accordance with paragraph (d)(4) of 
this section. If an election applies to a foreign state or possession of 
the United States (``elected country''), it applies to all qualifying 
levies of the elected country and to all qualifying levies of all 
political subdivisions of the elected country with respect to which the 
electing person claims credit for amounts paid (or deemed to be paid) by 
any dual capacity taxpayer. A member of an affiliated group that files a 
consolidated United States income tax return may use the safe harbor 
method for a foreign state or U.S. possession only if an election to use 
the safe harbor method for that state or possession has been made by the 
common parent of such affiliated group on behalf of all members of the 
group. Similarly, a member of an affiliated group that does not file a 
consolidated United States income tax return may elect to use the safe 
harbor method for a foreign state or U.S. possession only if an election 
to use the safe harbor method for that state or possession is made by 
each member of the affiliated group which claims credit for taxes paid 
to such state or possession or to any political subdivision thereof. An 
election to use the safe harbor method for an elected country does not 
apply to foreign taxes carried back or forward to any election year from 
any taxable year to which the election does not apply. Such election 
does apply to foreign taxes carried back or forward from any election 
year to any taxable year. A person who elects to use the safe harbor 
method for one or more foreign countries may, in a later taxable year, 
also elect to use that method for other foreign countries.
    (2) Effect of election. An election to use the safe harbor method 
described in

[[Page 690]]

paragraph (c)(3) of this section requires the electing person to apply 
the safe harbor formula of paragraph (e) of this section to all 
qualifying levies of all elected countries and their political 
subdivisions, and constitutes a specific waiver by such person of the 
right to use the facts and circumstances method described in paragraph 
(c)(2) of this section with respect to any levy of any elected country 
or any political subdivision thereof.
    (3) Time and manner of making election--(i) In general. To elect to 
use the safe harbor method, an electing person must attach a statement 
to its United States income tax return for the taxable year for which 
the election is made and must file such return by the due date 
(including extensions) for the filing thereof. Such statement shall 
state--
    (A) That the electing person elects to use the safe harbor method 
for the foreign states and the possessions of the United States 
designated in the statement and their political subdivisions, and
    (B) That the electing person waives the right, for any election 
year, to use the facts and circumstances method for any levy of the 
designated states, possessions and political subdivisions. 
Notwithstanding the foregoing, a person may, with the consent of the 
Commissioner, elect to use the safe harbor method for a taxable year for 
one or more foreign states or possessions of the United States, at a 
date later than that specified in the first sentence of this paragraph 
(d)(3)(i), e.g., upon audit of such person's United States income tax 
return for such taxable year. The Commissioner will normally consent to 
such a later election if such person demonstrates that it failed to make 
a timely election for such a foreign state or possession for such 
taxable year because such person reasonably believed either that it was 
not a dual capacity taxpayer with respect to such state or possession or 
that no levy that it paid to such state or possession or any political 
subdivision thereof was a qualifying levy (for example, because it 
reasonably, but incorrectly, believed that the levy it paid was not a 
separate levy from that applicable to persons other than dual capacity 
taxpayers). The Commissioner will not, however, consent to such a later 
election with respect to any state or possession for a taxable year if 
such person (or any other member of an affiliated group of which such 
person is a member) applied the facts and circumstances method to any 
levy of such state or possession or any political subdivision thereof 
for such taxable year.
    (ii) Certain retroactive elections. Notwithstanding the requirements 
of paragraph (d)(3)(i) of this section relating to the time and manner 
of making an election, an election may be made for a taxable year 
beginning on or before November 14, 1983, provided the electing person 
elects in accordance with Sec.  1.901-2(h) to apply all of the 
provisions of this section, Sec.  1.901-2 and Sec.  1.903-1 to such 
taxable year and provided all of the requirements set forth in this 
paragraph (d)(3)(ii) are satisfied. Such an election shall be made by 
timely (including extensions) filing a federal income tax return or an 
amended federal income tax return for such taxable year; by attaching to 
such return a statement containing the statements and information set 
forth in paragraph (d)(3)(i) of this section; and by filing amended 
income tax returns for all subsequent election years for which income 
tax returns have previously been filed in which credit is claimed under 
section 901 or 903 and applying the safe harbor method in such amended 
returns. All amended returns referred to in the immediately preceding 
sentence must be filed on or before October 12, 1984, (unless the 
Commissioner consents to a later filing in circumstances similar to 
those provided in paragraph (d)(3)(i)) and at a time when neither 
assessment of a deficiency for any of such election years nor the filing 
of a claim for any refund claimed in any such amended return is barred.
    (iii) Election to credit taxes made in amended return. If a person 
has filed a United States income tax return for a taxable year to which 
this Sec.  1.901-2A applies (including application by reason of the 
election provided in Sec.  1.901-2(h)(2)) in which such person has 
deducted (instead of credited) qualifying foreign taxes and such person 
validly makes an election to credit (instead of

[[Page 691]]

deduct) such taxes in a timely filed amended return for such taxable 
year, an election to use the safe harbor method may be made in such 
amended return provided all of the requirements of paragraph (d)(3)(ii) 
of this section are satisfied other than the requirement that such 
amended return and the other amended returns referred to in that 
paragraph be filed on or before October 12, 1984.
    (4) Revocation of election. An election to use the safe harbor 
method described in paragraph (c)(3) of this section may not be revoked 
without the consent of the Commissioner. An application for consent to 
revoke such election with respect to one or more elected countries shall 
be made to the Commissioner of Internal Revenue, Washington, DC 20224. 
Such application shall be made not later than the 30th day before the 
due date (including extensions) for the filing of the income tax return 
for the first taxable year for which the revocation is sought to be 
effective, except in the case of an event described in (i), (ii), (iii) 
or (iv) below, in which case an application for revocation with 
retroactive effect may be made within a reasonable time after such 
event. The Commissioner may make his consent to any revocation 
conditioned upon adjustments being made in one or more taxable years so 
as to prevent the revocation from resulting in a distortion of the 
amount of any item relating to tax liability in any taxable year. The 
Commissioner will normally consent to a revocation (including, in the 
case of (i), (ii), (iii) or (iv) below, one with retroactive effect), 
if--
    (i) An amendment to the Internal Revenue Code or the regulations 
thereunder is made which applies to the taxable year for which the 
revocation is to be effective and the amendment substantially affects 
the taxation of income from sources outside the United States under 
subchapter N of chapter 1 of the Internal Revenue Code; or
    (ii) After a safe harbor election is made with respect to a foreign 
state, a tax treaty between the United States and that state enters into 
force; that treaty covers a foreign tax to which the safe harbor 
election applies; and that treaty applies to the taxable year for which 
the revocation is to be effective; or
    (iii) After a safe harbor election is made with respect to a foreign 
state or possession of the United States, a material change is made in 
the tax law of that state or possession or of a political subdivision of 
that state or possession; and the changed law applies to the taxable 
year for which the revocation is to be effective and has a material 
effect on the taxpayer; or
    (iv) With respect to a foreign country to which a safe harbor 
election applies, the Internal Revenue Service issues a letter ruling to 
the electing person and that letter ruling (A) relates to the 
availability or application of the safe harbor method to one or more 
levies of such foreign country; (B) does not relate to the facts and 
circumstances method described in paragraph (c)(2) of this section; and 
(C) fails to include a ruling requested by the electing person or 
includes a ruling contrary to one requested by such person (in either 
case, other than one relating to the facts and circumstances method) and 
such failure or inclusion has a material adverse effect on the amount of 
such electing person's credit for taxes paid to such foreign country for 
the taxable year for which the revocation is to be effective; or
    (v) A corporation (``new member'') becomes a member of an affiliated 
group; the new member and one or more pre-existing members of such group 
are dual capacity taxpayers with respect to the same foreign country; 
and, with respect to such country, either the new member or the pre-
existing members (but not both) have made a safe harbor election; and 
the Commissioner in his discretion determines that obtaining the benefit 
of the right to revoke the safe harbor election with respect to such 
foreign country was not the principal purpose of the affiliation between 
such new member and such group; or
    (vi) The election has been in effect with respect to at least three 
taxable years prior to the taxable year for which the revocation is to 
be effective.


The Commissioner may, in his discretion, consent to a revocation even if 
none of the foregoing subdivisions (i)

[[Page 692]]

through (vi) is applicable. If an election has been revoked with respect 
to an elected country, a subsequent election to apply the safe harbor 
method with respect to such elected country may be made only with the 
consent of the Commissioner and upon such terms and conditions as the 
Commissioner in his discretion may require.
    (e) Safe harbor formula--(1) In general. The safe harbor formula 
applies to determine the distinct element of a qualifying levy that is a 
tax and the amount paid by a dual capacity taxpayer pursuant to such 
qualifying levy that is the qualifying amount with respect to such levy. 
Under the safe harbor formula the amount paid in a taxable year pursuant 
to a qualifying levy that is the qualifying amount with respect to such 
levy is an amount equal to:

(A - B - C) x D / (1 - D)

where (except as otherwise provided in paragraph (e)(5) of this 
section):
A = the amount of gross receipts as determined under paragraph (e)(2) of 
          this section
B = the amount of costs and expenses as determined under paragraph 
          (e)(2) of this section
C = the total amount paid in the taxable year by the dual capacity 
          taxpayer pursuant to the qualifying levy (the ``actual payment 
          amount'')
D = the tax rate as determined under paragraph (e)(3) of this section


In no case, however, shall the qualifying amount exceed the actual 
payment amount; and the qualifying amount is zero if the safe harbor 
formula yields a qualifying amount less than zero. The safe harbor 
formula is intended to yield a qualifying amount that is approximately 
equal to the amount of generally imposed income tax within the meaning 
of paragraphs (a) and (b)(1) of Sec.  1.903-1 (``general tax'') of the 
foreign country that would have been required to be paid in the taxable 
year by the dual capacity taxpayer if it had not been a dual capacity 
taxpayer and if the base of the general tax had allowed a deduction in 
such year for the amount (``specific economic benefit amount'') by which 
the actual payment amount exceeds the qualifying amount. See, however, 
paragraph (e)(5) of this section if an elected country has no general 
tax. The specific economic benefit amount is considered to be the 
portion of the actual payment amount that is paid pursuant to the 
distinct portion of the qualifying levy that imposes an obligation in 
exchange for a specific economic benefit. The specific economic benefit 
amount is therefore considered to be an amount paid by the dual capacity 
taxpayer in exchange for such specific economic benefit, which amount 
must be treated for purposes of chapter 1 of the Internal Revenue Code 
as provided in paragraph (b)(1) of this section.
    (2) Determination of gross receipts and costs and expenses. For 
purposes of the safe harbor formula, gross receipts and costs and 
expenses are, except as otherwise provided in this paragraph (e), the 
gross receipts and the deductions for costs and expenses, respectively, 
as determined under the foreign law applicable in computing the actual 
payment amount of the qualifying levy to which the safe harbor formula 
applies. However, except as otherwise provided in this paragraph (e), if 
provisions of the qualifying levy increase or decrease the liability 
imposed on dual capacity taxpayers compared to the general tax liability 
of persons other than dual capacity taxpayers by reason of the 
determination or treatment of gross receipts or of costs or expenses, 
the provisions generally applicable in computing such other persons' tax 
base under the general tax shall apply to determine gross receipts and 
costs and expenses for purposes of computing the qualifying amount. If 
provisions of the qualifying levy relating to gross receipts meet the 
requirements of Sec.  1.901-2(b) (3)(i), such provisions shall apply to 
determine gross receipts for purposes of computing the qualifying 
amount. If neither the general tax nor the qualifying levy permits 
recovery of one or more costs or expenses, and by reason of the failure 
to permit such recovery the qualifying levy does not satisfy the net 
income requirement of Sec.  1.901-2(b)(4) (even though the general tax 
does satisfy that requirement), then such cost or expense shall be 
considered a cost or expense for purposes of computing the qualifying 
amount. If the qualifying levy does not permit recovery of one or more 
significant costs

[[Page 693]]

or expenses, but provides allowances that effectively compensate for 
nonrecovery of such significant costs or expenses, then, for purposes of 
computing the qualifying amount, costs and expenses shall not include 
the costs and expenses under the general tax whose nonrecovery under the 
qualifying levy is compensated for by such allowances but shall instead 
include such allowances. In determining costs and expenses for purposes 
of computing the qualifying amount with respect to a qualifying levy, 
the actual payment amount with respect to such levy shall not be 
considered a cost or expense. For purposes of this paragraph, the 
following differences in gross receipts and costs and expenses between 
the qualifying levy and the general tax shall not be considered to 
increase the liability imposed on dual capacity taxpayers compared to 
the general tax liability of persons other than dual capacity taxpayers, 
but only if the general tax would be an income tax within the meaning of 
Sec.  1.901-2(a)(1) if such different treatment under the qualifying 
levy had also applied under the general tax:
    (i) Differences in the time of realization or recognition of one or 
more items of income or in the time when recovery of one or more costs 
and expenses is allowed (unless the period of recovery of such costs and 
expenses pursuant to the qualifying levy is such that it effectively is 
a denial of recovery of such costs and expenses, as described in Sec.  
1.901-2(b)(4)(i)); and
    (ii) Differences in consolidation or carryover provisions of the 
types described in paragraphs (b)(4)(ii) and (b)(4)(iii) of Sec.  1.901-
2.
    (3) Determination of tax rate. The tax rate for purposes of the safe 
harbor formula is the tax rate (expressed as a decimal) that is 
applicable in computing tax liability under the general tax. If the rate 
of the general tax varies according to the amount of the base of that 
tax, the rate to be applied in computing the qualifying amount is the 
rate that applies under the general tax to a person whose base is, using 
the terminology of paragraph (e)(1) of this section, ``A'' minus ``B'' 
minus the specific economic benefit amount paid by the dual capacity 
taxpayer pursuant to the qualifying levy, provided such rate applies in 
practice to persons other than dual capacity taxpayers, or, if such rate 
does not so apply in practice, the next lowest rate of the general tax 
that does so apply in practice.
    (4) Determination of applicable provisions of general tax--(i) In 
general. If the general tax is a series of income taxes (e.g., on 
different types of income), or if the application of the general tax 
differs by its terms for different classes of persons subject to the 
general tax (e.g., for persons in different industries), then, except as 
otherwise provided in this paragraph (e), the qualifying amount small be 
computed by reference to the income tax contained in such series of 
income taxes, or in the case of such different applications the 
application of the general tax, that by its terms and in practice 
imposes the highest tax burden on persons other than dual capacity 
taxpayers. Notwithstanding the preceding sentence, the general tax 
amount shall be computed by reference to the application of the general 
tax to entities of the same type (as determined under the general tax) 
as the dual capacity taxpayer and to persons of the same resident or 
nonresident status (as determined under the general tax) as the dual 
capacity taxpayer; and, if the general tax treats business income 
differently from non-business (e.g., investment) income (as determined 
under the general tax), the dual capacity taxpayer's business and non-
business income shall be treated as the general tax treats such income. 
If, for example, the dual capacity taxpayer would, under the general 
tax, be treated as a resident (e.g., because the general tax treats an 
entity that is organized in the foreign country or managed or controlled 
there as a resident) and as a corporation (i.e., because the rules of 
the general tax treat an entity like the dual capacity taxpayer as a 
corporation), and if some of the dual capacity taxpayer's income would, 
under the general tax, be treated as business income and some as non-
business income, the dual capacity taxpayer and its income shall be so 
treated in computing the qualifying amount.
    (ii) Establishing that provisions apply in practice. For purposes of 
the safe

[[Page 694]]

harbor formula a provision (including tax rate) shall be considered a 
provision of the general tax only if it is reasonably likely that that 
provision applies by its terms and in practice to persons other than 
dual capacity taxpayers. In general, it will be assumed that a provision 
(including tax rate) that by its terms applies to persons other than 
dual capacity taxpayers is reasonably likely to apply in practice to 
such other persons, unless the person claiming credit knows or has 
reason to know otherwise. However, in cases of doubt, the person 
claiming credit may be required to demonstrate that such provision is 
reasonably likely so to apply in practice.
    (5) No general tax. If a foreign country does not impose a general 
tax (and thus a levy, in order to be a qualifying levy must satisfy all 
of the criteria of section 901 (because section 903 cannot apply), other 
than the determination of the distinct element of the levy that is a tax 
and of the amount that is paid pursuant to that distinct element), 
paragraphs (e)(2), (3) and (4) of this section do not apply to a 
qualifying levy of such country, and the terms of the safe harbor 
formula set forth in paragraph (e)(1) of this section are defined with 
respect to such levy as follows:

A = the amount of gross receipts as determined under the qualifying 
          levy;
B = the amount of deductions for costs and expenses as determined under 
          the qualifying levy;
C = the actual payment amount; and
D = the lower of the rate of the qualifying levy, or the rate of tax 
          specified in section 11(b)(5) (or predecessor or successor 
          section, as the case may be) of the Internal Revenue Code as 
          applicable to the taxable year in which the actual payment 
          amount is paid.

    (6) Certain taxes in lieu of an income tax. To the extent a tax in 
lieu of an income tax (within the meaning of Sec.  1.903-1(a)) that 
applies in practice to persons other than dual capacity taxpayers would 
actually have been required to be paid in the taxable year by a dual 
capacity taxpayer if it had not been a dual capacity taxpayer (e.g., in 
substitution for the general tax with respect to a type of income, such 
as interest income, dividend income, royalty income, insurance income), 
such tax in lieu of an income tax shall be treated as if it were an 
application of the general tax for purposes of applying the safe harbor 
formula of this paragraph (e) to such dual capacity taxpayer, and such 
formula shall be applied to yield a qualifying amount that is 
approximately equal to the general tax (so defined) that would have been 
required to be paid in the taxable year by such dual capacity taxpayer 
if the base of such general tax had allowed a deduction in such year for 
the specific economic benefit amount.
    (7) Multiple levies. If, in any election year of an electing person, 
with respect to any elected country and all of its political 
subdivisions,
    (i) Amounts are paid by a dual capacity taxpayer pursuant to more 
than one qualifying levy or pursuant to one or more levies that are 
qualifying levies and one or more levies that are not qualifying levies 
by reason of the last sentence of paragraph (c)(1) of this section but 
with respect to which credit is allowable, or
    (ii) More than one general tax (including a tax treated as if it 
were an application of the general tax under paragraph (e)(6)) would 
have been required to be paid by a dual capacity taxpayer (or taxpayers) 
if it (or they) had not been a dual capacity taxpayer (or taxpayers), or
    (iii) Credit is claimed with respect to amounts paid by more than 
one dual capacity taxpayer,the provisions of this paragraph (e) shall be 
applied such that the aggregate qualifying amount with respect to such 
qualifying levy or levies plus the aggregate amount paid with respect to 
levies referred to in (e)(7)(i) that are not qualifying levies shall be 
the aggregate amount that would have been required to be paid in the 
taxable year by such dual capacity taxpayer (or taxpayers) pursuant to 
such general tax or taxes if it (or they) had not been a dual capacity 
taxpayer (or taxpayers) and if the base of such general tax or taxes had 
allowed a deduction in such year for the aggregate specific economic 
benefit amount (except that, if paragraph (e)(5) applies to any levy of 
such elected country or any political subdivision thereof, the aggregate 
qualifying amount for qualifying levies of such elected country and all 
of

[[Page 695]]

its political subdivisions plus the aggregate amount paid with respect 
to levies referred to in paragraph (e)(7)(i) that are not qualifying 
levies shall not exceed the greater of the aggregate amount paid with 
respect to levies referred to in paragraph (e)(7)(i) that are not 
qualifying levies and the amount determined in accordance with paragraph 
(e)(5) where ``D'' is the rate of tax specified in section 11(b)(5) (or 
predecessor or successor section, as the case may be) of the Internal 
Revenue Code as applicable to the taxable year in which the actual 
payment amount is paid). However, in no event shall such aggregate 
amount exceed the aggregate actual payment amount plus the aggregate 
amount paid with respect to levies referred to in (e)(7)(i) that are not 
qualifying levies, nor be less than the aggregate amount paid with 
respect to levies referred to in (e)(7)(i) that are not qualifying 
levies. In applying (e)(7)(ii) a person who is not subject to a levy but 
who is considered to receive a specific economic benefit by reason of 
Sec.  1.901-2(a)(2)(ii)(E) shall be treated as a dual capacity taxpayer. 
See example 12 in paragraph (e)(8) of this section.
    (8) Examples. The provisions of this paragraph (e) may be 
illustrated by the following examples:

    Example 1. Under a levy of country X called the country X income 
tax, every corporation that does business in country X is required to 
pay to country X 40% of its income from its business in country X. 
Income for purposes of the country X income tax is computed by 
subtracting specified deductions from the corporation's gross income 
derived from its business in country X. The specified deductions include 
the corporation's expenses attributable to such gross income and 
allowances for recovery of the cost of capital expenditures attributable 
to such gross income, except that under the terms of the country X 
income tax a corporation engaged in the exploitation of minerals K, L or 
M in country X is not permitted to recover, currently or in the future, 
expenditures it incurs in exploring for those minerals. Under the terms 
of the country X income tax interest is not deductible to the extent it 
exceeds an arm's length amount (e.g., if the loan to which the interest 
relates is not in accordance with normal commercial practice or to the 
extent the interest rate exceeds an arm's length rate). In practice, the 
only corporations that engage in exploitation of the specified minerals 
in country X are dual capacity taxpayers. Because no other persons 
subject to the levy engage in exploitation of minerals K, L or M in 
country X, the application of the country X income tax to dual capacity 
taxpayers is different from its application to other corporations. The 
country X income tax as applied to corporations that engage in the 
exploitation of minerals K, L or M (dual capacity taxpayers) is, 
therefore, a separate levy from the country X income tax as applied to 
other corporations.
    A is a U.S. corporation that is engaged in country X in exploitation 
of mineral K. Natural deposits of mineral K in country X are owned by 
country X, and A has been allowed to extract mineral K in consideration 
of payment of a bonus and of royalties to an instrumentality of country 
X. Therefore, A is a dual capacity taxpayer. In 1984, A does business in 
country X within the meaning of the levy. A has validly elected the safe 
harbor method for country X for 1984. In 1984, as determined in 
accordance with the country X income tax as applied to A, A has gross 
receipts of 120u (units of country X currency), deducts 20u of costs and 
expenses, and pays 40u (40% of (120u-20u)) to country X pursuant to the 
levy. A also incurs in 1984 10u of nondeductible expenditures for 
exploration for mineral K and 2u of nondeductible interest costs 
attributable to an advance of funds from a related party to finance an 
undertaking relating to the exploration for mineral K for which normal 
commercial financing was unavailable because of the substantial risk 
inherent in the undertaking. A establishes that the country X income tax 
as applied to persons other than dual capacity taxpayers is an income 
tax within the meaning of Sec.  1.901-2(a)(1), that it is the generally 
imposed income tax of country X and hence the general tax, and that all 
of the criteria of section 903 are satisfied with respect to the country 
X income tax as applied to dual capacity taxpayers, except for the 
determination of the distinct element of the levy that is a tax and of 
A's qualifying amount with respect thereto. (No conclusion is reached 
whether the country X income tax as applied to dual capacity taxpayers 
is an income tax within the meaning of Sec.  1.901-2(a)(1). Such a 
determination would require, among other things, that the country X 
income tax as so applied, judged on the basis of its predominant 
character, meets the net income requirement of Sec.  1.901-2(b)(4) 
notwithstanding its failure to permit recovery of exploration expenses.) 
A has therefore demonstrated that the country X income tax as applied to 
dual capacity taxpayers is a qualifying levy.
    In applying the safe harbor formula, in accordance with paragraph 
(e)(2), the amount of A's costs and expenses includes the 10u of 
nondeductible exploration expenses. The failure to permit recovery of 
interest in excess of arm's length amounts, a provision of both

[[Page 696]]

the general tax and the qualifying levy, does not cause the qualifying 
levy to fail to satisfy the net income requirement of Sec.  1.901-
2(b)(4); therefore, the amount of A's costs and expenses does not 
include the 2u of nondeductible interest costs. Thus, under the safe 
harbor method, A's qualifying amount with respect to the levy is 33.33u 
((120u-30u-40u) x .40/(1-.40)). A's specific economic benefit amount is 
6.67u (A's actual payment amount (40u) less A's qualifying amount 
(33.33u)). Under paragraph (a) of this section, this 6.67u is considered 
to be consideration paid by A for the right to extract mineral K. 
Pursuant to paragraph (b) of this section, this amount is characterized 
according to the nature of A's transactions with country X and its 
instrumentality and of the specific economic benefit received (the right 
to extract mineral K), as an additional royalty or other business 
expense paid or accrued by A and is so treated for all purposes of 
chapter 1 of the Internal Revenue Code, except that if an allowance for 
percentage depletion is allowable to A under sections 611 and 613 with 
respect to A's interest in mineral K, the determination whether this 
6.67u is tax or royalty for purposes of computing the amount of such 
allowance shall be made under sections 611 and 613 without regard to the 
determination that under the safe harbor formula such 6.67u is not tax 
for purposes of section 901 or 903.
    Example 2. Under a levy of country Y called the country Y income 
tax, each corporation incorporated in country Y is required to pay to 
country Y a percentage of its worldwide income. The applicable 
percentage is 40 percent of the first 1,000u (units of country Y 
currency) of income and 50 percent of income in excess of 1,000u. Income 
for purposes of the levy is computed by deducting from gross income 
specified types of expenses and specified allowances for capital 
expenditures. The expenses for which deductions are permitted differ 
depending on the type of business in which the corporation subject to 
the levy is engaged, e.g., a deduction for interest paid to a related 
party is not allowed for corporations engaged in enumerated types of 
activities. In addition, carryover of losses from one taxable period to 
another is permitted for corporations engaged in specified types of 
activities, but not for corporations engaged in other activities. By its 
terms, the foreign levy makes no distinction between dual capacity 
taxpayers and other persons. In practice the differences in the base of 
the country Y income tax (e.g., the lack of a deduction for interest 
paid to related parties for some corporations subject to the levy and 
the lack of a carryover provision for some corporations subject to the 
levy) apply to both dual capacity taxpayers and other persons, but the 
50 percent rate applies only to dual capacity taxpayers. By reason of 
such higher rate, application of the country Y income tax to dual 
capacity taxpayers is different in practice from application of the 
country Y income tax to other persons subject to it. The country Y 
income tax as applied to dual capacity taxpayers is therefore a separate 
levy from the country Y income tax as applied to other corporations 
incorporated in country Y.
    B is a corporation incorporated in country Y that is engaged in 
construction activities in country Y. B has a contract with the 
government of country Y to build a hospital in country Y for a fee that 
is not made available on substantially the same terms to substantially 
all persons who are subject to the general tax of country X. 
Accordingly, B is a dual capacity taxpayer. B has validly elected the 
safe harbor method for country Y for 1985. In 1985, as determined in 
accordance with the country Y income tax as applied to B, B has gross 
receipts of 10,000u, deducts 6,000u of costs and expenses, and pays 
1900u ((1,000u x 40%) + (3,000u x 50%)) to country Y pursuant to the 
levy.
    It is assumed that B has established that the country Y income tax 
as applied to persons other than dual capacity taxpayers is an income 
tax within the meaning of Sec.  1.901-2(a)(1) and is the general tax. It 
is further assumed that B has demonstrated that all of the criteria of 
section 901 are satisfied with respect to the country Y income tax as 
applied to dual capacity taxpayers, except for the determination of the 
distinct element of such levy that is a tax and of B's qualifying amount 
with respect to that levy, and therefore that the country Y income tax 
as applied to dual capacity taxpayers is a qualifying levy.
    In applying the safe harbor formula, in accordance with paragraph 
(e)(3), the 50 percent rate is not used because it does not apply in 
practice to persons other than dual capacity taxpayers. The next lowest 
rate of the general tax that does apply in practice to such persons, 40 
percent, is used. Accordingly, under the safe harbor formula, B's 
qualifying amount with respect to the levy is 1400u ((10,000u-6000u-
1900u) x .40/(1-.40)). B's specific economic benefit amount is 500u (B's 
actual payment amount (1900u) less B's qualifying amount (1400u)). 
Pursuant to paragraph (b) of this section, B's specific economic benefit 
amount is characterized according to the nature of B's transactions with 
country Y and of the specific economic benefit received, as a reduction 
of B's proceeds of its contract with country Y; and this amount is so 
treated for all purposes of chapter 1 of the Code, including the 
computation of B's accumulated profits for purposes of section 902.
    Example 3. The facts are the same as in example 2, with the 
following additional facts: The contract between B and country Y is a 
cost plus contract. One of the costs of the contract which country Y is 
required to pay

[[Page 697]]

or for which it is required to reimburse B is any tax of country Y on 
B's income or receipts from the contract. Instead of reimbursing B 
therefor, country Y agrees with B to assume any such tax liability. 
Under country Y tax law, B is not considered to have additional income 
or receipts by reason of country Y's assumption of B's country Y tax 
liability. In 1985, B's gross receipts of 10,000u include 3000u from the 
contract, and its costs and expenses of 6000u include 2000u attributable 
to the contract. B's other gross receipts and expenses do not relate to 
any transaction in which B receives a specific economic benefit. In 
accordance with the contract, country Y, and not B, is required to bear 
the amount of B's country Y income tax liability on B's 1000u (3000u-
2000u) income from the contract. In accordance with the contract B 
computes its country Y income tax without taking this 1000u into account 
and therefore pays 1400u ((1000u x 40%) + (2000u x 50%)) to country Y 
pursuant to the levy.
    In accordance with Sec.  1.901-2(f)(2)(i), the country Y income tax 
which country Y is, under the contract, required to bear is considered 
to be paid by country Y on behalf of B. B's proceeds of its contract, 
for all purposes of chapter 1 of the Code (including the computation of 
B's accumulated profits for purposes of section 902), therefore, are 
increased by the additional 500u (1900u computed as in example 2 less 
1400u as computed above) of B's liability under the country Y income tax 
that is assumed by country Y and such 500u is considered to be paid 
pursuant to the levy by country Y on behalf of B. In applying the safe 
harbor formula, therefore, the computation is exactly as in example 2 
and the results are the same as in example 2.
    Example 4. Country L issues a decree (the ``April 11 decree''), in 
which it states it is exercising its tax authority to impose a tax on 
all corporations on their ``net income'' from country L. ``Net income'' 
is defined as actual gross receipts less all expenses attributable 
thereto, except that in the case of income from extraction of petroleum, 
gross receipts are defined as 105 percent of actual gross receipts, and 
no deduction is allowed for interest incurred on loans whose proceeds 
are used for exploration for petroleum. Under the April 11 decree, wages 
paid by corporations subject to the decree are deductible in the year of 
payment, except that corporations engaged in the extraction of petroleum 
may deduct such wages only by amortization over a 5-year period and, to 
the extent such wages are paid to officers, they may be deducted only by 
amortization over a period of 50 years. The April 11 decree permits 
related corporations subject to the decree to file consolidated returns 
in which net income and net losses of related corporations offset each 
other in computing net income for purposes of the April 11 decree, 
except that corporations engaged in petroleum exploration or extraction 
activities are not eligible for inclusion in such a consolidated return. 
The law of country L does not require separate entities to carry on 
separate activities in connection with exploring for or extracting 
petroleum. Net losses of a taxable year may be carried over for 10 years 
to offset income, except that no more than 25% of net income (before 
deducting the loss carryover) in any such future year may be offset by a 
carryover of net loss, and, in the case of any corporation engaged in 
exploration or extraction of petroleum, losses incurred prior to such a 
corporation's having net income from production may be carried forward 
for only 8 years and no more than 15% of net income in any such future 
year may be offset by such a net loss. The rate to be paid under the 
April 11 decree is 50% of net income (as defined in the levy), except 
that if net income exceeds 10,000u (units of country L currency), the 
rate is 75% of the corporation's net income (including the first 10,000u 
thereof). In practice, no corporations other than corporations engaged 
in extraction of petroleum have net income in excess of 10,000u. All 
petroleum resources of country L are owned by the government of country 
L, whose petroleum ministry licenses corporations to explore for and 
extract petroleum in consideration for payment of royalties as petroleum 
is produced.
    J is a U.S. corporation that is engaged in country L in the 
exploration and extraction of petroleum and therefore is a dual capacity 
taxpayer. J has validly elected the safe harbor method for country L for 
the year 1983, the year that J commenced activities in country L, and 
has not revoked such election. For the years 1983 through 1986, J's 
gross receipts, deductions and net income before application of the 
carryover provisions, determined in accordance with the April 11 decree, 
are as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                     Net income
                                  Gross                                                             (loss) (B-C-
                                 receipts                 Wages paid    Wages paid                  amortization
                                   (105      Deductions   other than    to officers  Nondeductible       of
             Year               percent of   other than   to officers  (amortizable   exploration   cumulative D-
                                  actual       wages     (amortizable      at 2         interest    amortization
                                  gross                      at 20       percent)       expense          of
                                receipts)                  percent)                                  cumulative
                                                                                                         E)
----------------------------------------------------------------------------------------------------------------
A.                                      B.           C.            D.            E.            F.             G.
----------------------------------------------------------------------------------------------------------------
1983.........................            0      13,000u          100u           50u        1,000u      (13,021u)

[[Page 698]]

 
1984.........................            0      17,000u          100u           50u        2,800u      (17,042u)
1985.........................      42,000u      15,000u          100u           50u        2,800u        26,937u
1986.........................     105,000u      20,000u          100u           50u        2,800u        84,916u
----------------------------------------------------------------------------------------------------------------

    After application of the carryover provisions, J's net income and 
actual payment amounts pursuant to the April 11 levy are as follows:

------------------------------------------------------------------------
                                                                Actual
                                                 Net income    payment
                     Year                          (loss)    amount (I x
                                                             75 percent)
------------------------------------------------------------------------
H.                                                       I.           J.
------------------------------------------------------------------------
1983..........................................    (13,021u)            0
1984..........................................    (17,042u)            0
1985..........................................      22,896u      17,172u
1986..........................................      72,179u      54,134u
------------------------------------------------------------------------

    Pursuant to paragraph (a)(1) of this section, the April 11 decree as 
applied to corporations engaged in the exploration or extraction of 
petroleum in country L is a separate levy from the April 11 decree as 
applied to all other corporations. J establishes that the April 11 
decree, as applied to such other corporations, is an income tax within 
the meaning of Sec.  1.901-2(a)(1) and that the decree as so applied is 
the general tax.
    The April 11 decree as applied to corporations engaged in the 
exploration or extraction of petroleum in country L does not meet the 
gross receipts requirement of Sec.  1.901-2(b)(3); therefore, 
irrespective of whether it meets the other requirements of Sec.  1.901-
2(b)(1), it is not an income tax within the meaning of Sec.  1.901-
2(a)(1). However, the April 11 decree as applied to such corporations is 
a qualifying levy because J has demonstrated that all of the criteria of 
section 903 are satisfied with respect to the April 11 decree as applied 
to such corporations, except for the determination of the distinct 
element of such levy that imposes a tax and of J's qualifying amount 
with respect thereto.
    In applying the safe harbor formula, in accordance with paragraph 
(e)(2), gross receipts are computed by reference to the general levy, 
and thus are 100%, not 105%, of actual gross receipts. Similarly, costs 
and expenses include exploration interest expense. In accordance with 
paragraph (e)(2)(i) of this section the difference between the general 
tax and the qualifying levy in the timing of the deduction for wages, 
other than wages of officers, is not considered to increase the 
liability of dual capacity taxpayers because the general tax would not 
have failed to be an income tax within the meaning of Sec.  1.901-
2(a)(1) if it had provided for 5-year amortization of such wages instead 
of for current deduction. See Sec.  1.901-2(b)(4)(i). However, 
amortization of wages paid to officers over a 50-year period is such a 
deferred recovery of such wages that it effectively is a denial of the 
deduction of the excess of such wages paid in any year over the 
amortization of such cumulative wages permitted in such year. See Sec.  
1.901-2(b)(4)(i). The different treatment of wages paid to officers 
under the general tax and the qualifying levy is thus not merely a 
difference in timing within the meaning of paragraph (e)(2)(i) of this 
section. Accordingly, the difference between the amount of wages paid by 
J to officers in any year and J's deduction (in computing the actual 
payment amount) for amortization of such cumulative wages allowed in 
such year is, pursuant to paragraph (e)(2) of this section, treated as a 
cost and expense in computing J's qualifying amount for such year with 
respect to the April 11 decree. The differences in the consolidation and 
carryover provisions between the general tax and the qualifying levy are 
of the types described in paragraph (e)(2)(ii) of this section and, 
pursuant to paragraphs (b)(4)(ii) and (b)(4)(iii) of Sec.  1.901-2, the 
general tax would not fail to be an income tax within the meaning of 
Sec.  1.901-2(a)(i) even if it contained the consolidation and carryover 
provisions of the qualifying levy. Thus, such differences are not 
considered to increase the liability of dual capacity taxpayers pursuant 
to the qualifying levy as compared to the general tax liability of 
persons other than dual capacity taxpayers.
    Accordingly, in applying the safe harbor formula to the qualifying 
levy for 1985 and 1986, gross receipts and costs and expenses are 
computed as follows:

                             Gross receipts

1985: 42,000u x (100/105) - 40,000u
1986: 105,000u x (100/105) - 100,000u

[[Page 699]]


                           costs and expenses
------------------------------------------------------------------------
                     Item                           1985         1986
------------------------------------------------------------------------
1. Deductions other than wages (column C in         15,000u      20,000u
 the preceding chart).........................
2. Amortization of cumulative wages paid in             60u          80u
 1983 and thereafter other than to officers...
3. Deduction of wages to officers paid in               50u          50u
 current year, instead of amortization allowed
 in current year of such cumulative wages paid
 in 1983 and thereafter.......................
4. Deduction of exploration interest expense..       2,800u       2,800u
                                               -------------------------
5. Costs and expenses before carryover of net       17,910u      22,930u
 loss (sum of lines 1 through 4)..............
                                               =========================
6. Recalculation of loss carryover by
 recalculating 1983 and 1984 net income (loss)
 to reflect current deduction of wages to
 officers and exploration interest expense:
 1983 adjusted net loss carryover: (13,021u) +
 (49u) + (1000u) = (14,070u); 1984 adjusted
 net loss carryover: (17,042u) + (48u) +
 (2800u) = (19,890u)..........................
7. Recalculation of limitation on use of net
 loss carryover deduction:
  Gross receipts..............................      40,000u     100,000u
  Less costs and expenses.....................    (17,910u)     (22,930)
                                               -------------------------
   Total......................................      22,090u      77,070u
  Times 15 percent limitation.................       3,314u      11,561u
                                               -------------------------
8. Costs and expenses including net loss            21,224u      34,491u
 carryover deduction (line 5 plus line 7).....
------------------------------------------------------------------------

    In years after 1986, costs and expenses for purposes of determining 
the qualifying amount would reflect net loss carryforward deductions 
based on the recomputed losses carried forward from 1983 and 1984 
(14,070u and 19,890u, respectively) less the amounts thereof that were 
utilized in determining costs and expenses for 1985 and 1986 (3,314u and 
11,561u, respectively). The 1983 and 1984 loss carryforwards would be 
considered utilized in accordance with the order of priority in which 
such losses are utilized under the terms of the qualifying levy.
    In applying the safe harbor formula, the tax rate to be used, in 
accordance with paragraph (e)(3) of this section, is .50.
    Accordingly, under the safe harbor method, J's qualifying amounts 
with respect to the April 11 decree for 1985 and 1986 are computed as 
follows:

1985: (40,000u - 21,224u - 17,172u) x .50 / (1 - .50) = 1604u

1986: (100,000u - 34,491u - 54,134u) x .50 / (1 - .50) = 11,375u

    Under the safe harbor method J's qualifying amounts with respect to 
the April 11 decree for 1985 and 1986 are thus 1604u and 11,375u, 
respectively; and its specific economic benefit amounts are 15,568u 
(17,172u-1604u) and 42,759u, (54,134u-11,375u), respectively. Pursuant 
to paragraph (b) of this section, J's specific economic benefit amounts 
are characterized according to the nature of J's transactions with 
country L and of the specific economic benefit received by J as 
additional royalties paid to country L with respect to the petroleum 
extracted by J in country L in 1985 and 1986, and these amounts are so 
treated for all purposes of chapter 1 of the Code.
    Example 5. Country E, which has no generally imposed income tax, 
imposes a levy called the country E income tax only on corporations 
carrying on the banking business through a branch in country E and on 
corporations engaged in the extraction of petroleum in country E. All of 
the petroleum resources of country E are owned by the government of 
country E, whose petroleum ministry licenses corporations to explore for 
and extract petroleum in consideration of payment of royalties as 
petroleum is extracted. The base of the country E income tax is a 
corporation's actual gross receipts from sources in country E less all 
expenses attributable, on reasonable principles, to such gross receipts; 
the rate of tax is 29 percent.
    A is a U.S corporation that carries on the banking business through 
a branch in country E. B is a U.S. corporation (unrelated to A) that is 
engaged in the extraction of petroleum in country E. In 1984 A receives 
interest on loans it has made to 160 borrowers in country E, seven of 
which are agencies and instrumentalities of the government of country E. 
The economic benefits received by A and B (i.e., the interest received 
by A from the government and B's license to extract petroleum owned by 
the government) are not made available on substantially the same terms 
to the population of country E in general.
    A and B are dual capacity taxpayers. Each of them has validly 
elected the safe harbor method for country E for 1984. A demonstrates 
that the country E income tax as applied to it (a dual capacity 
taxpayer) is not different by its terms or in practice from the country 
E income tax as applied to persons (in this case other banks) that are 
not dual capacity taxpayers. A has therefore established pursuant to 
paragraph (a)(1) of this section and Sec.  1.901-2(d) that the country E 
income tax as applied to it and the country E income tax as applied to 
persons other than dual capacity taxpayers are together a single levy. A 
establishes that such levy is an income tax within the meaning of Sec.  
1.901-2(a)(1). In accordance with paragraph (a)(1) of this section, no 
portion of the amount paid by A pursuant to such levy is considered to

[[Page 700]]

be paid in exchange for a specific economic benefit. Thus, the entire 
amount paid by A pursuant to this levy is an amount of income tax paid.
    B does not demonstrate that the country E income tax as applied to 
corporations engaged in the extraction of petroleum in country E (dual 
capacity taxpayers) is not different by its terms or in practice from 
the country E income tax as applied to persons other than dual capacity 
taxpayers (i.e., banks that are not dual capacity taxpayers). 
Accordingly, pursuant to paragraph (a)(1) of this section and Sec.  
1.901-2(d), the country E income tax as applied to corporations engaged 
in the extraction of petroleum in country E is a separate levy from the 
country E income tax as applied to other persons.
    B demonstrates that all of the criteria of section 901 are satisfied 
with respect to the country E income tax as applied to corporations 
engaged in the exploration of petroleum in country E, except for the 
determination of the distinct element of such levy that imposes a tax 
and of B's qualifying amount with respect to the levy. Pursuant to 
paragraph (e)(5) of this section, in applying the safe harbor formula to 
B, ``A'' is the amount of B's gross receipts as determined under the 
country E income tax as applied to B; ``B'' is the amount of B's costs 
and expenses as determined thereunder; ``C'' is B's actual payment 
amount; and ``D'' is .29, the lower of the rate (29 percent) of the 
qualifying levy (the country E income tax as applied to corporations 
engaged in the extraction of petroleum in country E) or the rate (46 
percent) of tax specified for 1984 in section 11(b)(5) of the Internal 
Revenue Code. Thus, B's qualifying amount is equal to its actual payment 
amount.
    Example 6. The facts are the same as in example 5, except that the 
rate of the country E income tax is 55 percent. For the reasons stated 
in example 5, the results with respect to A are the same as in example 
5. In applying the safe harbor formula to B, ``A,'' ``B,'' and ``C'' are 
the same as in example 5, but ``D'' is .46, as that rate is less than 
.55. Thus, B's qualifying amount is less than B's actual payment amount, 
and the difference is B's specific economic benefit amount.
    Example 7. Country E imposes a tax (called the country E income tax) 
on the realized net income derived by corporations from sources in 
country E, except that, with respect to interest income received from 
sources in country E and certain insurance income, nonresident 
corporations are instead subject to other levies. With respect to such 
interest income a levy (called the country E interest tax) requires 
nonresident corporations to pay to country E 20 percent of such gross 
interest income unless the nonresident corporation falls within a 
specified category of corporations (``special corporations''), all of 
which are dual capacity taxpayers, in which case the rate is instead 25 
percent. With respect to such insurance income nonresident corporations 
are subject to a levy (called the country E insurance tax), which is not 
an income tax within the meaning of Sec.  1.901-2(a)(1).
    The country E interest tax applies at the 20 percent rate by its 
terms and in practice to persons other than dual capacity taxpayers. The 
country E interest tax as applied at the 25 percent rate to special 
corporations applies only to dual capacity taxpayers; therefore, the 
country E interest tax as applied to special corporations is a separate 
levy from the country E interest tax as applied at the 20 percent rate.
    A is a U.S. corporation which is a special corporation subject to 
the 25 percent rate of the country E interest tax. A does not have any 
insurance income that is subject to the country E insurance tax. A, a 
dual capacity taxpayer, has validly elected the safe harbor formula for 
1984. In 1984 A receives 100u (units of country E currency) of gross 
interest income subject to the country E interest tax and pays 25u to 
country E.
    A establishes that the country E income tax is the generally imposed 
income tax of country E; that all of the criteria of section 903 are 
satisfied with respect to the country E interest tax as applied to 
special corporations except for the determination of the distinct 
element of the levy that is a tax and of A's qualifying amount with 
respect thereto. A has therefore demonstrated that the country E 
interest tax as applied to special corporations is a qualifying levy. A 
establishes that the country E interest tax at the 20 percent rate is a 
tax in lieu of an income tax within the meaning of Sec.  1.903-1(a). 
Pursuant to paragraph (e)(6) of this section the country E interest tax 
at the 20 percent rate is treated as if it were an application of the 
general tax for purposes of the safe harbor formula of this paragraph 
(e), since that tax would actually have been required to have been paid 
by A with respect to its interest income had A not been a dual capacity 
taxpayer (special corporation) instead subject to the qualifying levy 
(the country E interest tax at the 25 percent rate).
    Even if the country E insurance tax is a tax in lieu of an income 
tax within the meaning of Sec.  1.903-1(a), that tax is not treated as 
if it were an application of the general tax for purposes of applying 
the safe harbor formula to A since A had no insurance income in 1984 and 
hence such tax would not actually have been required to be paid by A had 
A not been a dual capacity taxpayer.
    Example 8. Under a levy of country S called the country S income 
tax, each corporation operating in country S is required to pay country 
S 50 percent of its income from operations in country S. Income for 
purposes of the country S income tax is computed by

[[Page 701]]

subtracting all attributable costs and expenses from a corporation's 
gross receipts derived from its business in country S. Among 
corporations on which the country S income tax is imposed are 
corporations engaged in the exploitation of mineral K in country S. 
Natural deposits of mineral K in country S are owned by country S, and 
all corporations engaged in the exploitation thereof do so under 
concession agreement with an instrumentality of country S. Such 
corporations, in addition to the 50 percent country S income tax, are 
also subject to a levy called a surtax, which is equal to 60 percent of 
posted price net income less the amount of the contry S income tax. The 
surtax is not deductible in computing the country S income tax of 
corporations engaged in the exploitation of mineral K in country S.
    A is a U.S. corporation engaged in country S in the exploitation of 
mineral K, and A has been allowed to extract mineral K under a 
concession agreement with an instrumentality of country S. Therefore, A 
is a dual capacity taxpayer. In accordance with a term of the concession 
agreement, certain of A's income (net of expenses attributable thereto) 
is exempted from the income tax and surtax.
    The results for A in 1984 are as follows:

------------------------------------------------------------------------
                                                    Income Tax   Surtax
------------------------------------------------------------------------
Gross Receipts:
  Realized--Taxable..............................         120u        --
  Realized--Exempt...............................          15u        --
  Posted Price-Taxable...........................           --      145u
Costs:
  Attributable to Taxable Receipts...............          20u       20u
  Attributable to Exempt Receipts................           5u        --
Taxable Income...................................         100u      125u
Tentative Surtax (60 percent)....................           --       75u
Petroleum Levy at 50 percent.....................          50u       50u
Surtax...........................................           --       25u
------------------------------------------------------------------------

    Because of the difference (nondeductibility of the surtax) in the 
country S income tax as applied to dual capacity taxpayers from its 
application to other persons, the country S income tax as applied to 
dual capacity taxpayers and the country S income tax as applied to 
persons other than dual capacity taxpayers are separate levies. 
Moreover, because A's concession agreement provides for a modification 
(exemption of certain income) of the country S income tax and surtax as 
they otherwise apply to other persons engaged in the exploitation of 
mineral K in country S, those levies (contractual levies) as applied to 
A are separate levies from those levies as applied to other persons 
engaged in the exploitation of mineral K in country S.
    A establishes that the country S income tax as applied to persons 
other than dual capacity taxpayers is an income tax within the meaning 
of Sec.  1.901-2(a)(1) and is the general tax. A demonstrates that all 
the criteria of section 903 are satisfied with respect to the country S 
income tax as applied to A and with respect to the surtax as applied to 
A, except for the determination of the distinct elements of such levies 
that are taxes and of A's qualifying amounts with respect to such 
levies. Therefore, both the country S income tax as applied to A and the 
surtax as applied to A are qualifying levies.
    In applying the safe harbor formula, in accordance with paragraph 
(e)(2), the amount of A's gross receipts includes the exempt realized 
income, and the amount of A's costs and expenses includes the costs 
attributable to such exempt income. In accordance with paragraph 
(e)(7)(i), the amount of the qualifying levy for purposes of the formula 
is the sum of A's liability for the country S income tax and A's 
liability for the surtax. Accordingly, under the safe harbor formula, 
A's qualifying amount with respect to the country S income tax and the 
surtax is 35u ((135u-25u-75u) x .50/(1-.50)). A's specific economic 
benefit amount is 40u (A's actual payment amount (75u) less A's 
qualifying amount (35u)).
    Example 9. Country T imposes a levy on corporations, called the 
country T income tax. The country T income tax is imposed at a rate of 
50 percent on gross receipts less all costs and expenses, and affiliated 
corporations are allowed to consolidate their results in applying the 
country T income tax. Corporations engaged in the exploitation of 
mineral L in country T are subject to a levy that is identical to the 
country T income tax except that no consolidation among affiliated 
corporations is allowed. The levy allows unlimited loss carryforwards.
    C and D are affiliated U.S. corporations engaged in country T in the 
exploitation of mineral L. Natural deposits of mineral L in country T 
are owned by country T, and C and D have been allowed to extract mineral 
L in consideration of certain payments to an instrumentality of country 
T. Therefore, C and D are dual capacity taxpayers.
    The results for C and D in 1984 and 1985 are as follows:

------------------------------------------------------------------------
                                            1984              1985
                                     -----------------------------------
                                         C        D        C        D
------------------------------------------------------------------------
Gross Receipts......................     120u        0     120u     120u
Costs...............................      20u      50u      20u      20u
Loss Carryforward...................  .......  .......  .......      50u
Net Income (Loss)...................     100u    (50u)     100u      50u
Income Tax..........................      50u  .......      50u      25u
------------------------------------------------------------------------

    C and D establish that the country T income tax as applied to 
persons other than dual capacity taxpayers is an income tax within the 
meaning of Sec.  1.901-2(a)(1) and is the general tax. C and D 
demonstrate that all of the criteria of section 901 are satisfied with 
respect to the country T income tax as applied to dual capacity 
taxpayers, except for the determination of the distinct element of such 
levy that is a tax and of C and D's

[[Page 702]]

qualifying amounts with respect to that levy. Therefore, the country T 
income tax as applied to dual capacity taxpayers is a qualifying levy.
    In applying the safe harbor formula, in accordance with paragraphs 
(e)(2)(ii) and (e)(7)(iii), the gross receipts, costs and expenses, and 
actual payment amounts of C and D are aggregated, except that in D's 
loss year (1984) its gross receipts and costs and expenses are 
disregarded. The results of any loss year are disregarded since the 
country T income tax as applied to dual capacity taxpayers does not 
allow consolidation, and, pursuant to paragraph (e)(2)(ii), differences 
in consolidation provisions between such levy and the country T income 
tax as applied to persons that are not dual capacity taxpayers are not 
considered. Accordingly, in 1984 the qualifying amount with respect to 
the country T income tax is 50u ((120u-20u-50u) x .50/(1-.50)), all of 
which is considered paid by C. In 1985 the qualifying amount is 75u 
((120u + 120u-20u-20u-50u (loss carry forward)--50u--25u) x .50/
(1-.50)), of which 50u is considered to be paid by C and 25u by D.
    Example 10. Country W imposes a levy called the country W income tax 
on corporations doing business in country W. The country W income tax is 
imposed at a 50 percent rate on gross receipts less all costs and 
expenses. Corporations engaged in the exploitation of mineral M in 
country W are subject to a levy that is identical in all respects to the 
country W income tax except that it is imposed at a rate of 80 percent 
(the ``80 percent levy'').
    A is a U.S. corporation engaged in country W in exploitation of 
mineral M and is subject to the 80 percent levy. Natural deposits of 
mineral M in country W are owned by country W, and A has been allowed to 
extract mineral M in consideration of certain payments to an 
instrumentality of country W. Therefore, A is a dual capacity taxpayer. 
B, a U.S. corporation affiliated with A, also is engaged in business in 
country W, but has no transactions with country W. B is subject to the 
country W income tax. B is a dual capacity taxpayer within the meaning 
of Sec.  1.901-2(a)(2)(ii)(A) by virtue of its affiliation with A.
    The results for A and B in 1984 are as follows:

------------------------------------------------------------------------
                                                        A          B
------------------------------------------------------------------------
Gross Receipts....................................       120u       100u
Costs.............................................        20u        40u
Net Income........................................       100u        60u
Tax Rate..........................................        .80        .50
Tax...............................................        80u        30u
------------------------------------------------------------------------

    A and B establish that the country W income tax as applied to 
persons other than dual capacity taxpayers is an income tax within the 
meaning of Sec.  1.901-2(a)(1) and is the general tax. It is assumed 
that B has demonstrated that the country W income tax as applied to B 
does not differ by its terms or in practice from the country W income 
tax as applied to persons other than dual capacity taxpayers and hence 
that the country W income tax as applied to B, a dual capacity taxpayer, 
and the country W income tax as applied to such other persons is a 
single levy. Thus, with respect to B, the country W income tax is not a 
qualifying levy by reason of the last sentence of paragraph (c)(1) of 
this section. A demonstrates that all the criteria of section 901 are 
satisfied with respect to the 80 percent levy, except for the 
determination of the distinct element of such levy that is a tax and of 
A's qualifying amount with respect thereto. Accordingly, the 80 percent 
levy as applied to A is a qualifying levy.
    In applying the safe harbor formula in accordance with paragraphs 
(e)(7)(i) and (e)(7)(iii) in the instant case, it is not necessary to 
incorporate B's results in the safe harbor formula because B's taxation 
in country W is identical to the taxation of persons other than dual 
capacity taxpayers and because neither A's and B's results nor their 
taxation in country W interact in any way to change A's taxation. All of 
the amount paid by B, 30u, is an amount of income tax paid by B within 
the meaning of Sec.  1.901-2(a)(1). Accordingly, under the safe harbor 
formula, the qualifying amount for A with respect to the 80 percent levy 
is 20u ((120u-20u-80u) x .50/(1-.50)). The remaining 60u paid by A (80u 
- 20u) is A's specific economic benefit amount.
    Example 11. The facts are the same as in example 10, except that it 
is assumed that B has not demonstrated that the country W income tax as 
applied to B does not differ by its terms or in practice from the 
country W income tax as applied to persons other than dual capacity 
taxpayers. In addition, A and B demonstrate that all the criteria of 
section 901 are satisfied with respect to each of the country W income 
tax and the 80 percent levy as applied to dual capacity taxpayers, 
except for the determination of the distinct elements of such levies 
that are taxes of A and B's qualifying amounts with respect to such 
levies. Therefore, the country W income tax and 80 percent levy as 
applied to dual capacity taxpayers are qualifying levies.
    In applying the safe harbor formula in accordance with paragraphs 
(e)(7)(i) and (e)(7)(iii), the results of A and B are aggregated. 
Accordingly, under the safe harbor formula, the aggregate qualifying 
amount for A and B with respect to the country W income tax and 80 
percent levy is 50u ([(120u + 100u)-(20u + 40u)-(80u + 30u)] x .50/
(1-.50)).
    Example 12. Country Y imposes a levy on corporations operating in 
country Y, called the country Y income tax. Income for purposes of the 
country Y income tax is computed by subtracting all costs and expenses 
from a corporation's gross receipts derived

[[Page 703]]

from its business in country Y. The rate of the country Y income tax is 
50 percent. Country Y also imposes a 20 percent tax (the ``withholding 
tax'') on the gross amount of certain income, including dividends, 
received by persons who are not residents of country Y from persons who 
are residents of country Y and from corporations that operate there. 
Corporations engaged in the exploitation of mineral K in country Y are 
subject to a levy (the ``75 percent levy'') that is identical in all 
respects to the country Y income tax except that it is imposed at a rate 
of 75 percent. Dividends received from such corporations are not subject 
to the withholding tax.
    C, a wholly-owned country Y subsidiary of D, a U.S. corporation, is 
engaged in country Y in the exploitation of mineral K. Natural deposits 
of mineral K in country Y are owned by country Y, and C has been allowed 
to extract mineral K in consideration of certain payments to an 
instrumentality of country Y. Therefore, C is a dual capacity taxpayer. 
D has elected the safe harbor method for country Y for 1984. In 1984, 
C's gross receipts are 120u (units of country Y currency), its costs and 
expenses are 20u, and its liability under the 75 percent levy is 75u. C 
distributes the amount that remains, 25u, as a dividend to D.
    D establishes that the country Y income tax as applied to persons 
other than dual capacity taxpayers is an income tax within the meaning 
of Sec.  1.901-2(a)(1) and the general tax, and that all the criteria of 
section 901 are satisfied with respect to the 75 percent levy, except 
for the determination of the distinct element of such levy that is tax 
and of C's qualifying amount with respect thereto. Accordingly, the 75 
percent levy is a qualifying levy.
    Pursuant to paragraph (e)(7), D (which is not subject to a levy of 
country Y but is considered to receive a specific economic benefit by 
reason of Sec.  1.901-2(a)(2)(ii)(E)) is treated as a dual capacity 
taxpayer in applying paragraph (e)(7)(ii). D demonstrates that the 
withholding tax is a tax in lieu of an income tax within the meaning of 
Sec.  1.903-1, which tax applies in practice to persons other than dual 
capacity taxpayers, and that such tax actually would have applied to D 
had D not been a dual capacity taxpayer (i.e., had C not been a dual 
capacity taxpayer, in which case D also would not have been one). 
Accordingly, the withholding tax is treated for purposes of the safe 
harbor formula as if it were an application of the general tax.
    In applying the safe harbor formula to this situation in accordance 
with paragraph (e)(7)(ii), the rates of the country Y income tax and the 
withholding tax are aggregated into a single effective general tax rate. 
In this case, the rate is .60 (.50 + [(1-.50) x .20]). Accordingly, 
under the safe harbor formula, C's qualifying amount with respect to the 
75 percent levy is 37.5u [(120u-20u-75u) x .60/(1-.60)], the aggregate 
amount that C and D would have paid if C had been subject to the country 
Y income tax and had distributed to D as a dividend subject to the 
withholding tax the entire amount that remained for the year after 
payment of the country Y income tax. Because C is in fact the only 
taxpayer, the entire qualifying amount is paid by C.
    Example 13. The facts are the same as in example 12, except that 
dividends received from corporations engaged in the exploitation of 
mineral K in country Y are subject to the withholding tax. Thus, C's 
liability under the 75 percent levy is 75u, and D's liability under the 
withholding tax on the 25u distribution is 5u.
    D, which is a dual capacity taxpayer, demonstrates that the 
withholding tax as applied to D does not differ by its terms or in 
practice from the withholding tax as applied to persons other than dual 
capacity taxpayers and hence that the withholding tax as applied to D 
and that levy as applied to such other persons is a single levy. D 
demonstrates that all of the criteria of section 903 are satisfied with 
respect to the withholding tax. The withholding tax is not a qualifying 
levy by reason of the last sentence of paragraph (c)(1) of this section.
    Paragraphs (e)(7)(i), (e)(7)(ii) and (e)(7)(iii) all apply in this 
situation. As in example 10, it is not necessary to incorporate the 
withholding tax into the safe harbor formula. All of the amount paid by 
D, 5u, is an amount of tax paid by D in lieu of an income tax. In 
applying the safe harbor formula to C, therefore, with respect to the 75 
percent levy, ``A'' is 120, ``B'' is ``20'', ``C'' is 75 and ``D'' is 
.50. Accordingly, C's qualifying amount with respect to the 75 percent 
levy is 25u; the remaining 50u that it paid is its specific economic 
benefit amount.
    Example 14. The facts are the same as in example 12, except that 
dividends received from corporations engaged in the exploitation of 
mineral K in country Y are subject to a 10 percent withholding tax (the 
``10 percent withholding tax''). Thus, C's liability under the 75 
percent levy is 75u, and D's liability under the 10 percent withholding 
tax on the 25u distribution is 2.5u.
    The only difference between the withholding tax and the 10 percent 
withholding tax applicable only to dual capacity taxpayers (including D) 
is that a lower rate (but the same base) applies to dual capacity 
taxpayers. Although the withholding tax and the 10 percent withholding 
tax are together a single levy, this difference makes it necessary, when 
dealing with multiple levies, to incorporate the withholding tax and D's 
payment pursuant to the 10 percent withholding tax in the safe harbor 
formula. Accordingly, as in example 12, the safe harbor formula is 
applied by aggregation.
    The aggregate effective rate of the general taxes for purposes of 
the safe harbor formula

[[Page 704]]

is .60 (.50 + [(1-.50) x .20]). Pursuant to paragraph (e)(7), the 
aggregate actual payment amount of the qualifying levies for purposes of 
the formula is the sum of C and D's liability for the 75 percent levy 
and the 10 percent withholding tax. Accordingly, under the safe harbor 
formula, the aggregate qualifying amount with respect to the 75 percent 
levy on C and the 10 percent withholding tax on D is 33.75u ((120u-20u-
[75u + 2.5u]) x .60/(1-.60)), which is the aggregate amount of tax that 
C and D would have paid if C had been subject to the country Y income 
tax and had paid out its entire amount remaining after payment of that 
tax to D as a dividend subject to the withholding tax.
    Example 15. The facts are the same as in example 5, except that the 
rate of the country E income tax is 45 percent and a political 
subdivision of country E also imposes a levy, called the ``local tax,'' 
on all corporations subject to the country E income tax. The base of the 
local tax is the same as the base of the country E income tax; the rate 
is 10 percent.
    The reasoning of example 5 with regard to the country E income tax 
as applied to A and B, respectively, applies equally with regard to the 
local tax as applied to A and B, respectively. Accordingly, the entire 
amount paid by A pursuant to each of the country E income tax and the 
local tax is an amount of income tax paid, and both the country E income 
tax as applied to B and the local tax as applied to B are qualifying 
levies.
    Pursuant to paragraph (e)(7), in applying the safe harbor formula to 
B, ``A'' is the amount of B's gross receipts as determined under the 
(identical) country E income tax and local tax as applied to B; ``B'' is 
the amount of B's costs and expenses thereunder; and ``C'' is the sum of 
B's actual payment amounts with respect to the two levies. Pursuant to 
paragraph (e)(7), in applying the safe harbor formula to B, B's 
aggregate qualifying amount with respect to the two levies is limited to 
the amount determined in accordance with paragraph (e)(5) where ``D'' is 
the rate of tax specified in section 11(b)(5) of the Internal Revenue 
Code. Accordingly, ``D'' is .46, which is the lower of the aggregate 
rate (55 percent) of the qualifying levies or the section 11(b)(5) rate 
(46 percent). B's aggregate qualifying amount is, therefore, identical 
to B's qualifying amount in example 6, which is less than its aggregate 
actual payment amount, and the difference is B's specific economic 
benefit amount.

    (f) Effective date. The effective date of this section is as 
provided in Sec.  1.901-2(h).

(Approved by the Office of Management and Budget under control number 
1545-0746)

[T.D. 7918, 48 FR 46284, Oct. 12, 1983]



Sec.  1.901-3  Reduction in amount of foreign taxes on foreign mineral 
income allowed as a credit.

    (a) Determination of amount of reduction--(1) In general. For 
purposes of determining the amount of taxes which are allowed as a 
credit under section 901(a) for taxable years beginning after December 
31, 1969, the amount of any income, war profits, and excess profits 
taxes paid or accrued, or deemed to be paid under section 902, during 
the taxable year to any foreign country or possession of the United 
States with respect to foreign mineral income (as defined in paragraph 
(b) of this section) from sources within such country or possession 
shall be reduced by the amount, if any, by which--
    (i) The smaller of--
    (a) The amount of such foreign income, war profits, and excess 
profits taxes, or
    (b) The amount of the tax which would be computed under chapter 1 of 
the Code for such year with respect to such foreign mineral income if 
the deduction for depletion were determined under section 611 without 
regard to the deduction for percentage depletion under section 613, 
exceeds
    (ii) The amount of the tax computed under chapter 1 of the Code for 
such year with respect to such foreign mineral income.


The reduction required by this subparagraph must be made on a country-
by-country basis whether the taxpayer uses for the taxable year the per-
country limitation under section 904(a)(1), or the overall limitation 
under section 904(a)(2), on the amount of taxes allowed as credit under 
section 901(a).
    (2) Determination of amount of tax on foreign mineral income--(i) 
Foreign tax. For purposes of subparagraph (1)(i)(a) of this paragraph, 
the amount of the income, war profits, and excess profits taxes paid or 
accrued during the taxable year to a foreign country or possession of 
the United States with respect to foreign mineral income from sources 
within such country or possession is an amount which is the greater of--
    (a) The amount by which the total amount of the income, war profits, 
and excess profits taxes paid or accrued

[[Page 705]]

during the taxable year to such country or possession exceeds the amount 
of such taxes that would be paid or accrued for such year to such 
country or possession without taking into account such foreign mineral 
income, or
    (b) The amount of the income, war profits, and excess profits taxes 
that would be paid or accrued to such country or possession if such 
foreign mineral income were the taxpayer's only income for the taxable 
year, except that in no case shall the amount so determined exceed the 
total of all income, war profits, and excess profits taxes paid or 
accrued during the taxable year to such country or possession. For such 
purposes taxes which are paid or accrued also include taxes which are 
deemed paid under section 902. In the case of a dividend described in 
paragraph (b)(2)(i) (a) of this section which is from sources within a 
foreign country or possession of the United States and is attributable 
in whole or in part to foreign mineral income, the amount of the income, 
war profits, and excess profits taxes deemed paid under section 902 
during the taxable year to such country or possession with respect to 
foreign mineral income from sources within such country or possession is 
an amount which bears the same ratio to the amount of the income, war 
profits, and excess profits taxes deemed paid under section 902 during 
such year to such country or possession with respect to such dividend as 
the portion of the dividend which is attributable to foreign mineral 
income bears to the total dividend. For purposes of (a) and (b) of this 
subdivision, foreign mineral income is to be reduced by any credits, 
expenses, losses, and other deductions which are properly allocable to 
such income under the law of the foreign country or possession of the 
United States from which such income is derived.
    (ii) U.S. tax. For purposes of subparagraph (1)(ii) of this 
paragraph, the amount of the tax computed under chapter 1 of the Code 
for the taxable year with respect to foreign mineral income from sources 
within a foreign country or possession of the United States is the 
greater of--
    (a) The amount by which the tax under chapter 1 of the Code on the 
taxpayer's taxable income for the taxable year exceeds a tax determined 
under such chapter on the taxable income for such year determined 
without regard to such foreign mineral income, or
    (b) The amount of tax that would be determined under chapter 1 of 
the Code if such foreign mineral income were the taxpayer's only income 
for the taxable year.


For purposes of this subdivision the tax is to be determined without 
regard to any credits against the tax and without taking into account 
any tax against which a credit is not allowed under section 901(a). For 
purposes of (b) of this subdivision, the foreign mineral income is to be 
reduced only by expenses, losses, and other deductions properly 
allocable under chapter 1 of the Code to such income and is to be 
computed without any deduction for personal exemptions under section 151 
or 642(b).
    (iii) U.S. income tax computed without deduction allowed by section 
613. For purposes of subparagraph (1)(i)(b) of this paragraph, the 
amount of the tax which would be computed under chapter 1 of the Code 
(without regard to section 613) for the taxable year with respect to 
foreign mineral income from sources within a foreign country or 
possession of the United States is the amount of the tax on such income 
that would be computed under such chapter by using as the allowance for 
depletion cost depletion computed upon the adjusted depletion basis of 
the property. For purposes of this subdivision the tax is to be 
determined without regard to any credits against the tax and without 
taking into account any tax against which credit is not allowed under 
section 901(a). If the greater tax with respect to the foreign mineral 
income under subdivision (ii) of this subparagraph is the tax determined 
under (a) of such subdivision, the tax determined for purposes of 
subparagraph (1)(i)(b) of this paragraph is to be determined by applying 
the principles of (a) (rather than of (b)) of subdivision (ii) of this 
subparagraph. On the other hand, if the greater tax with respect to the 
foreign mineral income under subdivision (ii) of this subparagraph is 
the tax determined under (b) of such subdivision, the tax determined for 
purposes

[[Page 706]]

of subparagraph (1)(i)(b) of this paragraph is to be determined by 
applying the principles of (b) (rather than of (a)) of subdivision (ii) 
of this subparagraph.
    (3) Special rules. (i) The reduction required by this paragraph in 
the amount of taxes paid, accrued, or deemed to be paid to a foreign 
country or possession of the United States applies only where the 
taxpayer is allowed a deduction for percentage depletion under section 
613 with respect to any part of his foreign mineral income for the 
taxable year from sources within such country or possession, whether or 
not such deduction is allowed with respect to the entire foreign mineral 
income from sources within such country or possession for such year.
    (ii) For purposes of this section, the term ``foreign country'' or 
``possession of the United States'' includes the adjacent continental 
shelf areas to the extent, and in the manner, provided by section 638(2) 
and the regulations thereunder.
    (iii) The provisions of this section are to be applied before making 
any reduction required by section 1503(b) in the amount of income, war 
profits, and excess profits taxes paid or accrued to foreign countries 
or possessions of the United States by a Western Hemisphere trade 
corporation.
    (iv) If a taxpayer chooses with respect to any taxable year to claim 
a credit under section 901 and has any foreign mineral income from 
sources within a foreign country or possession of the United States with 
respect to which the deduction under section 613 is allowed, he must 
attach to his return a schedule showing the computations required by 
subdivisions (i), (ii), and (iii) of subparagraph (2) of this paragraph.
    (v) A taxpayer who has elected to use the overall limitation under 
section 904(a)(2) on the amount of the foreign tax credit for any 
taxable year beginning before January 1, 1970, may, for his first 
taxable year beginning after December 31, 1969, revoke his election 
without first securing the consent of the Commissioner. See paragraph 
(d) of Sec.  1.904-1.
    (b) Foreign mineral income defined--(1) In general. The term 
``foreign mineral income'' means income (determined under chapter 1 of 
the Code) from sources within a foreign country or possession of the 
United States derived from--
    (i) The extraction of minerals from mines, wells, or other natural 
deposits,
    (ii) The processing of minerals into their primary products, or
    (iii) The transportation, distribution, or sale of minerals or of 
the primary products derived from minerals.


Any income of the taxpayer derived from an activity described in either 
subdivision (i), (ii), or (iii) of this subparagraph is foreign mineral 
income, since it is not necessary that the taxpayer extract, process, 
and transport, distribute, or sell minerals or their primary products 
for the income derived from any such activity to be foreign mineral 
income. Thus, for example, an integrated oil company must treat as 
foreign mineral income from sources within a foreign country or 
possession of the United States all income from such sources derived 
from the production of oil, the refining of crude oil into gasoline, the 
distribution of gasoline to marketing outlets, and the retail sale of 
gasoline. Similarly, income from such sources from the refining, 
distribution, or marketing of fuel oil by the taxpayer is foreign 
mineral income, whether or not the crude oil was extracted by the 
taxpayer. In further illustration, income from sources within a foreign 
country or possession of the United States derived from the processing 
of minerals into their primary products by the taxpayer is foreign 
mineral income, whether or not the minerals were extracted, or the 
primary products were sold, by the taxpayer. Section 901(e) and this 
section apply whether or not the extraction, processing, transportation, 
distribution, or selling of the minerals or primary products is done by 
the taxpayer. Thus, for example, an individual who derives royalty 
income from the extraction of oil from an oil well in a foreign country 
has foreign mineral income for purposes of this paragraph. Income from 
the manufacture, distribution, and marketing of petrochemicals is not 
foreign mineral income. Foreign mineral income is not

[[Page 707]]

limited to gross income from the property within the meaning of section 
613(c) and Sec.  1.613-3.
    (2) Income included in foreign mineral income--(i) In general. 
Foreign mineral income from sources within a foreign country or 
possession of the United States includes, but is not limited to--
    (a) Dividends from such sources, as determined under Sec.  1.902-
1(h)(1), received from a foreign corporation in respect of which taxes 
are deemed paid by the taxpayer under section 902, to the extent such 
dividends are attributable to foreign mineral income described in 
subparagraph (1) of this paragraph. The portion of such a dividend which 
is attributable to such 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 mineral income 
bear to the total earnings and profits out of which such dividend is 
paid. For such purposes, the foreign mineral income of a foreign 
corporation is its foreign mineral income described in this paragraph 
(including any dividends described in this (a) which are received from 
another foreign corporation), whether or not such income is derived from 
sources within the foreign country or possession of the United States in 
which, or under the laws of which, the former corporation is created or 
organized. A foreign corporation is considered to have no foreign 
mineral income for any taxable year beginning before January 1, 1970.
    (b) Any section 78 dividend to which a dividend described in (a) of 
this subdivision gives rise, but only to the extent such section 78 
dividend is deemed paid under paragraph (a)(2)(i) of this section with 
respect to foreign mineral income from sources within such country or 
possession and to the extent it is treated under of Sec.  1.902-1(h)(1) 
as income from sources within such country or possession.
    (c) Any amounts includible in income of the taxpayer under section 
702(a) as his distributive share of the income of a partnership 
consisting of income described in subparagraph (1) of this paragraph.
    (d) Any amounts includible in income of the taxpayer by virtue of 
section 652(a), 662(a), 671, 682(a), or 691(a), to the extent such 
amounts consist of income described in subparagraph (1) of this 
paragraph.
    (ii) Illustration. The provisions of this subparagraph may be 
illustrated by the following example:

    Example. (a) Throughout 1974, M, a domestic corporation, owns all 
the one class of stock of N, a foreign corporation which is not a less 
developed country corporation within the meaning of section 902(d). Both 
corporations use the calendar year as the taxable year. N is 
incorporated in foreign country Y. During 1974, N has income from 
sources within foreign country X, all of which is foreign mineral 
income. During 1974, N also has income from sources within country Y, 
none of which is foreign mineral income. N is taxed in each foreign 
country only on income derived from sources within that country. Neither 
country X nor country Y allows a credit against its tax for foreign 
income taxes. N pays a dividend of $40,000 to M for 1974. For purposes 
of section 902, the dividend is paid from earnings and profits for 1974.
    (b) N's earnings and profits and taxes for 1974 are determined as 
follows:

Foreign mineral income from country X........................   $100,000
Less:
  Intangible drilling and development costs........   $21,000
  Cost depletion...................................     3,000     24,000
                                                    --------------------
Taxable income from country X................................     76,000
Income tax rate of country X.................................      x 50%
                                                    -----------
Tax paid to country X........................................     38,000
                                                    ===========
Income from country Y........................................    100,000
Less deductions..............................................     25,000
                                                    -----------
Taxable income from country Y................................     75,000
Income tax rate of country Y.................................      x 60%
                                                    -----------
Tax paid to country Y........................................     45,000
                                                    ===========
Total taxable income.........................................    151,000
Less total foreign income taxes..............................     83,000
                                                    -----------
Total earnings and profits...................................     68,000
                                                    ===========
Taxable income from foreign mineral income...................     76,000
Less: Tax paid on foreign mineral income.....................     38,000
                                                    -----------
Earnings and profits from foreign mineral income.............     38,000
 

    (c) For 1974, M has foreign mineral income from country Y of 
$49,636.68, determined in the following manner and by applying this 
section, Sec.  1.78-1, and Sec.  1.902-1(h)(1):

Portion of dividend from country Y attributable to foreign    $22,352.94
 mineral income (subdivision (i)(a) of this subparagraph)
 ($40,000 x $38,000/$68,000)................................
Foreign income tax deemed paid by M to country Y under         48,823.53
 section 902(a)(1) ($83,000 x $40,000/$68,000)..............

[[Page 708]]

 
Foreign income tax deemed paid by M to country Y with          27,283.74
 respect to foreign mineral income from country Y (paragraph
 (a)(2)(i) of this section) ($48,823.53 x $22,352.94/
 $40,000)...................................................
                                                             -----------
Foreign mineral income from country Y:
  Dividend attributable to foreign mineral income from         22,352.94
   country Y................................................
  Sec. 78 dividend deemed paid with respect to foreign         27,283.74
   mineral income (subdivision (i)(b) of this subparagraph).
  Total foreign mineral income..............................   49,636.68
                                                             ===========
 

    (c) Limitations on foreign tax credit--(1) In general. The reduction 
under section 901(e) and paragraph (a)(1) of this section in the amount 
of foreign taxes allowed as a credit under section 901(a) is to be made 
whether the per-country limitation under section 904(a)(1) or the 
overall limitation under section 904(a)(2) is used for the taxable year, 
but the reduction in the amount of foreign taxes allowed as a credit 
under section 901(a) must be made on a country-by-country basis before 
applying the limitation under section 904(a) to the reduced amount of 
taxes. If for the taxable year the separate limitation under section 
904(f) applies to any foreign mineral income, that limitation must also 
be applied after making the reduction under section 901(e) and paragraph 
(a)(1) of this section.
    (2) Carrybacks and carryovers of excess tax paid--(i) In general. 
Any amount by which (a) any income, war profits, and excess profits 
taxes paid or accrued, or deemed to be paid under section 902, during 
the taxable year to any foreign country or possession of the United 
States with respect to foreign mineral income from sources within such 
country or possession exceed (b) the reduced amount of such taxes as 
determined under paragraph (a)(1) of this section may not be deemed paid 
or accrued under section 904(d) in any other taxable year. See Sec.  
1.904-2(b)(2)(iii). However, to the extent such reduced amount of taxes 
exceeds the applicable limitation under section 904(a) for the taxable 
year it shall be deemed paid or accrued under section 904(d) in another 
taxable year as a carryback or carryover of an unused foreign tax. The 
amount so deemed paid or accrued in another taxable year is not, 
however, deemed paid or accrued with respect to foreign mineral income 
in such other taxable year. See Sec.  1.904-2(c)(3).
    (ii) Carryovers to taxable years beginning after December 31, 1969. 
Where, under the provisions of section 904(d), taxes paid or accrued, or 
deemed to be paid under section 902, to any foreign country or 
possession of the United States in any taxable year beginning before 
January 1, 1970, are deemed paid or accrued in one or more taxable years 
beginning after December 31, 1969, the amount of such taxes so deemed 
paid or accrued shall not be deemed paid or accrued with respect to 
foreign mineral income and shall not be reduced under section 901(e) and 
paragraph (a)(1) of this section.
    (iii) Carrybacks to taxable years beginning before January 1, 1970. 
Where income, war profits, and excess profits taxes are paid or accrued, 
or deemed to be paid under section 902, to any foreign country or 
possession of the United States in any taxable year beginning after 
December 31, 1969, with respect to foreign mineral income from sources 
within such country or possession, they must first be reduced under 
section 901(e) and paragraph (a)(1) of this section before they may be 
deemed paid or accrued under section 904(d) in one or more taxable years 
beginning before January 1, 1970.
    (d) Illustrations. The application of this section may be 
illustrated by the following examples, in which the surtax exemption 
provided by section 11(d) and the tax surcharge provided by section 
51(a) are disregarded for purposes of simplification:

    Example 1. (a) M, a domestic corporation using the calendar year as 
the taxable year, is an operator drilling for oil in foreign country W. 
For 1971, M's gross income under chapter 1 of the Code is $100,000, all 
of which is foreign mineral income from a property in country W and is 
subject to the allowance for depletion. During 1971, M incurs intangible 
drilling and development costs of $15,000, which are currently 
deductible for purposes of the tax of both countries. Cost depletion 
amounts to $2,000 for purposes of the tax of both countries, and only 
cost depletion is allowed as a deduction under the law of country W. It 
is assumed that no other deductions are allowable under the law of 
either country. Based upon the facts assumed, the income tax paid to 
country W on such foreign mineral income is $41,500, and the U.S. tax on 
such income before allowance of the foreign tax credit is $30,240, 
determined as follows:

[[Page 709]]



------------------------------------------------------------------------
                                                     U.S. tax    W tax
------------------------------------------------------------------------
Foreign mineral income............................   $100,000   $100,000
Less:
  Intangible drilling and development costs.......     15,000     15,000
  Cost depletion..................................  .........      2,000
  Percentage depletion (22% of $100,000, but not       22,000  .........
   to exceed 50% of $85,000)......................
Taxable income....................................     63,000     83,000
Income tax rate...................................        48%        50%
Tax...............................................     30,240     41,500
------------------------------------------------------------------------

    (b) Without taking this section into account, M would be allowed a 
foreign tax credit for 1971 of $30,240 ($30,240 x $63,000/$63,000), and 
foreign income tax in the amount of $11,260 ($41,500 less $30,240) would 
first be carried back to 1969 under section 904(d).
    (c) Pursuant to paragraph (a)(1) of this section, however, the 
foreign income tax allowable as a credit against the U.S. tax is reduced 
to $31,900, determined as follows:

Foreign income tax paid on foreign mineral income.............   $41,500
Less reduction under sec. 901(e):
  Smaller of $41,500 (tax paid to country W on          39,840
   foreign mineral income) or $39,840 (U.S. tax on
   foreign mineral income of $83,000 ($83,000 x
   48%), determined by deducting cost depletion of
   $2,000 in lieu of percentage depletion of
   $22,000).........................................
  Less: U.S. tax on foreign mineral income (before     $30,240     9,600
   credit)..........................................
                                                     -------------------
Foreign income tax allowable as a credit......................    31,900
 

    (d) After taking this section into account, M is allowed a foreign 
tax credit for 1971 of $30,240 ($30,240 x $63,000/$63,000). The amount 
of foreign income tax which may be first carried back to 1969 under 
section 904(d) is reduced from $11,260 to $1,660 ($31,900 less $30,240).
    Example 2. (a) M, a domestic corporation using the calendar year as 
the taxable year, is an operator drilling for oil in foreign country X. 
For 1972, M has gross income under chapter 1 of the Code of $100,000, 
all of which is foreign mineral income from a property in country X and 
is subject to the allowance for depletion. During 1972, M incurs 
intangible drilling and development costs of $50,000 which are currently 
deductible for purposes of the U.S. tax but which must be amortized for 
purposes of the tax of country X. Percentage depletion of $22,000 is 
allowed as a deduction by both countries. For purposes of the U.S. tax, 
cost depletion for 1972 amounts to $15,000. It is assumed that no other 
deductions are allowable under the law of either country. Based upon 
these facts, the income tax paid to country X on such foreign mineral 
income is $27,200, and the U.S. tax on such income before allowance of 
the foreign tax credit is $13,440, determined as follows:

------------------------------------------------------------------------
                                                     U.S. tax    X tax
------------------------------------------------------------------------
Foreign mineral income............................   $100,000   $100,000
Less:
  Intangible drilling and development costs.......     50,000     10,000
  Percentage depletion............................     22,000     22,000
Taxable income....................................     28,000     68,000
Income tax rate...................................        48%        40%
Tax...............................................     13,440     27,200
------------------------------------------------------------------------

    (b) Without taking this section into account, M would be allowed a 
foreign tax credit for 1972 of $13,440 ($13,440 x $28,000/$28,000), and 
foreign income tax in the amount of $13,760 ($27,200 less $13,440) would 
first be carried back to 1970 under section 904(d).
    (c) Pursuant to paragraph (a)(1) of this section, however, the 
foreign income tax allowable as a credit against the U.S. tax is reduced 
to $23,840, determined as follows:

Foreign income tax paid on foreign mineral income.............  $27,200
Less reduction under sec. 901(e):
  Smaller of $27,200 (tax paid to country X on         $16,800
   foreign mineral income) or $16,800 (U.S. tax on
   foreign mineral income of $35,000 ($35,000 x
   48%), determined by deducting cost depletion of
   $15,000 in lieu of percentage depletion of
   $22,000).........................................
  Less: U.S. tax on foreign mineral income (before      13,440     3,360
   credit)..........................................
                                                     -------------------
Foreign income tax allowable as a credit......................    23,840
 

    (d) After taking this section into account, M is allowed a foreign 
tax credit of $13,440 ($13,440 x $28,000/$28,000). The amount of foreign 
income tax which may be first carried back to 1970 under section 904(d) 
is reduced from $13,760 to $10,400 ($23,840 less $13,440).
    Example 3. (a) N, a domestic corporation using the calendar year as 
the taxable year, is an operator drilling for oil in foreign country Y. 
For 1972, N's gross income under chapter 1 of the Code is $100,000, all 
of which is foreign mineral income from a property in country Y and is 
subject to the allowance for depletion. During 1972, N incurs intangible 
drilling and development costs of $15,000, which are currently 
deductible for purposes of the U.S. tax but are not deductible under the 
law of country Y. Depreciation of $40,000 is allowed as a deduction for 
purposes of the U.S. tax; and of $20,000, for purposes of the Y tax. 
Cost depletion amounts to $10,000 for purposes of the tax of both 
countries, and only cost depletion is allowed as a deduction under the 
law of country Y. It is assumed that no other deductions are allowable 
under the law of either country. Based upon the facts assumed, the 
income tax paid to country Y on such foreign mineral income is $14,000, 
and the U.S. tax on such income before allowance of the foreign tax 
credit is $11,040, determined as follows:

[[Page 710]]



------------------------------------------------------------------------
                                                     U.S. tax    Y tax
------------------------------------------------------------------------
Foreign mineral income............................   $100,000   $100,000
Less:
  Intangible drilling and development costs.......     15,000  .........
  Depreciation....................................     40,000     20,000
  Cost depletion..................................  .........     10,000
  Percentage depletion (22% of $100,000, but not       22,000  .........
   to exceed 50% of $45,000)......................
  Taxable income..................................     23,000     70,000
  Income tax rate.................................        48%        20%
  Tax.............................................     11,040     14,000
------------------------------------------------------------------------

    (b) Without taking this section into account, N would be allowed a 
foreign tax credit for 1972 of $11,040 ($11,040 x $23,000/$23,000), and 
foreign income tax in the amount of $2,960 ($14,000 less $11,040) would 
first be carried back to 1970 under section 904(d).
    (c) Pursuant to paragraph (a)(1) of this section, however, the 
foreign income tax allowable as a credit against the U.S. tax is reduced 
to $11,040, determined as follows:

Foreign income tax paid on foreign mineral income.............   $14,000
Less reduction under sec. 901(e):
  Smaller of $14,000 (tax paid to country Y on         $14,000
   foreign mineral income) or $16,800 (U.S. tax on
   foreign mineral income of $35,000 ($35,000 x
   48%), determined by deducting cost depletion of
   $10,000 in lieu of percentage depletion of
   $22,000).........................................
  Less: U.S. tax on foreign mineral income (before      11,040     2,960
   credit)..........................................
                                                     -------------------
Foreign income tax allowable as a credit......................    11,040
 

    (d) After taking this section into account, N is allowed a foreign 
tax credit for 1972 of $11,040 ($11,040 x $23,000/$23,000), but no 
foreign income tax is carried back to 1970 under section 904(d) since 
the allowable credit of $11,040 does not exceed the limitation of 
$11,040.
    Example 4. (a) D, a domestic corporation using the calendar year as 
the taxable year, is an operator drilling for oil in foreign country Z. 
For 1971, D's gross income under chapter 1 of the Code is $100,000, all 
of which is foreign mineral income from a property in country Z and is 
subject to the allowance for depletion. During 1971, D incurs intangible 
drilling and development costs of $85,000, which are currently 
deductible for purposes of the U.S. Tax but are not deductible under the 
law of country Z. Cost depletion in the amount of $10,000 is allowed as 
a deduction for purposes of both the U.S. tax and the tax of country Z. 
Percentage depletion is not allowed as a deduction under the law of 
country Z and is not taken as a deduction for purposes of the U.S. tax. 
It is assumed that no other deductions are allowable under the law of 
either country. Based upon the facts assumed, the income tax paid to 
country Z on such foreign mineral income is $27,000, and the U.S. tax on 
such income before allowance of the foreign tax credit is $2,400, 
determined as follows:

------------------------------------------------------------------------
                                                     U.S. tax    Z tax
------------------------------------------------------------------------
Foreign mineral income............................   $100,000   $100,000
Less:
  Intangible drilling and development costs.......     85,000  .........
  Cost depletion..................................     10,000     10,000
Taxable income....................................      5,000     90,000
Income tax rate...................................        48%        30%
Tax...............................................      2,400     27,000
------------------------------------------------------------------------

    (b) Section 901(e) and this section do not apply to reduce the 
amount of the foreign income tax paid to country Z with respect to the 
foreign mineral income since for 1971 D is not allowed the deduction for 
percentage depletion with respect to any foreign mineral income from 
sources within country Z. Accordingly, D is allowed a foreign tax credit 
of $2,400 ($2,400 x $5,000/$5,000), and foreign income tax in the amount 
of $24,600 ($27,000 less $2,400) is first carried back to 1969 under 
section 904(d).
    Example 5. (a) R, a domestic corporation using the calendar year as 
the taxable year, is an operator drilling for oil in the United States 
and in foreign country Z. For 1971, R's gross income under chapter 1 of 
the Code is $250,000, of which $100,000 is foreign mineral income from a 
property in foreign country Z and $150,000 is from a property in the 
United States, all being subject to the allowance for depletion. During 
1971, R incurs intangible drilling and development costs of $125,000 in 
the United States and of $25,000 in country Z, all of which are 
currently deductible for purposes of the U.S. tax. Of these costs of 
$25,000 incurred in country Z, only $2,500 is currently deductible under 
the law of country Z. Cost depletion in the case of the U.S. property 
amounts to $60,000; and in the case of the property in country Z, to 
$5,000, which is allowed as a deduction under the laws of such country. 
Percentage depletion is not allowed as a deduction under the law of 
country Z. In computing the U.S. tax for 1971, R is required to use cost 
depletion with respect to the mineral income from the U.S. property and 
percentage depletion with respect to the foreign mineral income from the 
property in country Z. It is assumed that no other deductions are 
allowed under the law of either country. Based upon the facts assumed, 
the income tax paid to country Z on the foreign mineral income from 
sources therein is $37,000, and the U.S. tax on the entire mineral 
income before allowance of the foreign tax credit is $8,640, determined 
as follows:

------------------------------------------------------------------------
                                                     U.S. tax    Z tax
------------------------------------------------------------------------
Gross income (including foreign mineral income)...   $250,000   $100,000

[[Page 711]]

 
Less:
  Intangible drilling and development costs.......    150,000      2,500
  Cost depletion..................................     60,000      5,000
  Percentage depletion on foreign mineral income       22,000  .........
   (22% of $100,000, but not to exceed 50% of
   [$100,000-$25,000])............................
Taxable income....................................     18,000     92,500
Income tax rate...................................        48%        40%
Tax...............................................      8,640     37,000
------------------------------------------------------------------------

    (b) Without taking this section into account, R would be allowed a 
foreign tax credit for 1971 of $8,640 ($8,640 x $18,000/$18,000), and 
foreign income tax in the amount of $28,360 ($37,000 less $8,640) would 
first be carried back to 1969 under section 904(d).
    (c) Under paragraph (a)(2)(ii) of this section, the amount of the 
U.S. tax for 1971 with respect to foreign mineral income from country Z 
is $25,440, which is the greater of the amounts of tax determined under 
subparagraphs (1) and (2):
    (1) U.S. tax on total taxable income in excess of U.S. tax on 
taxable income excluding foreign mineral income from country Z 
(determined under paragraph (a)(2)(ii)(a) of this section):

U.S. tax on total taxable income..................  .........     $8,640
Less U.S. tax on taxable income other than foreign
 mineral income from country Z:
  Income from U.S. property.......................   $150,000
  Intangible drilling and development costs.......    125,000
  Cost depletion..................................     60,000
  Taxable income..................................          0
  Income tax rate.................................        48%
  U.S. tax........................................          0          0
                                                   ---------------------
Excess tax........................................  .........      8,640
 

    (2) U.S. tax on foreign mineral income from country Z (determined 
under paragraph (a)(2)(ii) (b) of this section):

Foreign mineral income.......................................   $100,000
Intangible drilling and development costs....................     25,000
Percentage depletion (22% of $100,000, but not to exceed 50%      22,000
 of $75,000).................................................
Taxable income...............................................     53,000
Income tax rate..............................................        48%
U.S. tax.....................................................     25,440
 

    (d) Under paragraph (a)(2)(iii) of this section, the amount of the 
U.S. tax which would be computed for 1971 (without regard to section 
613) with respect to foreign mineral income from sources within country 
Z is $33,600, computed by applying the principles of paragraph 
(a)(2)(ii)(b) of this section:

Foreign mineral income.......................................   $100,000
Intangible drilling and development costs....................     25,000
Cost depletion...............................................      5,000
Taxable income...............................................     70,000
Income tax rate..............................................        48%
U.S. tax.....................................................     33,600
 

    (e) Pursuant to paragraph (a)(1) of this section, the foreign income 
tax allowable as a credit against the U.S. tax for 1971 is reduced to 
$28,840, determined as follows:

Foreign income tax paid on foreign mineral income.............   $37,000
Less reduction under sec. 901(e):
  Smaller of $37,000 (tax paid to country Z on         $33,600
   foreign mineral income) or $33,600 (U.S. tax on
   foreign mineral income of $70,000, as determined
   under paragraph (d) of this example..............
  Less: U.S. tax on foreign mineral income of           25,440     8,160
   $53,000, as determined under paragraph (c) of
   this example.....................................
                                                     -------------------
Foreign income tax allowable as a credit......................   $28,840
 

    (f) After taking this section into account, R is allowed a foreign 
tax credit for 1971 of $8,640 ($8,640 x $18,000/$18,000). The amount of 
foreign income tax which may be first carried back to 1969 under section 
904(d) is reduced from $28,360 to $20,200 ($28,840 less $8,640).
    Example 6. (a) B, a single individual using the calendar year as the 
taxable year, is an operator drilling for oil in foreign countries X and 
Y. For 1972, B's gross income under chapter 1 of the Code is $250,000, 
of which $150,000 is foreign mineral income from a property in country X 
and $100,000 is foreign mineral income from a property in country Y, all 
being subject to the allowance for depletion. The assumption is made 
that B's earned taxable income for 1972 is insufficient to cause section 
1348 to apply. During 1972, B incurs intangible drilling and development 
costs of $16,000 in country X and of $9,000 in country Y, which are 
currently deductible for purposes of both the U.S. tax and the tax of 
countries X and Y, respectively. For purposes of both the U.S. tax and 
the tax of countries X and Y, respectively, cost depletion in the case 
of the X property amounts to $8,000, and in the case of Y property, to 
$7,000; and only cost depletion is allowed as a deduction under the law 
of countries X and Y. For 1972, B uses the overall limitation under 
section 904(a)(2) on the foreign tax credit. Percentage depletion is not 
allowed as a deduction under the law of countries X and Y. It is assumed 
that the only other allowable deductions amount to $2,250. None of these 
deductions is attributable to the income from the properties in 
countries X and Y, and none is deductible under the laws of country X or 
country Y. Based upon the facts assumed, the income tax paid to 
countries X and Y on the foreign mineral income from each such country 
is $71,820 and $25,200, respectively, and the U.S. tax on B's total 
taxable income before allowance of the foreign tax credit is $99,990, 
determined as follows:

[[Page 712]]



------------------------------------------------------------------------
                                          U.S. Tax    X tax      Y tax
------------------------------------------------------------------------
Total income (including foreign mineral   $250,000   $150,000   $100,000
 income from countries X and Y)........
Intangible drilling and development         25,000     16,000      9,000
 costs.................................
Cost depletion.........................  .........      8,000      7,000
Percentage depletion (22% of $150,000,      55,000  .........  .........
 but not to exceed 50% of $134,000;
 plus 22% of $100,000, but not to
 exceed 50% of $91,000)................
Adjusted gross income..................    170,000  .........  .........
Other deductions.......................      2,250  .........  .........
Personal exemption.....................        750  .........  .........
Taxable income.........................    167,000    126,000     84,000
Income tax rate........................  .........        57%        30%
Foreign tax............................  .........     71,820     25,200
U.S. tax ($53,090 plus 70% of $67,000).     99,990  .........  .........
------------------------------------------------------------------------

    (b) Without taking this section into account, B would be allowed a 
foreign tax credit for 1972 of $97,020 ($71,820 + $25,200), but not to 
exceed the overall limitation under section 904(a)(2) of $99,990 
($99,990 x $167,750/$167,750). There would be no foreign income tax 
carried back to 1970 under section 904(d) since the allowable credit of 
$97,020 does not exceed the limitation of $99,990.
    (c) Under paragraph (a)(2)(ii) of this section, the amount of the 
U.S. tax for 1972 with respect to foreign mineral income from sources 
within country X is $69,760, which is the greater of the amounts of tax 
determined under subparagraphs (1) and (2):
    (1) U.S. tax on total taxable income in excess of U.S. tax on 
taxable income excluding foreign mineral income from country X 
(determined under paragraph (a)(2)(ii)(a) of this section):

U.S. tax on total taxable income..................  .........    $99,990
Less U.S. tax on taxable income other than foreign
 mineral income from country X:
  Foreign mineral income from country Y...........   $100,000
  Intangible drilling and development costs.......      9,000
  Percentage depletion (22% of $100,000, but not       22,000
   to exceed 50% of $91,000)......................
  Adjusted gross income...........................     69,000
  Other deductions................................      2,250
  Personal exemption..............................        750
  Taxable income..................................     66,000
U.S. tax ($26,390 plus 64% of $6,000).............  .........     30,230
                                                              ----------
Excess tax........................................  .........     69,760
 

    (2) U.S. tax on foreign mineral income from country X (determined 
under paragraph (a)(2)(ii)(b) of this section):

Foreign mineral income from country X......................  $150,000.00
Intangible drilling and development costs..................    16,000.00
Percentage depletion (22% of $150,000, but not to exceed       33,000.00
 50% of $134,000)..........................................
Adjusted gross income......................................   101,000.00
Other deductions...........................................
Taxable income.............................................   101,000.00
U.S. tax ($53,090 plus 70% of excess over $100,000)........    53,790.00
 

    (d) Under paragraph (a)(2)(iii) of this section, and by applying the 
principles of paragraph (a)(2)(ii)(a) of this section, the amount of the 
U.S. tax which would be computed for 1972 (without regard to section 
613) with respect to foreign mineral income from sources within country 
X is $87,920, which is the excess of the U.S. tax ($127,990) determined 
under subparagraph (1) over the U.S. tax ($40,070) determined under 
subparagraph (2):
    (1) U.S. tax on total taxable income determined without regard to 
section 613:

Total income.................................................   $250,000
Intangible drilling and development costs....................     25,000
Cost depletion...............................................     15,000
Adjusted gross income........................................    210,000
Other deductions.............................................      2,250
Personal exemption...........................................        750
Taxable income...............................................    207,000
U.S. tax ($53,090 plus 70% of $107,000)......................    127,990
 

    (2) U.S. tax on total taxable income other than foreign mineral 
income from country X, determined without regard to section 613:

Foreign mineral income from country Y........................   $100,000
Intangible drilling and development costs....................      9,000
Cost depletion...............................................      7,000
Adjusted gross income........................................     84,000
Other deductions.............................................      2,250
Personal exemption...........................................        750
Taxable income...............................................     81,000
U.S. tax ($39,390 plus 68% of $1,000)........................     40,070
 

    (e) Under paragraph (a)(2)(i) of this section, the amount of income 
tax paid to country X for 1972 with respect to foreign mineral income 
from sources within such country is $71,820. This is the amount 
determined under both (a) and (b) of paragraph (a)(2)(i) of this 
section, since, in this case, there is no income from sources within 
country X other than foreign mineral income, and there are no deductions 
allowed under the law of country X which are not allocable to such 
foreign mineral income.
    (f) Pursuant to paragraph (a)(1) of this section, the foreign income 
tax with respect to foreign mineral income from sources within country X 
which is allowable as a credit against the U.S. tax for 1972 is reduced 
to $69,760, determined as follows:

Foreign income tax paid to country X on foreign mineral income   $71,820
Less reduction under sec. 901(e):
  Smaller of $71,820 (tax paid to country X on         $71,820
   foreign mineral income) or $87,920 (U.S. tax on
   foreign mineral income from sources within
   country X, as determined under paragraph (d) of
   this example)....................................
  Less: U.S. tax on foreign mineral income from         69,760     2,060
   sources within country X, determined under
   paragraph (c) of this example....................
                                                     -------------------

[[Page 713]]

 
Foreign income tax of country X allowable as a        ........    69,760
 credit.............................................
 

    (g) Under paragraph (a)(2)(ii) of this section, the amount of the 
U.S. tax for 1972 with respect to foreign mineral income from sources 
within country Y is $48,280, which is the greater of the amounts of tax 
determined under subparagraphs (1) and (2):
    (1) U.S. tax on total taxable income in excess of U.S. tax on 
taxable income excluding foreign mineral income from country Y 
(determined under paragraph (a)(2)(ii)(a) of this section):

U.S. tax on total taxable income..............................   $99,990
  Less U.S. tax on taxable income other than foreign mineral
   income from country Y:
  Foreign mineral income from country X............   $150,000
  Intangible drilling and development costs........     16,000
  Percentage depletion (22% of $150,000, but not to     33,000
   exceed 50% of $134,000).........................
  Adjusted gross income............................    101,000
  Other deductions.................................      2,250
  Personal exemption...............................        750
  Taxable income...................................     98,000
  U.S. tax ($46,190 plus 69% of $8,000)............  .........    51,710
                                                               ---------
Excess tax.........................................  .........    48,280
 

    (2) U.S. tax on foreign mineral income from country Y (determined 
under paragraph (a)(2)(ii)(b) of this section):

Foreign mineral income from country Y........................   $100,000
Intangible drilling and development costs....................      9,000
Percentage depletion (22% of $100,000, but not to exceed 50%      22,000
 of $91,000).................................................
Adjusted gross income........................................     69,000
Other deductions.............................................  .........
Taxable income...............................................     69,000
U.S. tax ($26,390 plus 64% of $9,000)........................     32,150
 

    (h) Under paragraph (a)(2)(iii) of this section, and by applying the 
principles of paragraph (a)(2)(ii)(a) of this section, the amount of the 
U.S. tax which would be computed for 1972 (without regard to section 
613) with respect to foreign mineral income from sources within country 
Y is $58,800, which is the excess of the U.S. tax ($127,990) determined 
under paragraph (d)(1) of this example over the U.S. tax ($69,190) on 
total taxable income other than foreign mineral income from country Y, 
determined without regard to section 613, as follows:

Foreign mineral income from country X........................   $150,000
Intangible drilling and development costs....................     16,000
Cost depletion...............................................      8,000
Adjusted gross income........................................    126,000
Other deductions.............................................      2,250
Personal exemption...........................................        750
Taxable income...............................................    123,000
U.S. tax ($53,090 plus 70% of $23,000).......................     69,190
 

    (i) Under paragraph (a)(2)(i) of this section, the amount of income 
tax paid to country Y for 1972 with respect to foreign mineral income 
from sources within such country is $25,200. This is the amount 
determined under both (a) and (b) of paragraph (a)(2)(i) of this 
section, since, in this case, there is no income from sources within 
country Y other than foreign mineral income, and there are no deductions 
allowed under the law of country Y which are not allocable to such 
foreign mineral income.
    (j) Pursuant to paragraph (a)(1) of this section, the foreign income 
tax with respect to foreign mineral income from sources within country Y 
which is allowable as a credit against the U.S. tax for 1972 is not 
reduced from $25,200, as follows:

Foreign income tax paid to country Y on foreign       ........   $25,200
 mineral income.....................................
Less reduction under sec. 901(e):
  Smaller of $25,200 (tax paid to country Y on         $25,200
   foreign mineral income) or $58,800 (U.S. tax on
   foreign mineral income from sources within
   country Y, as determined under paragraph (h) of
   this example)....................................
  Less: U.S. tax on foreign mineral income from         48,280
   sources within country Y, as determined under
   paragraph (g) of this example....................
                                                     -------------------
Foreign income tax of country Y allowable as a        ........    25,200
 credit.............................................
 

    (k) After taking this section into account, B is allowed a foreign 
tax credit for 1972 of $94,960 ($69,760 + $25,200), but not to exceed 
the overall limitation under section 904 (a)(2) of $99,990 ($99,990 x 
$167,750/$167,750). There would be no foreign income tax carried back to 
1970 under section 904(d) since the allowable credit of $94,960 does not 
exceed the limitation of $99,990.
    Example 7. (a) P, a domestic corporation using the calendar year as 
the taxable year, is an operator mining for iron ore in foreign country 
X. For 1971, P's gross income under chapter 1 of the Code is $100,000, 
all of which is foreign mineral income from a property in country X and 
is subject to the allowance for depletion. For 1971, cost depletion 
amounts to $5,000 for purposes of the tax of both countries, and only 
cost depletion is allowed as a deduction under the law of country X. It 
is assumed that deductions (other than for depletion) attributable to 
the mineral property in country X amount to $8,000, and these deductions 
are allowable under the law of both countries. Based upon the facts 
assumed, the income tax paid to country X on such foreign mineral income 
is $39,150, and the U.S. tax on such income before allowance of the 
foreign tax credit is $37,440 determined as follows:

------------------------------------------------------------------------
                                                     U.S. tax    X tax
------------------------------------------------------------------------
Foreign mineral income............................   $100,000   $100,000
Less:
  Percentage depletion (14% of $100,000, but not       14,000  .........
   to exceed 50% of $92,000)......................
  Cost depletion..................................  .........      5,000
  Other deductions................................      8,000      8,000
Taxable income....................................     78,000     87,000

[[Page 714]]

 
Income tax rate...................................        48%        45%
Tax...............................................     37,440     39,150
------------------------------------------------------------------------

    (b) Without taking this section into account, P would be allowed a 
foreign tax credit for 1971 of $37,440 ($37,440 x $78,000/ $78,000), and 
foreign income tax in the amount of $1,710 ($39,150 less $37,440) would 
first be carried back to 1969 under section 904(d).
    (c) Pursuant to paragraph (a)(1) of this section, however, the 
foreign income tax allowable as a credit against the U.S. tax is reduced 
to $37,440, determined as follows:

Foreign income tax paid on foreign mineral income.............   $39,150
Less reduction under sec. 901(e):
  Smaller of $39,150 (tax paid to country X on         $39,150
   foreign mineral income) or $41,760 (U.S. tax on
   foreign mineral income of $87,000 ($87,000 x
   48%), determined by deducting cost depletion of
   $5,000 in lieu of percentage depletion of
   $14,000).........................................
  Less: U.S. tax on foreign mineral income (before      37,440     1,710
   credit)..........................................
                                                     -------------------
Foreign income tax allowable as a credit......................    37,440
 

    (d) After taking this section into account, P is allowed a foreign 
tax credit for 1971 of $37,440 ($37,440 x $78,000/$78,000), but no 
foreign income tax is carried back to 1969 under section 904(d) since 
the allowable credit of $37,440 does not exceed the limitation of 
$37,440.
    Example 8. (a) The facts are the same as in example 7, except that P 
is assumed to have received dividends for 1971 of $25,000 from R, a 
foreign corporation incorporated in country X which is not a less 
developed country corporation within the meaning of section 902(d). 
Income tax of $2,500 ($25,000 x 10%) on such dividends is withheld at 
the source in country X. It is assumed that P is deemed under section 
902(a)(1) and Sec.  1.902-1(h) to have paid income tax of $22,500 to 
country X in respect of such dividends and that under paragraphs 
(a)(2)(i) and (b)(2)(i) of this section such dividends are deemed to be 
attributable to foreign mineral income from sources in country X and 
that such tax is deemed to be paid with respect to such foreign mineral 
income. Based upon the facts assumed, the U.S. tax on the foreign 
mineral income from sources in country X is $60,240 before allowance of 
the foreign tax credit, determined as follows:

Foreign mineral income from country X:
  Income from mining property.....................   $100,000
  Dividends from R................................     25,000
  Sec. 78 dividend................................     22,500   $147,500
                                                   -----------
Less:
  Percentage depletion (14% of $100,000, but not to exceed       $14,000
   50% of $92,000)...........................................
  Other deductions...........................................      8,000
Taxable income...............................................    125,500
Income tax rate..............................................        48%
U.S. tax.....................................................     60,240
 

    (b) Without taking this section into account, P would be allowed a 
foreign tax credit for 1971 of $60,240 ($60,240 x $125,500/$125,500), 
and foreign income tax in the amount of $3,910 ([$39,150 + $22,500 + 
$2,500] less $60,240) would first be carried back to 1969 under section 
904(d).
    (c) Pursuant to paragraph (a)(1) of this section, however, the 
foreign income tax allowable as a credit against the U.S. tax is reduced 
from $64,150 to $60,240, determined as follows:

Foreign income tax paid, and deemed to be paid, to country X     $64,150
 on foreign mineral income ($39,150 + $22,500 + $2,500)......
Less reduction under sec. 901(e):
  Smaller of $64,150 (tax paid and deemed paid to     $64,150
   country X on foreign mineral income) or $64,560
   (U.S. tax on foreign mineral income of $134,500
   ($134,500 x 48%), determined by deducting cost
   depletion of $5,000 in lieu of percentage
   depletion of $14,000)..........................
  Less: U.S. tax on foreign mineral income (before    $60,240     $3,910
   credit)........................................
                                                   ---------------------
Foreign income tax allowable as a credit.....................     60,240
 

    (d) After taking this section into account, P is allowed a foreign 
tax credit for 1971 of $60,240 ($60,240 x $125,500/$125,500), but no 
foreign income tax is carried back to 1969 under section 904(d) since 
the allowable credit of $60,240 does not exceed the limitation of 
$60,240.

[T.D. 7294, 38 FR 33074, Nov. 30, 1973, as amended by T.D. 7481, 42 FR 
20130, Apr. 18, 1977]



Sec.  1.901(m)-1T  Definitions (temporary).

    (a) Definitions. For purposes of section 901(m), this section, and 
Sec. Sec.  1.901(m)-2T through 1.901(m)-8T, the following definitions 
apply:
    (1)-(5) [Reserved]
    (6) The term basis difference has the meaning provided in Sec.  
1.901(m)-4T.
    (7) The term cost recovery amount has the meaning provided in Sec.  
1.901(m)-5T(b)(2).
    (8) The term covered asset acquisition (or CAA) has the meaning 
provided in Sec.  1.901(m)-2T.
    (9) [Reserved]
    (10) The term disposition means an event (for example, a sale, 
abandonment, or mark-to-market event) that results in gain or loss being 
recognized with respect to an RFA for purposes of U.S. income tax or a 
foreign income tax, or both.

[[Page 715]]

    (11) The term disposition amount has the meaning provided in Sec.  
1.901(m)-5T(c)(2).
    (12) [Reserved]
    (13) The term disregarded entity means an entity that is disregarded 
as an entity separate from its owner, as described in Sec.  301.7701-
2(c)(2)(i) of this chapter.
    (14) The term fiscally transparent entity means an entity, including 
a Disregarded Entity, that is fiscally transparent under the principles 
of Sec.  1.894-1(d)(3) for purposes of U.S. income tax or a foreign 
income tax (or both).
    (15)-(17) [Reserved].
    (18) The term foreign disposition gain means, with respect to a 
foreign income tax, the amount of gain recognized on a disposition of an 
RFA in determining Foreign Income, regardless of whether the gain is 
deferred or otherwise not taken into account currently. Notwithstanding 
the foregoing, if after a section 743(b) CAA there is a disposition of 
an asset that is an RFA with respect to that section 743(b) CAA, foreign 
disposition gain has the meaning provided in Sec.  1.901(m)-
5T(c)(2)(iii).
    (19) The term foreign disposition loss means, with respect to a 
foreign income tax, the amount of loss recognized on a disposition of an 
RFA in determining Foreign Income, regardless of whether the loss is 
deferred or disallowed or otherwise not taken into account currently. 
Notwithstanding the foregoing, if after a section 743(b) CAA there is a 
disposition of an asset that is an RFA with respect to that section 
743(b) CAA, foreign disposition loss has the meaning provided in Sec.  
1.901(m)-5T(c)(2)(iii).
    (20) The term foreign income means, with respect to a foreign income 
tax, the taxable income (or loss) reflected on a foreign tax return (as 
properly amended or adjusted), even if the taxable income (or loss) is 
reported by an entity that is a fiscally transparent entity for purposes 
of the foreign income tax. If, however, foreign law imposes tax on the 
combined income (within the meaning of Sec.  1.901-2(f)(3)(ii)) of two 
or more Foreign Payors, foreign income means the combined taxable income 
(or loss) of such Foreign Payors, regardless of whether such income (or 
loss) is reflected on a single foreign tax return.
    (21) The term foreign income tax means an income, war profits, or 
excess profits tax for which a credit is allowable under section 901 or 
903, except that it does not include any withholding tax determined on a 
gross basis as described in section 901(k)(1)(B).
    (22)-(25) [Reserved]
    (26) The term prior CAA has the meaning provided in Sec.  1.901(m)-
6T(b)(2).
    (27) The term prior section 743(b) CAA has the meaning provided in 
Sec.  1.901(m)-6T(b)(4)(iii).
    (28) The term relevant foreign asset (or RFA) has the meaning 
provided in Sec.  1.901(m)-2T.
    (29)-(32) [Reserved]
    (33) The term section 338 CAA has the meaning provided in Sec.  
1.901(m)-2T(b)(1).
    (34) The term section 743(b) CAA has the meaning provided in Sec.  
1.901(m)-2T(b)(3).
    (35) [Reserved]
    (36) The term subsequent CAA has the meaning provided in Sec.  
1.901(m)-6T(b)(4)(i).
    (37) The term subsequent section 743(b) CAA has the meaning provided 
in Sec.  1.901(m)-6T(b)(4)(iii).
    (38) The term successor transaction has the meaning provided in 
Sec.  1.901(m)-6T(b)(2).
    (39) [Reserved]
    (40) The term unallocated basis difference means, with respect to an 
RFA and a foreign income tax, the basis difference reduced by the sum of 
the cost recovery amounts and the disposition amounts that have been 
computed under Sec.  1.901(m)-5T.
    (41) The term U.S. basis means the adjusted basis of an asset 
determined for U.S. income tax purposes.
    (42) [Reserved].
    (43) The term U.S. disposition gain means the amount of gain 
recognized for U.S. income tax purposes on a disposition of an RFA, 
regardless of whether the gain is deferred or otherwise not taken into 
account currently. Notwithstanding the foregoing, if after a section 
743(b) CAA there is a disposition of an asset that is an RFA with 
respect to that section 743(b) CAA, U.S. disposition gain has the 
meaning provided in Sec.  1.901(m)-5T(c)(2)(iii).

[[Page 716]]

    (44) The term U.S. disposition loss means the amount of loss 
recognized for U.S. income tax purposes on a disposition of an RFA, 
regardless of whether the loss is deferred or disallowed or otherwise 
not taken into account currently. Notwithstanding the foregoing, if 
after a section 743(b) CAA there is a disposition of an asset that is an 
RFA with respect to that section 743(b) CAA, U.S. disposition loss has 
the meaning provided in Sec.  1.901(m)-5T(c)(2)(iii).
    (45) The term U.S. taxable year means a taxable year as defined in 
section 7701(a)(23).
    (b) Effective/applicability date. (1) [Reserved].
    (2) Paragraphs (a)(6), (7), (8), (10), (11), (13), (14), (18), (19), 
(20), (21), (26), (27), (28), (33), (34), (36), (37), (38), (40), (41), 
(43), (44), and (45) of this section apply to CAAs occurring on or after 
July 21, 2014, and to CAAs occurring before that date resulting from an 
entity classification election made under Sec.  301.7701-3 that is filed 
on or after July 29, 2014, and that is effective on or before July 21, 
2014. Paragraphs (a)(6), (7), (8), (10), (11), (13), (14), (18), (19), 
(20), (21), (26), (27), (28), (33), (34), (36), (37), (38), (40), (41), 
(43), (44), and (45) of this section also apply to CAAs occurring on or 
after January 1, 2011, and before July 21, 2014, other than CAAs 
occurring before July 21, 2014, resulting from an entity classification 
election made under Sec.  301.7701-3 that is filed on or after July 29, 
2014, and that is effective on or before July 21, 2014, but only if the 
basis difference (within the meaning of section 901(m)(3)(C)(i)) in one 
or more RFAs with respect to the CAA had not been fully taken into 
account under section 901(m)(3)(B) either as of July 21, 2014, or, in 
the case of an entity classification election made under Sec.  301.7701-
3 that is filed on or after July 29, 2014, and that is effective on or 
before July 21, 2014, prior to the transactions that are deemed to occur 
under Sec.  301.7701-3(g) as a result of the change in classification.
    (3) [Reserved].
    (c) Expiration date. The applicability of this section expires on 
December 6, 2019.

[T.D. 9800, 81 FR 88107, Dec. 7, 2016]



Sec.  1.901(m)-2T  Covered asset acquisitions and relevant foreign assets 
(temporary).

    (a) In general. Paragraph (b) of this section sets forth the 
transactions that are covered asset acquisitions (or CAAs). Paragraph 
(c) of this section provides rules for identifying assets that are 
relevant foreign assets (or RFAs) with respect to a CAA. Paragraph (d) 
of this section provides special rules for identifying CAAs and RFAs 
with respect to transactions to which paragraphs (b) and (c) of this 
section do not apply. Paragraph (e) of this section provides examples 
illustrating the rules of this section. Paragraph (f) of this section 
provides the effective/applicability date, and paragraph (g) of this 
section provides the expiration date.
    (b) Covered asset acquisitions. Except as provided in paragraph (d) 
of this section, the transactions set forth in this paragraph (b) are 
CAAs.
    (1) A qualified stock purchase (as defined in section 338(d)(3)) to 
which section 338(a) applies (section 338 CAA);
    (2) Any transaction that is treated as an acquisition of assets for 
U.S. income tax purposes and as an acquisition of stock of a corporation 
(or the transaction is disregarded) for foreign income tax purposes;
    (3) Any acquisition of an interest in a partnership that has an 
election in effect under section 754 (section 743(b) CAA);
    (4)-(6) [Reserved].
    (c) Relevant foreign asset--(1) In general. Except as provided in 
paragraph (d) of this section, an RFA means, with respect to a foreign 
income tax and a CAA, any asset (including goodwill, going concern 
value, or other intangible) subject to the CAA that is relevant in 
determining foreign income for purposes of the foreign income tax.
    (2) RFA status with respect to a foreign income tax [Reserved].
    (3) Subsequent RFA status with respect to another foreign income tax 
[Reserved].
    (d) Identifying covered asset acquisitions and relevant foreign 
assets to which paragraphs (b) and (c) of this section do not apply. For 
transactions occurring on or after January 1, 2011, and before July 21, 
2014, other than transactions occurring before July 21, 2014, resulting

[[Page 717]]

from an entity classification election made under Sec.  301.7701-3 of 
this chapter that is filed on or after July 29, 2014, and that is 
effective on or before July 21, 2014, the transactions set forth under 
section 901(m)(2) are CAAs and the assets that are relevant foreign 
assets with respect to the CAA under section 901(m)(4) are RFAs.
    (e) Examples. [Reserved].
    (f) Effective/applicability date--(1) Paragraphs (a), (b)(1) through 
(3), and (c)(1) of this section apply to transactions occurring on or 
after July 21, 2014, and to transactions occurring before that date 
resulting from an entity classification election made under Sec.  
301.7701-3 of this chapter that is filed on or after July 29, 2014, and 
that is effective on or before July 21, 2014. Paragraph (d) of this 
section applies to transactions occurring on or after January 1, 2011, 
and before July 21, 2014, other than transactions occurring before July 
21, 2014, resulting from an entity classification election made under 
Sec.  301.7701-3 of this chapter that is filed on or after July 29, 
2014, and that is effective on or before July 21, 2014.
    (2)-(3) [Reserved]
    (g) Expiration date. The applicability of this section expires on 
December 6, 2019.

[T.D. 9800, 81 FR 88108, Dec. 7, 2016]



Sec.  1.901(m)-3T  Disqualified tax amount and aggregate basis 
difference carryover (temporary). [Reserved].



Sec.  1.901(m)-4T  Determination of basis difference (temporary).

    (a) In general. This section provides rules for determining for each 
RFA the basis difference that arises as a result of a CAA. A basis 
difference is computed separately with respect to each foreign income 
tax for which an asset subject to a CAA is an RFA. Paragraph (b) of this 
section provides the general rule for determining basis difference that 
references only U.S. basis in the RFA. Paragraph (c) of this section 
provides for an election to determine basis difference by reference to 
foreign basis and sets forth the procedures for making the election. 
Paragraph (d) of this section provides special rules for determining 
basis difference in the case of a section 743(b) CAA. Paragraph (e) of 
this section provides a special rule for determining basis difference in 
an RFA with respect to a CAA to which paragraphs (b) through (d) of this 
section do not apply. Paragraph (f) of this section provides examples 
illustrating the rules of this section. Paragraph (g) of this section 
provides the effective/applicability date, and paragraph (h) of this 
section provides the expiration date.
    (b) General rule. Except as otherwise provided in paragraphs (c), 
(d), and (e) of this section, basis difference is the U.S. basis in the 
RFA immediately after the CAA, less the U.S. basis in the RFA 
immediately before the CAA. Basis difference is an attribute that 
attaches to an RFA.
    (c) Foreign basis election. [Reserved].
    (d) Determination of basis difference in a section 743(b) CAA--(1) 
In general. Except as provided in paragraphs (d)(2) and (e) of this 
section, if there is a section 743(b) CAA, basis difference is the 
resulting basis adjustment under section 743(b) that is allocated to the 
RFA under section 755.
    (2) Foreign basis election. [Reserved].
    (e) Determination of basis difference in an RFA with respect to a 
CAA with respect to which paragraphs (b), (c), and (d) of this section 
do not apply. For CAAs occurring on or after January 1, 2011, and before 
July 21, 2014, other than CAAs occurring before July 21, 2014, resulting 
from an entity classification election made under Sec.  301.7701-3 of 
this chapter that is filed on or after July 29, 2014, and that is 
effective on or before July 21, 2014, basis difference in an RFA with 
respect to the CAA is the amount of any basis difference (within the 
meaning of section 901(m)(3)(C)(i)) that had not been taken into account 
under section 901(m)(3)(B) either as of July 21, 2014, or, in the case 
of an entity classification election made under Sec.  301.7701-3 of this 
chapter that is filed on or after July 29, 2014, and that is effective 
on or before July 21, 2014, prior to the transactions that are deemed to 
occur under Sec.  301.7701-3(g) as a result of the change in 
classification.
    (f) Examples. [Reserved].
    (g) Effective/applicability date. (1) Paragraphs (a), (b), and 
(d)(1) of this section apply to CAAs occurring on or

[[Page 718]]

after July 21, 2014, and to CAAs occurring before that date resulting 
from an entity classification election made under Sec.  301.7701-3 that 
is filed on or after July 29, 2014, and that is effective on or before 
July 21, 2014. Paragraph (e) of this section applies to CAAs occurring 
on or after January 1, 2011, and before July 21, 2014, other than CAAs 
occurring before July 21, 2014, resulting from an entity classification 
election made under Sec.  301.7701-3 of this chapter that is filed on or 
after July 29, 2014, and that is effective on or before July 21, 2014. 
Taxpayers may, however, consistently apply paragraph (d)(1) of this 
section to all section 743(b) CAAs occurring on or after January 1, 
2011. For this purpose, persons that are related (within the meaning of 
section 267(b) or 707(b)) will be treated as a single taxpayer.
    (2)-(3) [Reserved]
    (h) Expiration date. The applicability of this section expires on 
December 6, 2019.

[T.D. 9800, 81 FR 88108, Dec. 7, 2016]



Sec.  1.901(m)-5T  Basis difference taken into account (temporary).

    (a) In general. [Reserved].
    (b) Basis difference taken into account under applicable cost 
recovery method--(1) In general. [Reserved].
    (2) Determining a cost recovery amount--(i) General rule. A cost 
recovery amount for an RFA is determined by applying the applicable cost 
recovery method to the basis difference rather than to the U.S. basis.
    (ii) U.S. basis subject to multiple cost recovery methods. 
[Reserved].
    (3) Applicable cost recovery method. [Reserved].
    (c) Basis difference taken into account as a result of a 
disposition--(1) In general. [Reserved].
    (2) Determining a disposition amount--(i) Disposition is fully 
taxable for purposes of both U.S. income tax and the foreign income tax. 
If a disposition of an RFA is fully taxable (that is, results in all 
gain or loss, if any, being recognized with respect to the RFA) for 
purposes of both U.S. income tax and the foreign income tax, the 
disposition amount is equal to the unallocated basis difference with 
respect to the RFA.
    (ii) Disposition is not fully taxable for purposes of U.S. income 
tax or the foreign income tax (or both). If the disposition of an RFA is 
not fully taxable for purposes of both U.S. income tax and the foreign 
income tax, the disposition amount is determined under this paragraph 
(c)(2)(ii). See Sec.  1.901(m)-6T for rules regarding the continued 
application of section 901(m) if the RFA has any unallocated basis 
difference after determining the disposition amount under paragraph 
(c)(2)(ii)(A) or (B) of this section, as applicable.
    (A) Positive basis difference. If the disposition of an RFA is not 
fully taxable for purposes of both U.S. income tax and the foreign 
income tax, and the RFA has a positive basis difference, the disposition 
amount equals the lesser of:
    (1) Any foreign disposition gain plus any U.S. disposition loss (for 
this purpose, expressed as a positive amount), or
    (2) Unallocated basis difference with respect to the RFA.
    (B) Negative basis difference. If the disposition of an RFA is not 
fully taxable for purposes of both U.S. income tax and the foreign 
income tax, and the RFA has a negative basis difference, the disposition 
amount equals the greater of:
    (1) Any U.S. disposition gain (for this purpose, expressed as a 
negative amount) plus any foreign disposition loss, or
    (2) Unallocated basis difference with respect to the RFA.
    (iii) Disposition of an RFA after a section 743(b) CAA. If an RFA 
was subject to a section 743(b) CAA and subsequently there is a 
disposition of the RFA, then, for purposes of determining the 
disposition amount, foreign disposition gain or foreign disposition loss 
are specially defined to mean the amount of gain or loss recognized for 
purposes of the foreign income tax on the disposition of the RFA that is 
allocable to the partnership interest that was transferred in the 
section 743(b) CAA. In addition, U.S. disposition gain or U.S. 
disposition loss are specially defined to mean the amount of gain or 
loss recognized for U.S. income tax purposes on the disposition of the 
RFA

[[Page 719]]

that is allocable to the partnership interest that was transferred in 
the section 743(b) CAA, taking into account the basis adjustment under 
section 743(b) that was allocated to the RFA under section 755.
    (d) General rules for allocating and assigning a cost recovery 
amount or a disposition amount when the RFA owner (U.S.) is a fiscally 
transparent entity. [Reserved].
    (e) Special rules for certain section 743(b) CAAs. [Reserved]
    (f) Mid-year transactions. [Reserved]
    (g) Reverse hybrids. [Reserved]
    (h) Examples. [Reserved]
    (i) Effective/applicability date. (1) [Reserved]
    (2) Paragraphs (b)(2)(i) and (c)(2) of this section apply to CAAs 
occurring on or after July 21, 2014, and to CAAs occurring before that 
date resulting from an entity classification election made under Sec.  
301.7701-3 of this chapter that is filed on or after July 29, 2014, and 
that is effective on or before July 21, 2014. Paragraphs (b)(2)(i) and 
(c)(2) of this section also apply to CAAs occurring on or after January 
1, 2011, and before July 21, 2014, other than CAAs occurring before July 
21, 2014, resulting from an entity classification election made under 
Sec.  301.7701-3 that is filed on or after July 29, 2014, and that is 
effective on or before July 21, 2014, but only with respect to basis 
difference determined under Sec.  1.901(m)-4T(e) with respect to the 
CAA.
    (3) [Reserved]
    (j) Expiration date. The applicability of this section expires on 
December 6, 2019.

[T.D. 9800, 81 FR 88109, Dec. 7, 2016]



Sec.  1.901(m)-6T  Successor rules (temporary).

    (a) In general. This section provides successor rules applicable to 
section 901(m). Paragraph (b) of this section provides rules for the 
continued application of section 901(m) after an RFA that has 
unallocated basis difference has been transferred, including special 
rules applicable to successor transactions that are also CAAs or that 
involve partnerships. Paragraph (c) of this section provides rules for 
determining when an aggregate basis difference carryover of a section 
901(m) payor either becomes an aggregate basis difference carryover of 
the section 901(m) payor with respect to another foreign payor or is 
transferred to another section 901(m) payor. Paragraph (d) of this 
section provides the effective/applicability date, and paragraph (e) of 
this section provides the expiration date.
    (b) Successor rules for unallocated basis difference--(1) In 
general. Except as provided in paragraph (b)(4) of this section, section 
901(m) continues to apply after a successor transaction to any 
unallocated basis difference attached to a transferred RFA until the 
entire basis difference has been taken into account as a cost recovery 
amount or a disposition amount (or both) under Sec.  1.901(m)-5T.
    (2) Definition of a successor transaction. A successor transaction 
occurs with respect to an RFA if, after a CAA (prior CAA), there is a 
transfer of the RFA for U.S. income tax purposes and the RFA has 
unallocated basis difference with respect to the prior CAA, determined 
immediately after the transfer. A successor transaction may occur 
regardless of whether the transfer of the RFA is a disposition, a CAA, 
or a non-taxable transaction for purposes of U.S. income tax. If the RFA 
was subject to multiple prior CAAs, a separate determination must be 
made with respect to each prior CAA as to whether the transfer is a 
successor transaction.
    (3) Special considerations. [Reserved].
    (4) Successor transaction is a CAA--(i) In general. An asset may be 
an RFA with respect to multiple CAAs if a successor transaction is also 
a CAA (subsequent CAA). Except as otherwise provided in this paragraph 
(b)(4), if there is a subsequent CAA, unallocated basis difference with 
respect to any prior CAAs will continue to be taken into account under 
section 901(m) after the subsequent CAA. Furthermore, the subsequent CAA 
may give rise to additional basis difference subject to section 901(m).
    (ii) Foreign basis election. [Reserved].
    (iii) Multiple section 743(b) CAAs. If an RFA is subject to two 
section 743(b) CAAs (prior section 743(b) CAA and subsequent section 
743(b) CAA) and the same partnership interest is acquired

[[Page 720]]

in both the CAAs, the RFA will be treated as having no unallocated basis 
difference with respect to the prior section 743(b) CAA if the basis 
difference for the section 743(b) CAA is determined independently from 
the prior section 743(b) CAA. In this regard, see generally Sec.  1.743-
1(f). If the subsequent section 743(b) CAA results from the acquisition 
of only a portion of the partnership interest acquired in the prior 
section 743(b) CAA, then the transferor will be required to equitably 
apportion the unallocated basis difference attributable to the prior 
section 743(b) CAA between the portion retained by the transferor and 
the portion transferred. In this case, with respect to the portion 
transferred, the RFAs will be treated as having no unallocated basis 
difference with respect to the prior section 743(b) CAA if basis 
difference for the subsequent section 743(b) CAA is determined 
independently from the prior section 743(b) CAA.
    (5) Example. The following example illustrates the rules of 
paragraph (b) of this section.

    Example. (i) Facts. USP, a domestic corporation, wholly owns CFC, a 
foreign corporation organized in Country A and treated as a corporation 
for both U.S. and Country A tax purposes. FT is an unrelated foreign 
corporation organized in Country A and treated as a corporation for both 
U.S. and Country A tax purposes. FT owns one asset, a parcel of land 
(Asset). Country A imposes a single tax that is a foreign income tax. On 
January 1, Year 1, CFC acquires all of the stock of FT in exchange for 
300u in a qualified stock purchase (as defined in section 338(d)(3)) to 
which section 338(a) applies (Acquisition). Immediately before the 
Acquisition, Asset had a U.S. basis of 100u, and immediately after the 
Acquisition, Asset had a U.S. basis of 300u. Effective on February 1, 
Year 1, FT elects to be a disregarded entity pursuant to Sec.  301.7701-
3. As a result of the election, FT is deemed, for U.S. income tax 
purposes, to distribute Asset to CFC in liquidation (Deemed Liquidation) 
immediately before the closing of the day before the election is 
effective pursuant to Sec.  301.7701-3(g)(1)(iii) and (3)(ii). The 
Deemed Liquidation is disregarded for Country A tax purposes. No gain or 
loss is recognized on the Deemed Liquidation for either U.S. or Country 
A tax purposes.
    (ii) Result. Under Sec.  1.901(m)-2T(b)(1), the Acquisition by CFC 
of the stock of FT is a section 338 CAA. Under Sec.  1.901(m)-2T(c)(1), 
Asset is an RFA with respect to Country A tax and the Acquisition, 
because immediately after the Acquisition, Asset is relevant in 
determining foreign income of FT for Country A tax purposes, and FT 
owned Asset when the Acquisition occurred. Under Sec.  1.901(m)-4T(b), 
the basis difference with respect to Asset is 200u (300u-100u). Under 
Sec.  1.901(m)-2T(b)(2), the Deemed Liquidation is a CAA (subsequent 
CAA) because the Deemed Liquidation is treated as an acquisition of 
assets for U.S. income tax purposes and is disregarded for Country A tax 
purposes. Because the U.S. basis in Asset is 300u immediately before and 
after the Deemed Liquidation, the subsequent CAA does not give rise to 
any additional basis difference. The Deemed Liquidation is not a 
disposition under Sec.  1.901(m)-1T(a)(10) because it did not result in 
gain or loss being recognized with respect to Asset for U.S. or Country 
A tax purposes. Accordingly, no basis difference with respect to Asset 
is taken into account under Sec.  1.901(m)-5T as a result of the Deemed 
Liquidation, and the unallocated basis difference with respect to Asset 
immediately after the Deemed Liquidation is 200u (200u-0u). Under 
paragraph (b)(2) of this section, the Deemed Liquidation is a successor 
transaction because there is a transfer of Asset for U.S. income tax 
purposes from FT to CFC and Asset has unallocated basis difference with 
respect to the Acquisition immediately after the Deemed Liquidation. 
Accordingly, under paragraph (b)(1) of this section, section 901(m) will 
continue to apply to the unallocated basis difference with respect to 
Asset until the entire 200u basis difference has been taken into account 
under Sec.  1.901(m)-5T.

    (c) Successor rules for aggregate basis difference carryover 
[Reserved].
    (d) Effective/applicability date. (1) Paragraphs (a), (b)(1), 
(b)(2), (b)(4)(i), (b)(4)(iii), and (b)(5) of this section apply to CAAs 
occurring on or after July 21, 2014, and to CAAs occurring before that 
date resulting from an entity classification election made under Sec.  
301.7701-3 of this chapter that is filed on or after July 29, 2014, and 
that is effective on or before July 21, 2014. Paragraphs (a), (b)(1), 
(b)(2), (b)(4)(i), (b)(4)(iii), and (b)(5) of this section also apply to 
CAAs occurring on or after January 1, 2011, and before July 21, 2014, 
other than CAAs occurring before July 21, 2014, resulting from an entity 
classification election made under Sec.  301.7701-3 that is filed on or 
after July 29, 2014, and that is effective on or before July 21, 2014, 
but only with respect to basis difference determined under Sec.  
1.901(m)-4T(e) with respect to the CAA.
    (2)-(3) [Reserved]

[[Page 721]]

    (e) Expiration date. The applicability of this section expires on 
December 6, 2019.

[T.D. 9800, 81 FR 88109, Dec. 7, 2016]



Sec.  1.901(m)-7T  De minimis rules. [Reserved]



Sec.  1.901(m)-8T  Miscellaneous. [Reserved]



Sec.  1.902-0  Outline of regulations provisions for section 902.

    This section lists the provisions under section 902.

  Sec.  1.902-1 Credit for domestic corporate shareholder of a foreign 
  corporation for foreign income taxes paid by the foreign corporation.

    (a) Definitions and special effective date.
    (1) Domestic shareholder.
    (2) First-tier corporation.
    (3) Second-tier corporation.
    (4) Third- or lower-tier corporation.
    (i) Third-tier corporation.
    (ii) Fourth-, fifth-, or sixth-tier corporation.
    (5) Example.
    (6) Upper- and lower-tier corporations.
    (7) Foreign income taxes.
    (8) Post-1986 foreign income taxes.
    (i) In general.
    (ii) Distributions out of earnings and profits accumulated by a 
lower-tier corporation in its taxable years beginning before January 1, 
1987, and included in the gross income of an upper-tier corporation in 
its taxable year beginning after December 31, 1986.
    (iii) Foreign income taxes paid or accrued with respect to high 
withholding tax interest.
    (9) Post-1986 undistributed earnings.
    (i) In general.
    (ii) Distributions out of earnings and profits accumulated by a 
lower-tier corporation in its taxable years beginning before January 1, 
1987, and included in the gross income of an upper-tier corporation in 
its taxable year beginning after December 31, 1986.
    (iii) Reduction for foreign income taxes paid or accrued.
    (iv) Special allocations.
    (10) Pre-1987 accumulated profits.
    (i) Definition.
    (ii) Computation of pre-1987 accumulated profits.
    (iii) Foreign income taxes attributable to pre-1987 accumulated 
profits.
    (11) Dividend.
    (12) Dividend received.
    (13) Special effective date.
    (i) Rule.
    (ii) Example.
    (b) Computation of foreign income taxes deemed paid by a domestic 
shareholder, first-tier corporation, or lower-tier corporation.
    (1) General rule.
    (2) Allocation rule for dividends attributable to post-1986 
undistributed earnings and pre-1987 accumulated profits.
    (i) Portion of dividend out of post-1986 undistributed earnings.
    (ii) Portion of dividend out of pre-1987 accumulated profits.
    (3) Dividends paid out of pre-1987 accumulated profits.
    (4) Deficits in accumulated earnings and profits.
    (5) Examples.
    (c) Special rules.
    (1) Separate computations required for dividends from each first-
tier and lower-tier corporation.
    (i) Rule.
    (ii) Example.
    (2) Section 78 gross-up.
    (i) Foreign income taxes deemed paid by a domestic shareholder.
    (ii) Foreign income taxes deemed paid by an upper-tier corporation.
    (iii) Example.
    (3) Creditable foreign income taxes.
    (4) Foreign mineral income.
    (5) Foreign taxes paid or accrued in connection with the purchase or 
sale of certain oil and gas.
    (6) Foreign oil and gas extraction income.
    (7) United States shareholders of controlled foreign corporations.
    (8) Effect of certain liquidations, reorganizations, or similar 
transactions on certain foreign taxes paid or accrued in taxable years 
beginning on or before August 5, 1997.
    (i) General rule.
    (ii) Example.
    (d) Dividends from controlled foreign corporations and noncontrolled 
section 902 corporations.
    (1) General rule.
    (2) Look-through.
    (i) Dividends.
    (ii) Coordination with section 960.
    (e) Information to be furnished.
    (f) Examples.
    (g) Effective date.

Sec.  1.902-2 Treatment of deficits in post-1986 undistributed earnings 
 and pre-1987 accumulated profits of a first- or lower-tier corporation 
 for purposes of computing an amount of foreign taxes deemed paid under 
                             Sec.  1.902-1.

    (a) Carryback of deficits in post-1986 undistributed earnings of a 
first- or lower-tier corporation to pre-effective date taxable years.
    (1) Rule.
    (2) Examples.
    (b) Carryforward of deficit in pre-1987 accumulated profits of a 
first- or lower-tier corporation to post-1986 undistributed earnings for 
purposes of section 902.
    (1) General rule.

[[Page 722]]

    (2) Effect of pre-effective date deficit.
    (3) Examples.

  Sec.  1.902-3 Credit for domestic corporate shareholder of a foreign 
 corporation for foreign income taxes paid with respect to accumulated 
  profits of taxable years of the foreign corporation beginning before 
                            January 1, 1987.

    (a) Definitions.
    (1) Domestic shareholder.
    (2) First-tier corporation.
    (3) Second-tier corporation.
    (4) Third-tier corporation.
    (5) Foreign income taxes.
    (6) Dividend.
    (7) Dividend received.
    (b) Domestic shareholder owning stock in a first-tier corporation.
    (1) In general.
    (2) Amount of foreign taxes deemed paid by a domestic shareholder.
    (c) First-tier corporation owning stock in a second-tier 
corporation.
    (1) In general.
    (2) Amount of foreign taxes deemed paid by a first-tier corporation.
    (d) Second-tier corporation owning stock in a third-tier 
corporation.
    (1) In general.
    (2) Amount of foreign taxes deemed paid by a second-tier 
corporation.
    (e) Determination of accumulated profits of a foreign corporation.
    (f) Taxes paid on or with respect to accumulated profits of a 
foreign corporation.
    (g) Determination of earnings and profits of a foreign corporation.
    (1) Taxable year to which section 963 does not apply.
    (2) Taxable year to which section 963 applies.
    (3) Time and manner of making choice.
    (4) Determination by district director.
    (h) Source of income from first-tier corporation and country to 
which tax is deemed paid.
    (1) Source of income.
    (2) Country to which taxes deemed paid.
    (i) United Kingdom income taxes paid with respect to royalties.
    (j) Information to be furnished.
    (k) Illustrations.
    (l) Effective date.

   Sec.  1.902-4 Rules for distributions attributable to accumulated 
 profits for taxable years in which a first-tier corporation was a less 
                     developed country corporation.

    (a) In general.
    (b) Combined distributions.
    (c) Distributions of a first-tier corporation attributable to 
certain distributions from second- or third-tier corporations.
    (d) Illustrations.

[T.D. 8708, 62 FR 927, Jan. 7, 1997, as amended by T.D. 9260, Apr. 25, 
2006]



Sec.  1.902-1  Credit for domestic corporate shareholder of 
a foreign corporation for foreign income taxes paid by the foreign corporation.

    (a) Definitions and special effective date. For purposes of section 
902, this section, and Sec.  1.902-2, the definitions provided in 
paragraphs (a) (1) through (12) of this section and the special 
effective date of paragraph (a)(13) of this section apply.
    (1) Domestic shareholder. In the case of dividends received by a 
domestic corporation from a foreign corporation after December 31, 1986, 
the term domestic shareholder means a domestic corporation, other than 
an S corporation as defined in section 1361(a), that owns at least 10 
percent of the voting stock of the foreign corporation at the time the 
domestic corporation receives a dividend from that foreign corporation.
    (2) First-tier corporation. In the case of dividends received by a 
domestic shareholder from a foreign corporation in a taxable year 
beginning after December 31, 1986, the term first-tier corporation means 
a foreign corporation, at least 10 percent of the voting stock of which 
is owned by a domestic shareholder at the time the domestic shareholder 
receives a dividend from that foreign corporation. The term first-tier 
corporation also includes a DISC or former DISC, but only with respect 
to dividends from the DISC or former DISC that are treated under 
sections 861(a)(2)(D) and 862(a)(2) as income from sources without the 
United States.
    (3) Second-tier corporation. In the case of dividends paid to a 
first-tier corporation by a foreign corporation in a taxable year 
beginning after December 31, 1986, the foreign corporation is a second-
tier corporation if, at the time a first-tier corporation receives a 
dividend from that foreign corporation, the first-tier corporation owns 
at least 10 percent of the foreign corporation's voting stock and the 
product of the following equals at least 5 percent--
    (i) The percentage of voting stock owned by the domestic shareholder 
in the first-tier corporation; multiplied by
    (ii) The percentage of voting stock owned by the first-tier 
corporation in the second-tier corporation.

[[Page 723]]

    (4) Third- or lower-tier corporation.-- (i) Third-tier corporation. 
In the case of dividends paid to a second-tier corporation by a foreign 
corporation in a taxable year beginning after December 31, 1986, a 
foreign corporation is a third-tier corporation if, at the time a 
second-tier corporation receives a dividend from that foreign 
corporation, the second-tier corporation owns at least 10 percent of the 
foreign corporation's voting stock and the product of the following 
equals at least 5 percent--
    (A) The percentage of voting stock owned by the domestic shareholder 
in the first-tier corporation; multiplied by
    (B) The percentage of voting stock owned by the first-tier 
corporation in the second-tier corporation; multiplied by
    (C) The percentage of voting stock owned by the second-tier 
corporation in the third-tier corporation.
    (ii) Fourth-, fifth-, or sixth-tier corporation. In the case of 
dividends paid to a third-, fourth-, or fifth-tier corporation by a 
foreign corporation in a taxable year beginning after August 5, 1997, 
the foreign corporation is a fourth-, fifth-, or sixth-tier corporation, 
respectively, if at the time the dividend is paid, the corporation 
receiving the dividend owns at least 10 percent of the foreign 
corporation's voting stock, the chain of foreign corporations that 
includes the foreign corporation is connected through stock ownership of 
at least 10 percent of their voting stock, the domestic shareholder in 
the first-tier corporation in such chain indirectly owns at least 5 
percent of the voting stock of the foreign corporation through such 
chain, such corporation is a controlled foreign corporation (as defined 
in section 957) and the domestic shareholder is a United States 
shareholder (as defined in section 951(b)) in the foreign corporation. 
Taxes paid by a fourth-, fifth-, or sixth-tier corporation shall be 
taken into account in determining post-1986 foreign income taxes only if 
such taxes are paid with respect to taxable years beginning after August 
5, 1997, in which the corporation was a controlled foreign corporation.
    (5) Example. The following example illustrates the ownership 
requirements of paragraphs (a) (1) through (4) of this section:

    Example. (i) Domestic corporation M owns 30 percent of the voting 
stock of foreign corporation A on January 1, 1991, and for all periods 
thereafter. Corporation A owns 40 percent of the voting stock of foreign 
corporation B on January 1, 1991, and continues to own that stock until 
June 1, 1991, when Corporation A sells its stock in Corporation B. Both 
Corporation A and Corporation B use the calendar year as the taxable 
year. Corporation B pays a dividend out of its post-1986 undistributed 
earnings to Corporation A, which Corporation A receives on February 16, 
1991. Corporation A pays a dividend out of its post-1986 undistributed 
earnings to Corporation M, which Corporation M receives on January 20, 
1992. Corporation M uses a fiscal year ending on June 30 as the taxable 
year.
    (ii) On February 16, 1991, when Corporation B pays a dividend to 
Corporation A, Corporation M satisfies the 10 percent stock ownership 
requirement of paragraphs (a) (1) and (2) of this section with respect 
to Corporation A. Therefore, Corporation A is a first-tier corporation 
within the meaning of paragraph (a)(2) of this section and Corporation M 
is a domestic shareholder of Corporation A within the meaning of 
paragraph (a)(1) of this section. Also on February 16, 1991, Corporation 
B is a second-tier corporation within the meaning of paragraph (a)(3) of 
this section because Corporation A owns at least 10 percent of its 
voting stock, and the percentage of voting stock owned by Corporation M 
in Corporation A on February 16, 1991 (30 percent) multiplied by the 
percentage of voting stock owned by Corporation A in Corporation B on 
February 16, 1991 (40 percent) equals 12 percent. Corporation A shall be 
deemed to have paid foreign income taxes of Corporation B with respect 
to the dividend received from Corporation B on February 16, 1991.
    (iii) On January 20, 1992, Corporation M satisfies the 10-percent 
stock ownership requirement of paragraphs (a)(1) and (2) of this section 
with respect to Corporation A. Therefore, Corporation A is a first-tier 
corporation within the meaning of paragraph (a)(2) of this section and 
Corporation M is a domestic shareholder within the meaning of paragraph 
(a)(1) of this section. Accordingly, for its taxable year ending on June 
30, 1992, Corporation M is deemed to have paid a portion of the post-
1986 foreign income taxes paid, accrued, or deemed to be paid, by 
Corporation A. Those taxes will include taxes paid by Corporation B that 
were deemed paid by Corporation A with respect to the dividend paid by 
Corporation B to Corporation A on February 16, 1991, even though 
Corporation B is no longer a second-tier corporation with respect to 
Corporations A and M on January 20, 1992, and has not been a second-

[[Page 724]]

tier corporation with respect to Corporations A and M at any time during 
the taxable years of Corporations A and M that include January 20, 1992.

    (6) Upper- and lower-tier corporations. In the case of a sixth-tier 
corporation, the term upper-tier corporation means a first-, second-, 
third-, fourth-, or fifth-tier corporation. In the case of a fifth-tier 
corporation, the term upper-tier corporation means a first-, second-, 
third-, or fourth-tier corporation. In the case of a fourth-tier 
corporation, the term upper-tier corporation means a first-, second-, or 
third-tier corporation. In the case of a third-tier corporation, the 
term upper-tier corporation means a first- or second-tier corporation. 
In the case of a second-tier corporation, the term upper-tier 
corporation means a first-tier corporation. In the case of a first-tier 
corporation, the term lower-tier corporation means a second-, third-, 
fourth-, fifth-, or sixth-tier corporation. In the case of a second-tier 
corporation, the term lower-tier corporation means a third-, fourth-, 
fifth-, or sixth-tier corporation. In the case of a third-tier 
corporation, the term lower-tier corporation means a fourth-, fifth-, or 
sixth-tier corporation. In the case of a fourth-tier corporation, the 
term lower-tier corporation means a fifth- or sixth-tier corporation. In 
the case of a fifth-tier corporation, the term lower-tier corporation 
means a sixth-tier corporation.
    (7) Foreign income taxes. The term foreign income taxes means 
income, war profits, and excess profits taxes as defined in Sec.  1.901-
2(a), and taxes included in the term income, war profits, and excess 
profits taxes by reason of section 903, that are imposed by a foreign 
country or a possession of the United States, including any such taxes 
deemed paid by a foreign corporation under this section. Foreign income, 
war profits, and excess profits taxes shall not include amounts excluded 
from the definition of those taxes pursuant to section 901 and the 
regulations under that section. See section 901(f) and (i) and paragraph 
(c)(5) of this section. Foreign income, war profits, and excess profits 
taxes also shall not include taxes for which a credit is disallowed 
under section 901 and the regulations under section 901. See section 
901(j), (k), and (l), and paragraphs (c)(4) and (8) of this section.
    (8) Post-1986 foreign income taxes--(i) In general. Except as 
provided in paragraphs (a)(10) and (13) of this section, the term post-
1986 foreign income taxes of a foreign corporation means the sum of the 
foreign income taxes paid, accrued, or deemed paid in the taxable year 
of the foreign corporation in which it distributes a dividend plus the 
foreign income taxes paid, accrued, or deemed paid in the foreign 
corporation's prior taxable years beginning after December 31, 1986, to 
the extent the foreign taxes were not attributable to dividends 
distributed to, or earnings otherwise included (for example, under 
section 304, 367(b), 551, 951(a), 1248, or 1293) in the income of, a 
foreign or domestic shareholder in prior taxable years. Except as 
provided in paragraph (b)(4) of this section, foreign taxes paid or 
deemed paid by the foreign corporation on or with respect to earnings 
that were distributed or otherwise removed from post-1986 undistributed 
earnings in prior post-1986 taxable years shall be removed from post-
1986 foreign income taxes regardless of whether the shareholder is 
eligible to compute an amount of foreign taxes deemed paid under section 
902, and regardless of whether the shareholder in fact chose to credit 
foreign income taxes under section 901 for the year of the distribution 
or inclusion. Thus, if an amount is distributed or deemed distributed by 
a foreign corporation to a United States person that is not a domestic 
shareholder within the meaning of paragraph (a)(1) of this section (for 
example, an individual or a corporation that owns less than 10% of the 
foreign corporation's voting stock), or to a foreign person that does 
not meet the definition of an upper-tier corporation under paragraph 
(a)(6) of this section, then although no foreign income taxes shall be 
deemed paid under section 902, foreign income taxes attributable to the 
distribution or deemed distribution that would have been deemed paid had 
the shareholder met the ownership requirements of paragraphs (a)(1) 
through (4) of this section shall be removed from post-1986 foreign 
income taxes. Further, if a domestic shareholder chooses to deduct 
foreign taxes

[[Page 725]]

paid or accrued for the taxable year of the distribution or inclusion, 
it shall nonetheless be deemed to have paid a proportionate share of the 
foreign corporation's post-1986 foreign income taxes under section 
902(a), and the foreign income taxes deemed paid must be removed from 
post-1986 foreign income taxes. In the case of a foreign corporation the 
foreign income taxes of which are determined based on an accounting 
period of less than one year, the term year means that accounting 
period. See sections 441(b)(3) and 443.
    (ii) Distributions out of earnings and profits accumulated by a 
lower-tier corporation in its taxable years beginning before January 1, 
1987, and included in the gross income of an upper-tier corporation in 
its taxable year beginning after December 31, 1986. Post-1986 foreign 
income taxes shall include foreign income taxes that are deemed paid by 
an upper-tier corporation with respect to distributions from a lower-
tier corporation out of nonpreviously taxed pre-1987 accumulated 
profits, as defined in paragraph (a)(10) of this section, that are 
received by an upper-tier corporation in any taxable year of the upper-
tier corporation beginning after December 31, 1986, provided the upper-
tier corporation's earnings and profits in that year are included in its 
post-1986 undistributed earnings under paragraph (a)(9) of this section. 
Foreign income taxes deemed paid with respect to a distribution of pre-
1987 accumulated profits shall be translated from the functional 
currency of the lower-tier corporation into dollars at the spot exchange 
rate in effect on the date of the distribution. To determine the 
character of the earnings and profits and associated taxes for foreign 
tax credit limitation purposes, see section 904 and Sec.  1.904-7(a).
    (iii) Foreign income taxes paid or accrued with respect to high 
withholding tax interest. Post-1986 foreign income taxes shall not 
include foreign income taxes paid or accrued by a noncontrolled section 
902 corporation (as defined in section 904(d)(2)(E)(i)) in a taxable 
year beginning on or before December 31, 2002 with respect to high 
withholding tax interest (as defined in section 904(d)(2)(B)) to the 
extent the foreign tax rate imposed on such interest exceeds 5 percent. 
See section 904(d)(2)(E)(ii) and Sec.  1.904-4(g)(2)(iii) (26 CFR 
revised as of April 1, 2006). The reduction in foreign income taxes paid 
or accrued by the amount of tax in excess of 5 percent imposed on high 
withholding tax interest income must be computed in functional currency 
before foreign income taxes are translated into U.S. dollars and 
included in post-1986 foreign income taxes.
    (9) Post-1986 undistributed earnings--(i) In general. Except as 
provided in paragraphs (a) (10) and (13) of this section, the term post-
1986 undistributed earnings means the amount of the earnings and profits 
of a foreign corporation (computed in accordance with sections 964(a) 
and 986) accumulated in taxable years of the foreign corporation 
beginning after December 31, 1986, determined as of the close of the 
taxable year of the foreign corporation in which it distributes a 
dividend. Post-1986 undistributed earnings shall not be reduced by 
reason of any earnings distributed or otherwise included in income, for 
example under section 304, 367(b), 551, 951(a), 1248 or 1293, during the 
taxable year. Post-1986 undistributed earnings shall be reduced to 
account for distributions or deemed distributions that reduced earnings 
and profits and inclusions that resulted in previously-taxed amounts 
described in section 959(c) (1) and (2) or section 1293(c) in prior 
taxable years beginning after December 31, 1986. Thus, post-1986 
undistributed earnings shall not be reduced to the extent of the ratable 
share of a controlled foreign corporation's subpart F income, as defined 
in section 952, attributable to a shareholder that is not a United 
States shareholder within the meaning of section 951(b) or section 
953(c)(1)(A), because that amount has not been included in a 
shareholder's gross income. Post-1986 undistributed earnings shall be 
reduced as provided herein regardless of whether any shareholder is 
deemed to have paid any foreign taxes, and regardless of whether any 
domestic shareholder chose to claim a foreign tax credit under section 
901(a) for the year of the distribution. For rules on carrybacks and 
carryforwards of deficits and their

[[Page 726]]

effect on post-1986 undistributed earnings, see Sec.  1.902-2. In the 
case of a foreign corporation the foreign income taxes of which are 
computed based on an accounting period of less than one year, the term 
year means that accounting period. See sections 441(b)(3) and 443.
    (ii) Distributions out of earnings and profits accumulated by a 
lower-tier corporation in its taxable years beginning before January 1, 
1987, and included in the gross income of an upper-tier corporation in 
its taxable year beginning after December 31, 1986. Distributions by a 
lower-tier corporation out of non-previously taxed pre-1987 accumulated 
profits, as defined in paragraph (a)(10) of this section, that are 
received by an upper-tier corporation in any taxable year of the upper-
tier corporation beginning after December 31, 1986, shall be treated as 
post-1986 undistributed earnings of the upper-tier corporation, provided 
the upper-tier corporation's earnings and profits for that year are 
included in its post-1986 undistributed earnings under paragraph 
(a)(9)(i) of this section. To determine the character of the earnings 
and profits and associated taxes for foreign tax credit limitation 
purposes, see section 904 and Sec.  1.904-7(a).
    (iii) Reduction for foreign income taxes paid or accrued. In 
computing post-1986 undistributed earnings, earnings and profits shall 
be reduced by foreign income taxes paid or accrued regardless of whether 
the taxes are creditable. Thus, earnings and profits shall be reduced by 
foreign income taxes paid with respect to high withholding tax interest 
even though a portion of the taxes is not creditable pursuant to section 
904(d)(2)(E)(ii) and is not included in post-1986 foreign income taxes 
under paragraph (a)(8)(iii) of this section. Earnings and profits of an 
upper-tier corporation, however, shall not be reduced by foreign income 
taxes paid by a lower-tier corporation and deemed to have been paid by 
the upper-tier corporation.
    (iv) Special allocations. The term post-1986 undistributed earnings 
means the total amount of the earnings of the corporation determined at 
the corporate level. Special allocations of earnings and taxes to 
particular shareholders, whether required or permitted by foreign law or 
a shareholder agreement, shall be disregarded. If, however, the 
Commissioner establishes that there is an agreement to pay dividends 
only out of earnings in the separate categories for passive or high 
withholding tax interest income, then only taxes imposed on passive or 
high withholding tax interest earnings shall be treated as related to 
the dividend. See Sec.  1.904-6(a)(2).
    (10) Pre-1987 accumulated profits--(i) Definition. The term pre-1987 
accumulated profits means the amount of the earnings and profits of a 
foreign corporation computed in accordance with section 902 and 
attributable to its taxable years beginning before January 1, 1987. If 
the special effective date of paragraph (a)(13) of this section applies, 
pre-1987 accumulated profits also includes any earnings and profits 
(computed in accordance with sections 964(a) and 986) attributable to 
the foreign corporation's taxable years beginning after December 31, 
1986, but before the first day of the first taxable year of the foreign 
corporation in which the ownership requirements of section 902(c)(3)(B) 
and paragraphs (a) (1) through (4) of this section are met with respect 
to that corporation.
    (ii) Computation of pre-1987 accumulated profits. Pre-1987 
accumulated profits must be computed under United States principles 
governing the computation of earnings and profits. Pre-1987 accumulated 
profits are determined at the corporate level. Special allocations of 
accumulated profits and taxes to particular shareholders with respect to 
distributions of pre-1987 accumulated profits in taxable years beginning 
after December 31, 1986, whether required or permitted by foreign law or 
a shareholder agreement, shall be disregarded. Pre-1987 accumulated 
profits of a particular year shall be reduced by amounts distributed 
from those accumulated profits or otherwise included in income from 
those accumulated profits, for example under sections 304, 367(b), 551, 
951(a), 1248 or 1293. If a deficit in post-1986 undistributed earnings 
is carried back to offset pre-1987 accumulated profits, pre-1987 
accumulated profits of a particular taxable year shall be reduced by the 
amount of the deficit carried back to that year.

[[Page 727]]

See Sec.  1.902-2. The amount of a distribution out of pre-1987 
accumulated profits, and the amount of foreign income taxes deemed paid 
under section 902, shall be determined and translated into United States 
dollars by applying the law as in effect prior to the effective date of 
the Tax Reform Act of 1986. See Sec. Sec.  1.902-3, 1.902-4 and 1.964-1.
    (iii) Foreign income taxes attributable to pre-1987 accumulated 
profits. The term pre-1987 foreign income taxes means any foreign income 
taxes paid, accrued, or deemed paid by a foreign corporation on or with 
respect to its pre-1987 accumulated profits. Pre-1987 foreign income 
taxes of a particular year shall be reduced by the amount of taxes paid 
or deemed paid by the foreign corporation on or with respect to amounts 
distributed or otherwise included in income from pre-1987 accumulated 
profits of that year. Thus, pre-1987 foreign income taxes shall be 
reduced by the amount of taxes deemed paid by a domestic shareholder 
(regardless of whether the shareholder chose to credit foreign income 
taxes under section 901 for the year of the distribution or inclusion) 
or a first-tier or second-tier corporation, and by the amount of taxes 
that would have been deemed paid had any other shareholder been eligible 
to compute an amount of foreign taxes deemed paid under section 902. 
Foreign income taxes deemed paid with respect to a distribution of pre-
1987 accumulated profits shall be translated from the functional 
currency of the distributing corporation into United States dollars at 
the spot exchange rate in effect on the date of the distribution.
    (11) Dividend. For purposes of section 902, the definition of the 
term dividend in section 316 and the regulations under that section 
applies. Thus, for example, distributions and deemed distributions under 
sections 302, 304, 305(b) and 367(b) that are treated as dividends 
within the meaning of section 301(c)(1) also are dividends for purposes 
of section 902. In addition, the term dividend includes deemed dividends 
under sections 551 and 1248, but not deemed inclusions under sections 
951(a) and 1293. For rules concerning excess distributions from section 
1291 funds that are treated as dividends solely for foreign tax credit 
purposes, (see Regulation Project INTL-656-87 published in 1992-1 C.B. 
1124; see Sec.  601.601(d)(2)(ii)(b) of this chapter).
    (12) Dividend received. A dividend shall be considered received for 
purposes of section 902 when the cash or other property is unqualifiedly 
made subject to the demands of the distributee. See Sec.  1.301-1(b). A 
dividend also is considered received for purposes of section 902 when it 
is deemed received under section 304, 367(b), 551, or 1248.
    (13) Special effective date--(i) Rule. If the first day on which the 
ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) 
through (4) of this section are met with respect to a foreign 
corporation, without regard to whether a dividend is distributed, is in 
a taxable year of the foreign corporation beginning after December 31, 
1986, then--
    (A) The post-1986 undistributed earnings and post-1986 foreign 
income taxes of the foreign corporation shall be determined by taking 
into account only taxable years beginning on and after the first day of 
the first taxable year of the foreign corporation in which the ownership 
requirements are met, including subsequent taxable years in which the 
ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) 
through (4) of this section are not met; and
    (B) Earnings and profits accumulated prior to the first day of the 
first taxable year of the foreign corporation in which the ownership 
requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) 
of this section are met shall be considered pre-1987 accumulated 
profits.
    (ii) Example. The following example illustrates the special 
effective date rules of this paragraph (a)(13):

    Example. As of December 31, 1991, and since its incorporation, 
foreign corporation A has owned 100 percent of the stock of foreign 
corporation B. Corporation B is not a controlled foreign corporation. 
Corporation B uses the calendar year as its taxable year, and its 
functional currency is the u. Assume 1u equals $1 at all relevant times. 
On April 1, 1992, Corporation B pays a 200u dividend to Corporation A 
and the ownership requirements of section 902(c)(3)(B) and paragraphs 
(a)(1) through (4) of this section are not met

[[Page 728]]

at that time. On July 1, 1992, domestic corporation M purchases 10 
percent of the Corporation B stock from Corporation A and, for the first 
time, Corporation B meets the ownership requirements of section 
902(c)(3)(B) and paragraph (a)(2) of this section. Corporation M uses 
the calendar year as its taxable year. Corporation B does not distribute 
any dividends to Corporation M during 1992. For its taxable year ending 
December 31, 1992, Corporation B has 500u of earnings and profits (after 
foreign taxes but before taking into account the 200u distribution to 
Corporation A) and pays 100u of foreign income taxes that is equal to 
$100. Pursuant to paragraph (a)(13)(i) of this section, Corporation B's 
post-1986 undistributed earnings and post-1986 foreign income taxes will 
include earnings and profits and foreign income taxes attributable to 
Corporation B's entire 1992 taxable year and all taxable years 
thereafter. Thus, the April 1, 1992, dividend to Corporation A will 
reduce post-1986 undistributed earnings to 300u (500u-200u) under 
paragraph (a)(9)(i) of this section. The foreign income taxes 
attributable to the amount distributed as a dividend to Corporation A 
will not be creditable because Corporation A is not a domestic 
shareholder. Post-1986 foreign income taxes, however, will be reduced by 
the amount of foreign taxes attributable to the dividend. Thus, as of 
the beginning of 1993, Corporation B has $60 ($100-[$100 x 40% (200u/
500u)]) of post-1986 foreign income taxes. See paragraphs (a)(8)(i) and 
(b)(1) of this section.

    (b) Computation of foreign income taxes deemed paid by a domestic 
shareholder, first-tier corporation, or lower-tier corporation--(1) 
General rule. If a foreign corporation pays a dividend in any taxable 
year out of post-1986 undistributed earnings to a shareholder that is a 
domestic shareholder or an upper-tier corporation at the time it 
receives the dividend, the recipient shall be deemed to have paid the 
same proportion of any post-1986 foreign income taxes paid, accrued or 
deemed paid by the distributing corporation on or with respect to post-
1986 undistributed earnings which the amount of the dividend out of 
post-1986 undistributed earnings (determined without regard to the 
gross-up under section 78) bears to the amount of the distributing 
corporation's post-1986 undistributed earnings. An upper-tier 
corporation shall not be entitled to compute an amount of foreign taxes 
deemed paid on a dividend from a lower-tier corporation, however, unless 
the ownership requirements of paragraphs (a) (1) through (4) of this 
section are met at each tier at the time the upper-tier corporation 
receives the dividend. Foreign income taxes deemed paid by a domestic 
shareholder or an upper-tier corporation must be computed under the 
following formula:
[GRAPHIC] [TIFF OMITTED] TC07OC91.030

    (2) Allocation rule for dividends attributable to post-1986 
undistributed earnings and pre-1987 accumulated profits--(i) Portion of 
dividend out of post-1986 undistributed earnings. Dividends will be 
deemed to be paid first out of post-1986 undistributed earnings to the 
extent thereof. If dividends exceed post-1986 undistributed earnings and 
dividends are paid to more than one shareholder, then the dividend to 
each shareholder shall be deemed to be paid pro rata out of post-1986 
undistributed earnings, computed as follows:

[[Page 729]]

[GRAPHIC] [TIFF OMITTED] TC07OC91.031

    (ii) Portion of dividend out of pre-1987 accumulated profits. After 
the portion of the dividend attributable to post-1986 undistributed 
earnings is determined under paragraph (b)(2)(i) of this section, the 
remainder of the dividend received by a shareholder is attributable to 
pre-1987 accumulated profits to the extent thereof. That part of the 
dividend attributable to pre-1987 accumulated profits will be treated as 
paid first from the most recently accumulated earnings and profits. See 
Sec.  1.902-3. If dividends paid out of pre-1987 accumulated profits are 
attributable to more than one pre-1987 taxable year and are paid to more 
than one shareholder, then the dividend to each shareholder attributable 
to earnings and profits accumulated in a particular pre-1987 taxable 
year shall be deemed to be paid pro rata out of accumulated profits of 
that taxable year, computed as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.032

    (3) Dividends paid out of pre-1987 accumulated profits. If dividends 
are paid by a first-tier corporation or a lower-tier corporation out of 
pre-1987 accumulated profits, the domestic shareholder or upper-tier 
corporation that receives the dividends shall be deemed to have paid 
foreign income taxes to the extent provided under section 902 and the 
regulations thereunder as in effect prior to the effective date of the 
Tax Reform Act of 1986. See paragraphs (a) (10) and (13) of this section 
and Sec. Sec.  1.902-3 and 1.902-4.
    (4) Deficits in accumulated earnings and profits. No foreign income 
taxes shall be deemed paid with respect to a distribution from a foreign 
corporation out of current earnings and profits that is treated as a 
dividend under section 316(a)(2), and post-1986 foreign income taxes 
shall not be reduced, if as of the end of the taxable year in which the 
dividend is paid or accrued, the corporation has zero or a deficit in 
post-1986 undistributed earnings and the sum of current plus accumulated 
earnings and profits is zero or less than zero. The dividend shall 
reduce post- 1986 undistributed earnings and accumulated earnings and 
profits.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (b):

    Example 1. Domestic corporation M owns 100 percent of foreign 
corporation A. Both Corporation M and Corporation A use the calendar 
year as the taxable year, and Corporation A uses the u as its functional 
currency. Assume that 1u equals $1 at all relevant times. All of 
Corporation A's pre-1987 accumulated profits and post-1986 undistributed 
earnings are non-subpart F general limitation earnings and profits under 
section 904(d)(1)(I). As of December 31, 1992, Corporation A has 100u of 
post-1986 undistributed earnings and $40 of post-1986 foreign income 
taxes. For its 1986 taxable year, Corporation A has accumulated profits 
of 200u (net of foreign taxes) and paid 60u of foreign income taxes on 
those earnings. In 1992, Corporation A distributes 150u to Corporation 
M. Corporation A has 100u of post-1986 undistributed earnings and the 
dividend, therefore, is treated as paid out of post-1986 undistributed 
earnings to the extent of 100u. The first 100u distribution is from 
post-1986 undistributed earnings, and, because the distribution exhausts 
those earnings, Corporation M is deemed to have paid the entire amount 
of post-1986 foreign income taxes of Corporation

[[Page 730]]

A ($40). The remaining 50u dividend is treated as a dividend out of 1986 
accumulated profits under paragraph (b)(2) of this section. Corporation 
M is deemed to have paid $15 (60u x 50u/200u, translated at the 
appropriate exchange rates) of Corporation A's foreign income taxes for 
1986. As of January 1, 1993, Corporation A's post-1986 undistributed 
earnings and post-1986 foreign income taxes are 0. Corporation A has 
150u of accumulated profits and 45u of foreign income taxes remaining in 
1986.
    Example 2. Domestic corporation M (incorporated on January 1, 1987) 
owns 100 percent of foreign corporation A (incorporated on January 1, 
1987). Both Corporation M and Corporation A use the calendar year as the 
taxable year, and Corporation A uses the u as its functional currency. 
Assume that 1u equals $1 at all relevant times. Corporation A has no 
pre-1987 accumulated profits. All of Corporation A's post-1986 
undistributed earnings are non-subpart F general limitation earnings and 
profits under section 904(d)(1)(I). On January 1, 1992, Corporation A 
has a deficit in accumulated earnings and profits and a deficit in post-
1986 undistributed earnings of (200u). No foreign taxes have been paid 
with respect to post-1986 undistributed earnings. During 1992, 
Corporation A earns 100u (net of foreign taxes), pays $40 of foreign 
taxes on those earnings and distributes 50u to Corporation M. As of the 
end of 1992, Corporation A has a deficit of (100u) ((200u) post1986 
undistributed earnings + 100u current earnings and profits) in post-1986 
undistributed earnings. Corporation A, however, has current earnings and 
profits of 100u. Therefore, the 50u distribution is treated as a 
dividend in its entirety under section 316(a)(2). Under paragraph (b)(4) 
of this section, Corporation M is not deemed to have paid any of the 
foreign taxes paid by Corporation A because post-1986 undistributed 
earnings and the sum of current plus accumulated earnings and profits 
are (100u). The dividend reduces both post-1986 undistributed earnings 
and accumulated earnings and profits. Therefore, as of January 1, 1993, 
Corporation A's post-1986 undistributed earnings are (150u) and its 
accumulated earnings and profits are (150u). Corporation A's post-1986 
foreign income taxes at the start of 1993 are $40.

    (c) Special rules--(1) Separate computations required for dividends 
from each first-tier and lower-tier corporation--(i) Rule. If in a 
taxable year dividends are received by a domestic shareholder or an 
upper-tier corporation from two or more first-tier corporations or two 
or more lower-tier corporations, the foreign income taxes deemed paid by 
the domestic shareholder or the upper-tier corporation under sections 
902 (a) and (b) and paragraph (b) of this section shall be computed 
separately with respect to the dividends received from each first-tier 
corporation or lower-tier corporation. If a domestic shareholder 
receives dividend distributions from one or more first-tier corporations 
and in the same taxable year the first-tier corporation receives 
dividends from one or more lower-tier corporations, then the amount of 
foreign income taxes deemed paid shall be computed by starting with the 
lowest-tier corporation and working upward.
    (ii) Example. The following example illustrates the application of 
this paragraph (c)(1):

    Example. P, a domestic corporation, owns 40 percent of the voting 
stock of foreign corporation S. S owns 30 percent of the voting stock of 
foreign corporation T, and 30 percent of the voting stock of foreign 
corporation U. Neither S, T, nor U is a controlled foreign corporation. 
P, S, T and U all use the calendar year as their taxable year. In 1993, 
T and U both pay dividends to S and S pays a dividend to P. To compute 
foreign taxes deemed paid, paragraph (c)(1) of this section requires P 
to start with the lowest tier corporations and to compute foreign taxes 
deemed paid separately for dividends from each first-tier and lower-tier 
corporation. Thus, S first will compute foreign taxes deemed paid 
separately on its dividends from T and U. The deemed paid taxes will be 
added to S's post-1986 foreign income taxes, and the dividends will be 
added to S's post-1986 undistributed earnings. Next, P will compute 
foreign taxes deemed paid with respect to the dividend from S. This 
computation will take into account the taxes paid by T and U and deemed 
paid by S.

    (2) Section 78 gross-up--(i) Foreign income taxes deemed paid by a 
domestic shareholder. Except as provided in section 960(b) and the 
regulations under that section (relating to amounts excluded from gross 
income under section 959(b)), any foreign income taxes deemed paid by a 
domestic shareholder in any taxable year under section 902(a) and 
paragraph (b) of this section shall be included in the gross income of 
the domestic shareholder for the year as a dividend under section 78. 
Amounts included in gross income under section 78 shall, for purposes of 
section 904, be deemed to be derived from sources within the United 
States to the extent the earnings and profits on which the taxes were 
paid are treated under section 904(g) as United States source

[[Page 731]]

earnings and profits. Section 1.904-5(m)(6). Amounts included in gross 
income under section 78 shall be treated for purposes of section 904 as 
income in a separate category to the extent that the foreign income 
taxes were allocated and apportioned to income in that separate 
category. See section 904(d)(3)(G) and Sec.  1.904-6(b)(3).
    (ii) Foreign income taxes deemed paid by an upper-tier corporation. 
Foreign income taxes deemed paid by an upper-tier corporation on a 
distribution from a lower-tier corporation are not included in the 
earnings and profits of the upper-tier corporation. For purposes of 
section 904, foreign income taxes shall be allocated and apportioned to 
income in a separate category to the extent those taxes were allocated 
to the earnings and profits of the lower-tier corporation in that 
separate category. See section 904(d)(3)(G) and Sec.  1.904-6(b)(3). To 
the extent that section 904(g) treats the earnings of the lower-tier 
corporation on which those foreign income taxes were paid as United 
States source earnings and profits, the foreign income taxes deemed paid 
by the upper-tier corporation on the distribution from the lower-tier 
corporation shall be treated as attributable to United States source 
earnings and profits. See section 904(g) and Sec.  1.904-5(m)(6).
    (iii) Example. The following example illustrates the rules of this 
paragraph (c)(2):

    Example. P, a domestic corporation, owns 100 percent of the voting 
stock of controlled foreign corporation S. Corporations P and S use the 
calendar year as their taxable year, and S uses the u as its functional 
currency. Assume that 1u equals $1 at all relevant times. As of January 
1, 1992, S has -0- post-1986 undistributed earnings and -0- post-1986 
foreign income taxes. In 1992, S earns 150u of non-subpart F general 
limitation income net of foreign taxes and pays 60u of foreign income 
taxes. As of the end of 1992, but before dividend payments, S has 150u 
of post-1986 undistributed earnings and $60 of post-1986 foreign income 
taxes. Assume that 50u of S's earnings for 1992 are from United States 
sources. S pays P a dividend of 75u which P receives in 1992. Under 
Sec.  1.904-5(m)(4), one-third of the dividend, or 25u (75u x 50u/150u), 
is United States source income to P. P computes foreign taxes deemed 
paid on the dividend under paragraph (b)(1) of this section of $30 ($60 
x 50%[75u/150u]) and includes that amount in gross income under section 
78 as a dividend. Because 25u of the 75u dividend is United States 
source income to P, $10 ($30 x 33.33%[25u/75u]) of the section 78 
dividend will be treated as United States source income to P under this 
paragraph (c)(2).

    (3) Creditable foreign income taxes. The amount of creditable 
foreign income taxes under section 901 shall include, subject to the 
limitations and conditions of sections 902 and 904, foreign income taxes 
actually paid and deemed paid by a domestic shareholder that receives a 
dividend from a first-tier corporation. Foreign income taxes deemed paid 
by a domestic shareholder under paragraph (b) of this section shall be 
deemed paid by the domestic shareholder only for purposes of computing 
the foreign tax credit allowed under section 901.
    (4) Foreign mineral income. Certain foreign income, war profits and 
excess profits taxes paid or accrued with respect to foreign mineral 
income will not be considered foreign income taxes for purposes of 
section 902. See section 901(e) and Sec.  1.901-3.
    (5) Foreign taxes paid or accrued in connection with the purchase or 
sale of certain oil and gas. Certain income, war profits, or excess 
profits taxes paid or accrued to a foreign country in connection with 
the purchase and sale of oil or gas extracted in that country will not 
be considered foreign income taxes for purposes of section 902. See 
section 901(f).
    (6) Foreign oil and gas extraction income. For rules relating to 
reduction of the amount of foreign income taxes deemed paid with respect 
to foreign oil and gas extraction income, see section 907(a) and the 
regulations under that section.
    (7) United States shareholders of controlled foreign corporations. 
See paragraph (d) of this section and sections 960 and 962 and the 
regulations under those sections for special rules relating to the 
application of section 902 in computing foreign income taxes deemed paid 
by United States shareholders of controlled foreign corporations.
    (8) Effect of certain liquidations, reorganizations, or similar 
transactions on certain foreign taxes paid or accrued in taxable years 
beginning on or before August

[[Page 732]]

5, 1997--(i) General rule. Notwithstanding the effect of any 
liquidation, reorganization, or similar transaction, foreign taxes paid 
or accrued by a member of a qualified group (as defined in section 
902(b)(2)) shall not be eligible to be deemed paid if they were paid or 
accrued in a taxable year beginning on or before August 5, 1997, by a 
corporation that was a fourth-, fifth- or sixth-tier corporation with 
respect to the taxpayer on the first day of the corporation's first 
taxable year beginning after August 5, 1997.
    (ii) Example. The following examples illustrate the application of 
this paragraph (c)(8):

    Example. P, a domestic corporation, has owned 100 percent of the 
voting stock of foreign corporation S at all times since January 1, 
1987. Until June 30, 2002, S owned 100 percent of the voting stock of 
foreign corporation T, T owned 100 percent of the voting stock of 
foreign corporation U, and U owned 100 percent of the voting stock of 
foreign corporation V. P, S, T, U, and V each use the calendar year as 
their U.S. taxable year. Thus, beginning in 1998 V was a fourth-tier 
controlled foreign corporation, and its foreign taxes paid or accrued in 
1998 and later taxable years were eligible to be deemed paid. On June 
30, 2002, T was liquidated, causing S to acquire 100 percent of the 
stock of U. As a result, V became a third-tier controlled foreign 
corporation. In 2003, V paid a dividend to U. Under paragraph (c)(8) of 
this section, foreign taxes paid by V in taxable years beginning before 
1998 are not taken into account in computing the foreign taxes deemed 
paid with respect to the dividend paid by V to U.

    (d) Dividends from controlled foreign corporations and noncontrolled 
section 902 corporations--(1) General rule. If a dividend is described 
in paragraphs (d)(1)(i) through (iv) of this section, the following 
rules apply. If a dividend is paid out of post-1986 undistributed 
earnings or pre-1987 accumulated profits of a foreign corporation 
attributable to more than one separate category, the amount of foreign 
income taxes deemed paid by the domestic shareholder or the upper-tier 
corporation under section 902 and paragraph (b) of this section shall be 
computed separately with respect to the post-1986 undistributed earnings 
or pre-1987 accumulated profits in each separate category out of which 
the dividend is paid. See Sec.  1.904-5(c)(4) and (i), and paragraph 
(d)(2) of this section. The separately computed deemed-paid taxes shall 
be added to other taxes paid by the domestic shareholder or upper-tier 
corporation with respect to income in the appropriate separate category. 
The rules of this paragraph (d)(1) apply to dividends received by --
    (i) A domestic shareholder that is a United States shareholder (as 
defined in section 951(b) or section 953(c)) from a first-tier 
corporation that is a controlled foreign corporation;
    (ii) A domestic shareholder from a first-tier corporation that is a 
noncontrolled section 902 corporation;
    (iii) An upper-tier controlled foreign corporation from a lower-tier 
controlled foreign corporation if the corporations are related look-
through entities within the meaning of Sec.  1.904-5(i) (see Sec.  
1.904-5(i)(3)); or
    (iv) A foreign corporation that is eligible to compute an amount of 
foreign taxes deemed paid under section 902(b)(1), from a controlled 
foreign corporation or a noncontrolled section 902 corporation (that is, 
both the payor and payee corporations are members of the same qualified 
group as defined in section 902(b)(2) (see Sec.  1.904-5 (i)(4)).
    (2) Look-through--(i) Dividends. Any dividend distribution by a 
controlled foreign corporation or noncontrolled section 902 corporation 
to a domestic shareholder or a foreign corporation that is eligible to 
compute an amount of foreign taxes deemed paid under section 902(b)(1) 
shall be deemed paid pro rata out of each separate category of income. 
Any dividend distribution by a controlled foreign corporation to a 
controlled foreign corporation that is a related look-through entity 
within the meaning of Sec.  1.904-5(i)(3) shall also be deemed to be 
paid pro rata out of each separate category of income. See Sec. Sec.  
1.904-5(c)(4) and (i), and 1.904-7. The portion of the foreign income 
taxes attributable to a particular separate category that shall be 
deemed paid by the domestic shareholder or upper-tier corporation must 
be computed under the following formula:

[[Page 733]]

[GRAPHIC] [TIFF OMITTED] TR11JN09.004

    (ii) Coordination with section 960. For rules coordinating the 
computation of foreign taxes deemed paid with respect to amounts 
included in gross income under section 951(a) and dividends distributed 
by a controlled foreign corporation, see section 960 and the regulations 
under that section.
    (e) Information to be furnished. If the credit for foreign income 
taxes claimed under section 901 includes foreign income taxes deemed 
paid under section 902 and paragraph (b) of this section, the domestic 
shareholder must furnish the same information with respect to the 
foreign income taxes deemed paid as it is required to furnish with 
respect to the foreign income taxes it directly paid or accrued and for 
which the credit is claimed. See Sec.  1.905-2. For other information 
required to be furnished by the domestic shareholder for the annual 
accounting period of certain foreign corporations ending with or within 
the shareholder's taxable year, and for reduction in the amount of 
foreign income taxes paid, accrued, or deemed paid for failure to 
furnish the required information, see section 6038 and the regulations 
under that section.
    (f) Examples. The following examples illustrate the application of 
this section:

    Example 1. Since 1987, domestic corporation M has owned 10 percent 
of the one class of stock of foreign corporation A. The remaining 90 
percent of Corporation A's stock is owned by Z, a foreign corporation. 
Corporation A is not a controlled foreign corporation. Corporation A 
uses the u as its functional currency, and 1u equals $1 at all relevant 
times. Both Corporation A and Corporation M use the calendar year as the 
taxable year. In 1992, Corporation A pays a 30u dividend out of post-
1986 undistributed earnings, 3u to Corporation M and 27u to Corporation 
Z. Corporation M is deemed, under paragraph (b) of this section, to have 
paid a portion of the post-1986 foreign income taxes paid by Corporation 
A and includes the amount of foreign taxes deemed paid in gross income 
under section 78 as a dividend. Both the foreign taxes deemed paid and 
the dividend would be subject to a separate limitation for dividends 
from Corporation A, a noncontrolled section 902 corporation. Under 
paragraph (a)(9)(i) of this section, Corporation A must reduce its post-
1986 undistributed earnings as of January 1, 1993, by the total amount 
of dividends paid to Corporation M and Corporation Z in 1992. Under 
paragraph (a)(8)(i) of this section, Corporation A must reduce its post-
1986 foreign income taxes as of January 1, 1993, by the amount of 
foreign income taxes that were deemed paid by Corporation M and by the 
amount of foreign income taxes that would have been deemed paid by 
Corporation Z had Corporation Z been eligible to compute an amount of 
foreign income taxes deemed paid with respect to the dividend received 
from Corporation A. Foreign income taxes deemed paid by Corporation M 
and Corporation A's opening balances in post-1986 undistributed earnings 
and post-1986 foreign income taxes for 1993 are computed as follows:

1. Assumed post-1986 undistributed earnings of     25u
 Corporation A at start of 1992.
2. Assumed post-1986 foreign income taxes of       $25
 Corporation A at start of 1992.
3. Assumed pre-tax earnings and profits of         50u
 Corporation A for 1992.
4. Assumed foreign income taxes paid or accrued    15u
 by Corporation A in 1992.
5. Post-1986 undistributed earnings in             60u
 Corporation A for 1992 (pre-dividend) (Line 1
 plus Line 3 minus Line 4).
6. Post-1986 foreign income taxes in Corporation   $40
 A for 1992 (pre-dividend) (Line 2 plus Line 4
 translated at the appropriate exchange rates).
7. Dividends paid out of post-1986 undistributed   3u
 earnings of Corporation A to Corporation M in
 1992.
8. Percentage of Corporation A's post-1986         5%
 undistributed earnings paid to Corporation M
 (Line 7 divided by Line 5).
9. Foreign income taxes of Corporation A deemed    $2
 paid by Corporation M under section 902(a) (Line
 6 multiplied by Line 8).
10. Total dividends paid out of post-1986          30u
 undistributed earnings of Corporation A to all
 shareholders in 1992.
11. Percentage of Corporation A's post-1986        50%
 undistributed earnings paid to all shareholders
 in 1992 (Line 10 divided by Line 5).
12. Post-1986 foreign income taxes paid with       $20
 respect to post-1986 undistributed earnings
 distributed to all shareholders in 1992 (Line 6
 multiplied by Line 11).
13. Corporation A's post-1986 undistributed        30u
 earnings at the start of 1993 (Line 5 minus Line
 10).
14. Corporation A's post-1986 foreign income       $20
 taxes at the start of 1993 (Line 6 minus Line
 12).
 


[[Page 734]]

    Example 2. (i) The facts are the same as in Example 1, except that 
Corporation M has also owned 10 percent of the one class of stock of 
foreign corporation B since 1987. Corporation B uses the calendar year 
as the taxable year. The remaining 90 percent of Corporation B's stock 
is owned by Corporation Z. Corporation B is not a controlled foreign 
corporation. Corporation B uses the u as its functional currency, and 1u 
equals $1 at all relevant times. In 1992, Corporation B has earnings and 
profits and pays foreign income taxes, a portion of which are 
attributable to high withholding tax interest, as defined in section 
904(d)(2)(B)(i). Corporation B must reduce its pool of post-1986 foreign 
income taxes by the amount of tax imposed on high withholding tax 
interest in excess of 5 percent because that amount is not treated as a 
tax for purposes of section 902. See section 904(d)(2)(E)(ii) and 
paragraph (a)(8)(iii) of this section. Corporation B pays 50u in 
dividends in 1992, 5u to Corporation M and 45u to Corporation Z. 
Corporation M must compute its section 902(a) deemed paid taxes 
separately for the dividends it receives in 1992 from Corporation A (as 
computed in Example 1) and from Corporation B. Foreign income taxes of 
Corporation B deemed paid by Corporation M, and Corporation B's opening 
balances in post-1986 undistributed earnings and post-1986 foreign 
income taxes for 1993 are computed as follows:

1. Assumed post-1986 undistributed earnings of     (100u)
 Corporation B at start of 1992.
2. Assumed post-1986 foreign income taxes of       $0
 Corporation B at start of 1992.
3. Assumed pre-tax earnings and profits of         302.50u
 Corporation B for 1992 (including 50u of high
 withholding tax interest on which 5u of tax is
 withheld).
4. Assumed foreign income taxes paid or accrued    102.50u
 by Corporation B in 1992.
5. Post-1986 undistributed earnings in             100u
 Corporation B for 1992 (pre-dividend) (Line 1
 plus Line 3 minus Line 4).
6. Amount of foreign income tax of Corporation B   2.50u
 imposed on high withholding tax interest in
 excess of 5% (5u withholding tax--[5% x 50u high
 withholding tax interest]).
7. Post-1986 foreign income taxes in Corporation   $100
 B for 1992 (pre-dividend) (Line 2 plus [Line 4
 minus Line 6 translated at the appropriate
 exchange rate]).
8. Dividends paid out of post-1986 undistributed   5u
 earnings to Corporation M in 1992.
9. Percentage of Corporation B's post-1986         5%
 undistributed earnings paid to Corporation M
 (Line 8 divided by Line 5).
10. Foreign income taxes of Corporation B deemed   $5
 paid by Corporation M under section 902(a) (Line
 7 multiplied by Line 9).
11. Total dividends paid out of post-1986          50u
 undistributed earnings of Corporation B to all
 shareholders in 1992.
12. Percentage of Corporation B's post-1986        50%
 undistributed earnings paid to all shareholders
 in 1992 (Line 11 divided by Line 5).
13. Post-1986 foreign income taxes of Corporation  $50
 B paid on or with respect to post-1986
 undistributed earnings distributed to all
 shareholders in 1992 (Line 7 multiplied by Line
 12).
14. Corporation B's post-1986 undistributed        50u
 earnings at start of 1993 (Line 5 minus Line 11).
15. Corporation B's post-1986 foreign income       $50
 taxes at start of 1993 (Line 7 minus Line 13).
 

    (ii) For 1992, as computed in Example 1, Corporation M is deemed to 
have paid $2 of the post-1986 foreign income taxes paid by Corporation A 
and includes $2 in gross income as a dividend under section 78. Both the 
income inclusion and the credit are subject to a separate limitation for 
dividends from Corporation A, a noncontrolled section 902 corporation. 
Corporation M also is deemed to have paid $5 of the post-1986 foreign 
income taxes paid by Corporation B and includes $5 in gross income as a 
deemed dividend under section 78. Both the income inclusion and the 
foreign taxes deemed paid are subject to a separate limitation for 
dividends from Corporation B, a noncontrolled section 902 corporation.
    Example 3. (i) Since 1987, domestic corporation M has owned 50 
percent of the one class of stock of foreign corporation A. The 
remaining 50 percent of Corporation A is owned by foreign corporation Z. 
For the same time period, Corporation A has owned 40 percent of the one 
class of stock of foreign corporation B, and Corporation B has owned 30 
percent of the one class of stock of foreign corporation C. The 
remaining 60 percent of Corporation B is owned by foreign corporation Y, 
and the remaining 70 percent of Corporation C is owned by foreign 
corporation X. Corporations A, B, and C are not controlled foreign 
corporations. Corporations A, B, and C use the u as their functional 
currency, and 1u equals $1 at all relevant times. Corporation B uses a 
fiscal year ending June 30 as its taxable year; all other corporations 
use the calendar year as the taxable year. On February 1, 1992, 
Corporation C pays a 500u dividend out of post-1986 undistributed 
earnings, 150u to Corporation B and 350u to Corporation X. On February 
15, 1992, Corporation B pays a 300u dividend out of post-1986 
undistributed earnings computed as of the close of Corporation B's 
fiscal year ended June 30, 1992, 120u to Corporation A and 180u to 
Corporation Y. On August 15, 1992, Corporation A pays a 200u dividend 
out of post-1986 undistributed earnings, 100u to Corporation M and 100u 
to Corporation Z. In computing foreign taxes deemed paid by Corporations 
B and A, section 78 does not apply and Corporations B and A thus do not 
have to include the foreign taxes deemed paid in earnings and profits. 
See paragraph (c)(2)(ii)

[[Page 735]]

of this section. Foreign income taxes deemed paid by Corporations B, A 
and M, and the foreign corporations' opening balances in post-1986 
undistributed earnings and post-1986 foreign income taxes for 
Corporation B's fiscal year beginning July 1, 1992, and Corporation C's 
and Corporation A's 1993 calendar years are computed as follows:

A. Corporation C (third-tier corporation):
    1. Assumed post-1986 undistributed earnings    1300u
     in Corporation C at start of 1992.
    2. Assumed post-1986 foreign income taxes in   $500
     Corporation C at start of 1992.
    3. Assumed pre-tax earnings and profits of     500u
     Corporation C for 1992.
    4. Assumed foreign income taxes paid or        300u
     accrued in 1992.
    5. Post-1986 undistributed earnings in         1500u
     Corporation C for 1992 (pre-dividend) (Line
     1 plus Line 3 minus Line 4).
    6. Post-1986 foreign income taxes in           $800
     Corporation C for 1992 (pre-dividend) (Line
     2 plus Line 4 translated at the appropriate
     exchange rates).
    7. Dividends paid out of post-1986             150u
     undistributed earnings of Corporation C to
     Corporation B in 1992.
    8. Percentage of Corporation C's post-1986     10%
     undistributed earnings paid to Corporation B
     (Line 7 divided by Line 5).
    9. Foreign income taxes of Corporation C       $80
     deemed paid by Corporation B under section
     902(b)(2) (Line 6 multiplied by Line 8).
    10. Total dividends paid out of post-1986      500u
     undistributed earnings of Corporation C to
     all shareholders in 1992.
    11. Percentage of Corporation C's post-1986    33.33%
     undistributed earnings paid to all
     shareholders in 1992 (Line 10 divided by
     Line 5).
    12. Post-1986 foreign income taxes paid with   $266.66
     respect to post-1986 undistributed earnings
     distributed to all shareholders in 1992
     (Line 6 multiplied by Line 11).
    13. Post-1986 undistributed earnings in        1000u
     Corporation C at start of 1993 (Line 5 minus
     Line 10).
    14. Post-1986 foreign income taxes in          $533.34
     Corporation C at start of 1993 (Line 6 minus
     Line 12).
B. Corporation B (second-tier corporation):
    1. Assumed post-1986 undistributed earnings    0
     in Corporation B as of July 1, 1991.
    2. Assumed post-1986 foreign income taxes in   0
     Corporation B as of July 1, 1991.
    3. Assumed pre-tax earnings and profits of     1000u
     Corporation B for fiscal year ended June 30,
     1992, (including 150u dividend from
     Corporation B).
    4. Assumed foreign income taxes paid or        200u
     accrued by Corporation B in fiscal year
     ended June 30, 1992.
    5. Foreign income taxes of Corporation C       $80
     deemed paid by Corporation B in its fiscal
     year ended June 30, 1992 (Part A, Line 9 of
     paragraph (i) of this Example 3).
    6. Post-1986 undistributed earnings in         800u
     Corporation B for fiscal year ended June 30,
     1992 (pre-dividend) (Line 1 plus Line 3
     minus Line 4).
    7. Post-1986 foreign income taxes in           $280
     Corporation B for fiscal year ended June 30,
     1992 (pre-dividend) (Line 2 plus Line 4
     translated at the appropriate exchange rates
     plus Line 5).
    8. Dividends paid out of post-1986             120u
     undistributed earnings of Corporation B to
     Corporation A on February 15, 1992.
    9. Percentage of Corporation B's post-1986     15%
     undistributed earnings for fiscal year ended
     June 30, 1992, paid to Corporation A (Line 8
     divided by Line 6).
    10. Foreign income taxes paid and deemed paid  $42
     by Corporation B as of June 30, 1992, deemed
     paid by Corporation A under section
     902(b)(1) (Line 7 multiplied by Line 9).
    11. Total dividends paid out of post-1986      300u
     undistributed earnings of Corporation B for
     fiscal year ended June 30, 1992.
    12. Percentage of Corporation B's post-1986    37.5%
     undistributed earnings for fiscal year ended
     June 30, 1992, paid to all shareholders
     (Line 11 divided by Line 6).
    13. Post-1986 foreign income taxes paid and    $105
     deemed paid with respect to post-1986
     undistributed earnings distributed to all
     shareholders during Corporation B's fiscal
     year ended June 30, 1992 (Line 7 multiplied
     by Line 12).
    14. Post-1986 undistributed earnings in        500u
     Corporation B as of July 1, 1992 (Line 6
     minus Line 11).
    15. Post-1986 foreign income taxes in          $175
     Corporation B as of July 1, 1992 (Line 7
     minus Line 13).
C. Corporation A (first-tier corporation):
    1. Assumed post-1986 undistributed earnings    250u
     in Corporation A at start of 1992.
    2. Assumed post-1986 foreign income taxes in   $100
     Corporation A at start of 1992.
    3. Assumed pre-tax earnings and profits of     250u
     Corporation A for 1992 (including 120u
     dividend from Corporation B).
    4. Assumed foreign income taxes paid or        100u
     accrued by Corporation A in 1992.
    5. Foreign income taxes paid or deemed paid    $42
     by Corporation B as of June 30, 1992, that
     are deemed paid by Corporation A in 1992
     (Part B, Line 10 of paragraph (i) of this
     Example 3).
    6. Post-1986 undistributed earnings in         400u
     Corporation A for 1992 (pre-dividend) (Line
     1 plus Line 3 minus Line 4).
    7. Post-1986 foreign income taxes in           $242
     Corporation A for 1992 (pre-dividend) (Line
     2 plus Line 4 translated at the appropriate
     exchange rates plus Line 5).
    8. Dividends paid out of post-1986             100u
     undistributed earnings of Corporation A to
     Corporation M on August 15, 1992.
    9. Percentage of Corporation A's post-1986     25%
     undistributed earnings paid to Corporation M
     in 1992 (Line 8 divided by Line 6).
    10. Foreign income taxes paid and deemed paid  $60.50
     by Corporation A in 1992 that are deemed
     paid by Corporation M under section 902(a)
     (Line 7 multiplied by Line 9).
    11. Total dividends paid out of post-1986      200u
     undistributed earnings of Corporation A to
     all shareholders in 1992.
    12. Percentage of Corporation A's post-1986    50%
     undistributed earnings paid to all
     shareholders in 1992 (Line 11 divided by
     Line 6).

[[Page 736]]

 
    13. Post-1986 foreign income taxes paid and    $121
     deemed paid by Corporation A with respect to
     post-1986 undistributed earnings distributed
     to all shareholders in 1992 (Line 7
     multiplied by Line 12).
    14. Post-1986 undistributed earnings in        200u
     Corporation A at start of 1993 (Line 6 minus
     Line 11).
    15. Post-1986 foreign income taxes in          $121
     Corporation A at start of 1993 (Line 7 minus
     Line 13).
 

    (ii) Corporation M is deemed, under section 902(a) and paragraph (b) 
of this section, to have paid $60.50 of post-1986 foreign income taxes 
paid, or deemed paid, by Corporation A on or with respect to its post-
1986 undistributed earnings (Part C, Line 10) and Corporation M includes 
that amount in gross income as a dividend under section 78. Both the 
income inclusion and the credit are subject to a separate limitation for 
dividends from Corporation A, a noncontrolled section 902 corporation.
    Example 4. (i) Since 1987, domestic corporation M has owned 100 
percent of the voting stock of controlled foreign corporation A, and 
Corporation A has owned 100 percent of the voting stock of controlled 
foreign corporation B. Corporations M, A and B use the calendar year as 
the taxable year. Corporations A and B are organized in the same foreign 
country and use the u as their functional currency. 1u equals $1 at all 
relevant times. Assume that all of the earnings of Corporations A and B 
are general limitation earnings and profits within the meaning of 
section 904(d)(2)(I), and that neither Corporation A nor Corporation B 
has any previously taxed income accounts. In 1992, Corporation B pays a 
dividend of 150u to Corporation A out of post-1986 undistributed 
earnings, and Corporation A computes an amount of foreign taxes deemed 
paid under section 902(b)(1). The dividend is not subpart F income to 
Corporation A because section 954(c)(3)(B)(i) (the same country dividend 
exception) applies. Pursuant to paragraph (c)(2)(ii) of this section, 
Corporation A is not required to include the deemed paid taxes in 
earnings and profits. Corporation A has no pre-1987 accumulated profits 
and a deficit in post-1986 undistributed earnings for 1992. In 1992, 
Corporation A pays a dividend of 100u to Corporation M out of its 
earnings and profits for 1992 (current earnings and profits). Under 
paragraph (b)(4) of this section, Corporation M is not deemed to have 
paid any of the foreign income taxes paid or deemed paid by Corporation 
A because Corporation A has a deficit in post-1986 undistributed 
earnings as of December 31, 1992, and the sum of its current plus 
accumulated profits is less than zero. Note that if instead of paying a 
dividend to Corporation A in 1992, Corporation B had made an additional 
investment of $150 in United States property under section 956, that 
amount would have been included in gross income by Corporation M under 
section 951(a)(1)(B) and Corporation M would have been deemed to have 
paid $50 of foreign income taxes paid by Corporation B. See sections 
951(a)(1)(B) and 960. Foreign income taxes of Corporation B deemed paid 
by Corporation A and the opening balances in post-1986 undistributed 
earnings and post-1986 foreign income taxes for Corporation A and 
Corporation B for 1993 are computed as follows:

A. Corporation B (second-tier corporation):
    1. Assumed post-1986 undistributed earnings    200u
     in Corporation B at start of 1992.
    2. Assumed post-1986 foreign income taxes in   $50
     Corporation B at start of 1992.
    3. Assumed pre-tax earnings and profits of     150u
     Corporation B for 1992.
    4. Assumed foreign income taxes paid or        50u
     accrued in 1992.
    5. Post-1986 undistributed earnings in         300u
     Corporation B for 1992 (pre-dividend) (Line
     1 plus Line 3 minus Line 4).
    6. Post-1986 foreign income taxes in           $100
     Corporation B for 1992 (pre-dividend) (Line
     2 plus Line 4 translated at the appropriate
     exchange rates).
    7. Dividends paid out of post-1986             150u
     undistributed earnings of Corporation B to
     Corporation A in 1992.
    8. Percentage of Corporation B's post-1986     50%
     undistributed earnings paid to Corporation A
     (Line 7 divided by Line 5).
    9. Foreign income taxes of Corporation B       $50
     deemed paid by Corporation A under section
     902(b)(1) (Line 6 multiplied by Line 8).
    10. Post-1986 undistributed earnings in        150u
     Corporation B at start of 1993 (Line 5 minus
     Line 7).
    11. Post-1986 foreign income taxes in          $50
     Corporation B at start of 1993 (Line 6 minus
     Line 9).
B. Corporation A (first-tier corporation):
    1. Assumed post-1986 undistributed earnings    (200u)
     in Corporation A at start of 1992.
    2. Assumed post-1986 foreign income taxes in   0
     Corporation A at start of 1992.
    3. Assumed pre-tax earnings and profits of     200u
     Corporation A for 1992 (including 150u
     dividend from Corporation B).
    4. Assumed foreign income taxes paid or        40u
     accrued by Corporation A in 1992.
    5. Foreign income taxes paid by Corporation B  $50
     in 1992 that are deemed paid by Corporation
     A (Part A, Line 9 of paragraph (i) of this
     Example 4).
    6. Post-1986 undistributed earnings in         (40u)
     Corporation A for 1992 (pre-dividend) (Line
     1 plus Line 3 minus Line 4).
    7. Post-1986 foreign income taxes in           $90
     Corporation A for 1992 (pre-dividend) (Line
     2 plus Line 4 translated at the appropriate
     exchange rates plus Line 5).
    8. Dividends paid out of current earnings and  100u
     profits of Corporation A for 1992.
    9. Percentage of post-1986 undistributed       0
     earnings of Corporation A paid to
     Corporation M in 1992 (Line 8 divided by the
     greater of Line 6 or zero).

[[Page 737]]

 
    10. Foreign income taxes paid and deemed paid  0
     by Corporation A in 1992 that are deemed
     paid by Corporation M under section 902(a)
     (Line 7 multiplied by Line 9).
    11. Post-1986 undistributed earnings in        (140u)
     Corporation A at start of 1993 (line 6 minus
     line 8).
    12. Post-1986 foreign income taxes in          $90
     Corporation A at start of 1993 (Line 7 minus
     Line 10).
 

    (ii) For 1993, Corporation A has 500u of earnings and profits on 
which it pays 160u of foreign income taxes. Corporation A receives no 
dividends from Corporation B, and pays a 100u dividend to Corporation M. 
The 100u dividend to Corporation M carries with it some of the foreign 
income taxes paid and deemed paid by Corporation A in 1992, which were 
not deemed paid by Corporation M in 1992 because Corporation A had no 
post-1986 undistributed earnings. Thus, for 1993, Corporation M is 
deemed to have paid $125 of post-1986 foreign income taxes paid and 
deemed paid by Corporation A and includes that amount in gross income as 
a dividend under section 78, determined as follows:

1. Post-1986 undistributed earnings in             (140u)
 Corporation A at start of 1993.
2. Post-1986 foreign income taxes in Corporation   $90
 A at start of 1993.
3. Pre-tax earnings and profits of Corporation A   500u
 for 1993.
4. Foreign income taxes paid or accrued by         160u
 Corporation A in 1993.
5. Post-1986 undistributed earnings in             200u
 Corporation A for 1993 (pre-dividend) (Line 1
 plus Line 3 minus Line 4).
6. Post-1986 foreign income taxes in Corporation   $250
 A for 1993 (pre-dividend) (Line 2 plus Line 4
 translated at the appropriate exchange rates).
7. Dividends paid out of post-1986 undistributed   100u
 earnings of Corporation A to Corporation M in
 1993.
8. Percentage of post-1986 undistributed earnings  50%
 of Corporation A paid to Corporation M in 1993
 (Line 7 divided by Line 5).
9. Foreign income taxes paid and deemed paid by    $125
 Corporation A that are deemed paid by
 Corporation M in 1993 (Line 6 multiplied by Line
 8).
10. Post-1986 undistributed earnings in            100u
 Corporation A at start of 1994 (Line 5 minus
 Line 7).
11. Post-1986 foreign income taxes in Corporation  $125
 A at start of 1994 (Line 6 minus Line 9).
 

    Example 5. (i) Since 1987, domestic corporation M has owned 100 
percent of the voting stock of controlled foreign corporation A. 
Corporation M also conducts operations through a foreign branch. Both 
Corporation A and Corporation M use the calendar year as the taxable 
year. Corporation A uses the u as its functional currency and 1u equals 
$1 at all relevant times. Corporation A has no subpart F income, as 
defined in section 952, and no increase in earnings invested in United 
States property under section 956 for 1992. Corporation A also has no 
previously taxed income accounts. Corporation A has general limitation 
income and high withholding tax interest income that, by operation of 
section 954(b)(4), does not constitute foreign base company income under 
section 954(a). Because Corporation A is a controlled foreign 
corporation, it is not required to reduce post-1986 foreign income taxes 
by foreign taxes paid or accrued with respect to high withholding tax 
interest in excess of 5 percent. See Sec.  1.902-1(a)(8)(iii). 
Corporation A pays a 60u dividend to Corporation M in 1992. For 1992, 
Corporation M is deemed, under paragraph (b) of this section, to have 
paid $24 of the post-1986 foreign income taxes paid by Corporation A and 
includes that amount in gross income under section 78 as a dividend, 
determined as follows:

1. Assumed post-1986 undistributed earnings in
 Corporation A at start of 1992 attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  20u
     interest.
    (b) Section 904(d)(1)(I) general limitation    55u
     income.
2. Assumed post-1986 foreign income taxes in
 Corporation A at start of 1992 attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  $5
     interest.
    (b) Section 904(d)(1)(I) general limitation    $20
     income.
3. Assumed pre-tax earnings and profits of
 Corporation A for 1992 attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  20u
     interest.
    (b) Section 904(d)(1)(I) general limitation    20u
     income.
4. Assumed foreign income taxes paid or accrued
 in 1992 on or with respect to:
    (a) Section 904(d)(1)(B) high withholding tax  10u
     interest.
    (b) Section 904(d)(1)(I) general limitation    5u
     income.
5. Post-1986 undistributed earnings in
 Corporation A for 1992 (pre-dividend)
 attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  30u
     interest (Line 1(a) + Line 3(a) minus Line
     4(a)).
    (b) Section 904(d)(1)(I) general limitation    70u
     income (Line 1(b) + Line 3(b) minus Line
     4(b)).
                                                  ----------------------
    (c) Total....................................  100u
6. Post-1986 foreign income taxes in Corporation
 A for 1992 (pre-dividend) attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  $15
     interest (Line 2(a) + Line 4(a) translated
     at the appropriate exchange rates).
    (b) Section 904(d)(1)(I) general limitation    $25
     income (Line 2(b) + Line 4(b) translated at
     the appropriate exchange rates).
7. Dividends paid to Corporation M in 1992.......  60u

[[Page 738]]

 
8. Dividends paid to Corporation M in 1992
 attributable to section 904(d) separate
 categories pursuant to Sec.   1.904-5(d):
    (a) Dividends paid to Corporation M in 1992    18u
     attributable to section 904(d)(1)(B) high
     withholding tax interest (Line 7 multiplied
     by Line 5(a) divided by Line 5(c)).
    (b) Dividends paid to Corporation M in 1992    42u
     attributable to section 904(d)(1)(I) general
     limitation income (Line 7 multiplied by Line
     5(b) divided by Line 5(c)).
9. Percentage of Corporation A's post-1986
 undistributed earnings for 1992 paid to
 Corporation M attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  60%
     interest (Line 8(a) divided by Line 5(a)).
    (b) Section 904(d)(1)(I) general limitation    60%
     income (Line 8(b) divided by Line 5(b)).
10. Foreign income taxes of Corporation A deemed
 paid by Corporation M under section 902(a)
 attributable to:
    (a) Foreign income taxes of Corporation A      $9
     deemed paid by Corporation M under section
     902(a) with respect to section 904(d)(1)(B)
     high withholding tax interest (Line 6(a)
     multiplied by Line 9(a)).
    (b) Foreign income taxes of Corporation A      $15
     deemed paid by Corporation M under section
     902(a) with respect to section 904(d)(1)(I)
     general limitation income (Line 6(b)
     multiplied by Line 9(b)).
11. Post-1986 undistributed earnings in
 Corporation A at start of 1993 attributable to:
    (a) Section 904(d)(1)(B) high withholding tax  12u
     interest (Line 5(a) minus Line 8(a)).
    (b) Section 904(d)(1)(I) general limitation    28u
     income (Line 5(b) minus Line 8(b)).
12. Post-1986 foreign income taxes in Corporation
 A at start of 1989 allocable to:
    (a) Section 904(d)(1)(B) high withholding tax  $6
     interest (Line 6(a) minus Line 10(a)).
    (b) Section 904(d)(1)(I) general limitation    $10
     income (Line 6(b) minus Line 10(b)).
 

    (ii) For purposes of computing Corporation M's foreign tax credit 
limitation, the post-1986 foreign income taxes of Corporation A deemed 
paid by Corporation M with respect to income in separate categories will 
be added to the foreign income taxes paid or accrued by Corporation M 
associated with income derived from Corporation M's branch operation in 
the same separate categories. The dividend (and the section 78 inclusion 
with respect to the dividend) will be treated as income in separate 
categories and added to Corporation M's other income, if any, 
attributable to the same separate categories. See section 904(d) and 
Sec.  1.904-6.

    (g) Effective/applicability dates. This section applies to any 
distribution made in and after a foreign corporation's first taxable 
year beginning on or after January 1, 1987, except that the provisions 
of paragraphs (a)(4)(ii), (a)(6), (a)(7), (a)(8)(i), and (c)(8) of this 
section and, except as provided in Sec.  1.904-7(f)(9), the provisions 
of paragraph (d) of this section apply to distributions made in taxable 
years of foreign corporations ending on or after April 20, 2009. See 26 
CFR 1.902-1T(a)(4)(ii), (a)(6), (a)(7), (a)(8)(i), and (c)(8) (revised 
as of April 1, 2009) for rules applicable to distributions made in 
taxable years of foreign corporations beginning after April 25, 2006, 
and ending before April 20, 2009, and 26 CFR 1.902-1T(d), except as 
provided in 26 CFR 1.904-7T(f)(9) (revised as of April 1, 2009), for 
rules applicable to distributions made in taxable years of foreign 
corporations beginning after December 31, 2002, and ending before April 
20, 2009.

[T.D. 8708, 62 FR 928, Jan. 7, 1997, as amended by T.D. 8916, 66 FR 274, 
Jan. 3, 2001; T.D. 9260, 71 FR 24526, Apr. 25, 2006; 71 FR 77264, Dec. 
26, 2006; T.D. 9452, 74 FR 27875, June 11, 2009]



Sec.  1.902-2  Treatment of deficits in post-1986 undistributed earnings 
and pre-1987 accumulated profits of a first- or lower-tier corporation 
for purposes of computing an amount of foreign taxes deemed paid 
under Sec. 1.902-1.

    (a) Carryback of deficits in post-1986 undistributed earnings of a 
first- or lower-tier corporation to pre-effective date taxable years--
(1) Rule. For purposes of computing foreign income taxes deemed paid 
under Sec.  1.902-1(b) with respect to dividends paid by a first- or 
lower-tier corporation, when there is a deficit in the post-1986 
undistributed earnings of that corporation and the corporation makes a 
distribution to shareholders that is a dividend or would be a dividend 
if there were current or accumulated earnings and profits, then the 
post-1986 deficit shall be carried back to the most recent pre-effective 
date taxable year of the first- or lower-tier corporation with positive 
accumulated profits computed under section 902. See Sec.  1.902-3(e). 
For purposes of this Sec.  1.902-2, a pre-effective date taxable year is 
a taxable year beginning before January 1, 1987, or a taxable year 
beginning after December 31, 1986, if the special effective date of 
Sec.  1.902-1(a)(13) applies. The deficit shall reduce the section 902 
accumulated

[[Page 739]]

profits in the most recent pre-effective date year to the extent 
thereof, and any remaining deficit shall be carried back to the next 
preceding year or years until the deficit is completely allocated. The 
amount carried back shall reduce the deficit in post-1986 undistributed 
earnings. Any foreign income taxes paid in a post-effective date year 
will not be carried back to pre-effective date taxable years or removed 
from post-1986 foreign income taxes. See section 960 and the regulations 
under that section for rules governing the carryback of deficits and the 
computation of foreign income taxes deemed paid with respect to deemed 
income inclusions from controlled foreign corporations.
    (2) Examples. The following examples illustrate the rules of this 
paragraph (a):

    Example 1. (i) From 1985 through 1990, domestic corporation M owns 
10 percent of the one class of stock of foreign corporation A. The 
remaining 90 percent of Corporation A's stock is owned by Z, a foreign 
corporation. Corporation A is not a controlled foreign corporation and 
uses the u as its functional currency. 1u equals $1 at all relevant 
times. Both Corporation A and Corporation M use the calendar year as the 
taxable year. Corporation A has pre-1987 accumulated profits and post-
1986 undistributed earnings or deficits in post-1986 undistributed 
earnings, pays pre-1987 and post-1986 foreign income taxes, and pays 
dividends as summarized below:

Taxable year................  1985........  1986........  1987........  1988........  1989........  1990
Current E & P (Deficits) of   150u........  150u........  (100u)......  100u........  0...........  0
 Corp. A.
Current Plus Accumulated E &  150u........  300u........  200u........  250u........  250u........  200u
 P of Corp. A.
Post-'86 Undistributed        ............  ............  (100u)......  100u........  100u........  50u
 Earnings of Corp. A.
Post-'86 Undistributed        ............  ............  0...........  100u........  50u.........  50u
 Earnings of Corp. A Reduced
 By Current Year Dividend
 Distributions (increased by
 deficit carryback).
Foreign Income Taxes of       120u........  120u........  $10.........  $50.........  0...........  0
 Corp. A (Annual).
Post-'86 Foreign Income       ............  ............  $10.........  $60.........  $60.........  $30
 Taxes of Corp. A.
12/31 Distributions to Corp.  0...........  0...........  5u..........  0...........  5u..........  0
 M.
12/31 Distributions to Corp.  0...........  0...........  45u.........  0...........  45u.........  0
 Z.
 

    (ii) On December 31, 1987, Corporation A distributes a 5u dividend 
to Corporation M and a 45u dividend to Corporation Z. At that time 
Corporation A has a deficit of (100u) in post-1986 undistributed 
earnings and $10 of post-1986 foreign income taxes. The (100u) deficit 
(but not the post-1986 foreign income taxes) is carried back to offset 
the accumulated profits of 1986 and removed from post-1986 undistributed 
earnings. The accumulated profits for 1986 are reduced to 50u (150u-
100u). The dividend is paid out of the reduced 1986 accumulated profits. 
Foreign taxes deemed paid by Corporation M with respect to the 5u 
dividend are 12u (120u x (5u / 50u)). See Sec.  1.902-1(b)(3). 
Corporation M must include 12u in gross income (translated under the 
rule applicable to foreign income taxes paid on earnings accumulated in 
pre-effective date years) under section 78 as a dividend. Both the 
income inclusion and the foreign taxes deemed paid are subject to a 
separate limitation for dividends from Corporation A, a noncontrolled 
section 902 corporation. No accumulated profits remain in Corporation A 
with respect to 1986 after the carryback of the 1987 deficit and the 
December 31, 1987, dividend distributions to Corporations M and Z.
    (iii) On December 31, 1989, Corporation A distributes a 5u dividend 
to Corporation M and a 45u dividend to Corporation Z. At that time 
Corporation A has 100u of post-1986 undistributed earnings and $60 of 
post-1986 foreign income taxes. Therefore, the dividend is considered 
paid out of Corporation A's post-1986 undistributed earnings. Foreign 
taxes deemed paid by Corporation M with respect to the 5u dividend are 
$3 ($60 x 5%[5u / 100u]). Corporation M must include $3 in gross income 
under section 78 as a dividend. Both the income inclusion and the 
foreign taxes deemed paid are subject to a separate limitation for 
dividends from noncontrolled section 902 corporation A. Corporation A's 
post-1986 undistributed earnings as of January 1, 1990, are 50u (100u-
50u). Corporation A's post-1986 foreign income taxes must be reduced by 
the amount of foreign taxes that would have been deemed paid if both 
Corporations M and Z were eligible to compute an amount of deemed paid 
taxes. Section 1.902-1(a)(8)(i). The amount of foreign income taxes that 
would have been deemed paid if

[[Page 740]]

both Corporations M and Z were eligible to compute an amount of deemed 
paid taxes on the 50u dividend distributed by Corporation A is $30 ($60 
x 50%[50u / 100u]). Thus, post-1986 foreign income taxes as of January 
1, 1990, are $30 ($60-$30).
    Example 2. The facts are the same as in Example 1, except that 
Corporation A has a deficit in its post-1986 undistributed earnings of 
(150u) on December 31, 1987. The deficit is carried back to 1986 and 
reduces accumulated profits for that year to -0-. Thus, the foreign 
income taxes paid with respect to the 1986 accumulated profits will 
never be deemed paid. The 1987 dividend is deemed to be out of 
Corporation A's 1985 accumulated profits. Foreign taxes deemed paid by 
Corporation M under section 902 with respect to the 5u dividend paid on 
December 31, 1987, are 4u (120u x 5u / 150u). See Sec.  1.902-1(b)(3). 
As a result of the December 31, 1987, dividend distributions, 100u 
(150u-50u) of accumulated profits and 80u (120u reduced by 40u[120u x 
50u / 150u] of foreign taxes that would have been deemed paid had all of 
Corporation A's shareholders been eligible to compute an amount of 
foreign taxes deemed paid with respect to the dividend paid out of 1985 
accumulated profits) remain in Corporation A with respect to 1985.
    Example 3. (i) From 1986 through 1991, domestic corporation M owns 
10 percent of the one class of stock of foreign corporation A. The 
remaining 90 percent of Corporation A's stock is owned by Corporation Z, 
a foreign corporation. Corporation A is not a controlled foreign 
corporation and uses the u as its functional currency. 1u equals $1 at 
all relevant times. Both Corporation A and Corporation M use the 
calendar year as the taxable year. Corporation A has pre-1987 
accumulated profits and post-1986 undistributed earnings or deficits in 
post-1986 undistributed earnings, pays pre-1987 and post-1986 foreign 
income taxes, and pays dividends as summarized below:

Taxable year................  1986........  1987........  1988........  1989........  1990........  1991
Current E & P (Deficits) of   100u........  (50u).......  150u........  75u.........  25u.........  0
 Corp. A.
Current Plus Accumulated E &  100u........  50u.........  200u........  175u........  200u........  80u
 P of Corp. A.
Post-'86 Undistributed        ............  (50u).......  100u........  75u.........  100u........  0
 Earnings of Corp. A.
Post-'86 Undistributed        ............  (50u).......  0...........  75u.........  0...........  0
 Earnings of Corp. A Reduced
 By Current Year Dividend
 Distributions (increased by
 deficit carryback).
Foreign Income Taxes          80u.........  0...........  $120........  $20.........  $20.........  0
 (Annual) of Corp. A.
Post-'86 Foreign Income       ............  0...........  $120........  $20.........  $40.........  0
 Taxes of Corp. A.
12/31 Distributions to Corp.  0...........  0...........  10u.........  0...........  12u.........  0
 M.
12/31 Distributions to Corp.  0...........  0...........  90u.........  0...........  108u........  0
 Z.
 

    (ii) On December 31, 1988, Corporation A distributes a 10u dividend 
to Corporation M and a 90u dividend to Corporation Z. At that time 
Corporation A has 100u in its post-1986 undistributed earnings and $120 
in its post-1986 foreign income taxes. Corporation M is deemed, under 
Sec.  1.902-1(b)(1), to have paid $12 ($120 x 10%[10u / 100u]) of the 
post-1986 foreign income taxes paid by Corporation A and includes that 
amount in gross income under section 78 as a dividend. Both the income 
inclusion and the foreign taxes deemed paid are subject to a separate 
limitation for dividends from noncontrolled section 902 corporation A. 
Corporation A's post-1986 undistributed earnings as of January 1, 1989, 
are 0 (100u-100u). Its post-1986 foreign taxes as of January 1, 1989, 
also are 0, $120 reduced by $120 of foreign income taxes paid that would 
have been deemed paid if both Corporations M and Z were eligible to 
compute an amount of foreign taxes deemed paid on the dividend from 
Corporation A ($120 x 100%[100u / 100u]).
    (iii) On December 31, 1990, Corporation A distributes a 12u dividend 
to Corporation M and a 108u dividend to Corporation Z. At that time 
Corporation A has 100u in its post-1986 undistributed earnings and $40 
in its post-1986 foreign income taxes. The dividend is paid out of post-
1986 undistributed earnings to the extent thereof (100u), and the 
remainder of 20u is paid out of 1986 accumulated profits. Under Sec.  
1.902-1(b)(2), the 12u dividend to Corporation M is deemed to be paid 
out of post-1986 undistributed earnings to the extent of 10u (100u x 12u 
/ 120u) and the remaining 2u is deemed to be paid out of Corporation A's 
1986 accumulated profits. Similarly, the 108u dividend to Corporation Z 
is deemed to be paid out of post-1986 undistributed earnings to the 
extent of 90u (100u x 108u / 120u) and the remaining 18u is deemed to be 
paid out of Corporation A's 1986 accumulated profits. Foreign income 
taxes deemed paid by Corporation M under section 902 with respect to the 
portion of the dividend paid out of post-1986 undistributed earnings are 
$4 ($40 x 10%[10u / 100u]), and foreign taxes deemed paid by Corporation 
M with respect to the portion of the dividend deemed paid out of

[[Page 741]]

1986 accumulated profits are 1.6u (80u x 2u / 100u). Corporation M must 
include $4 plus 1.6u translated under the rule applicable to foreign 
income taxes paid on earnings accumulated in taxable years prior to the 
effective date of the Tax Reform Act of 1986 in gross income as a 
dividend under section 78. The income inclusion and the foreign income 
taxes deemed paid are subject to a separate limitation for dividends 
from noncontrolled section 902 Corporation A. As of January 1, 1991, 
Corporation A's post-1986 undistributed earnings are 0 (100u-100u). 80u 
(100u-20u) of accumulated profits remain with respect to 1986. Post-1986 
foreign income taxes as of January 1, 1991, are 0, $40 reduced by $40 of 
foreign income taxes paid that would have been deemed paid if both 
Corporations M and Z were eligible to compute an amount of deemed paid 
taxes on the 100u dividend distributed by Corporation A out of post-1986 
undistributed earnings ($40 x 100%[100u / 100u]). Corporation A has 64u 
of foreign income taxes remaining with respect to 1986, 80u reduced by 
16u [80u x 20u / 100u] of foreign income taxes that would have been 
deemed paid if Corporations M and Z both were eligible to compute an 
amount of deemed paid taxes on the 20u dividend distributed by 
Corporation A out of 1986 accumulated profits.

    (b) Carryforward of deficit in pre-1987 accumulated profits of a 
first- or lower-tier corporation to post-1986 undistributed earnings for 
purposes of section 902--(1) General rule. For purposes of computing 
foreign income taxes deemed paid under Sec.  1.902-1(b) with respect to 
dividends paid by a first- or lower-tier corporation out of post-1986 
undistributed earnings, the amount of a deficit in accumulated profits 
of the foreign corporation determined under section 902 as of the end of 
its last pre-effective date taxable year is carried forward and reduces 
post-1986 undistributed earnings on the first day of the foreign 
corporation's first taxable year beginning after December 31, 1986, or 
on the first day of the first taxable year in which the ownership 
requirements of section 902(c)(3)(B) and Sec.  1.902-1(a)(1) through (4) 
are met if the special effective date of Sec.  1.902-1(a)(13) applies. 
Any foreign income taxes paid with respect to a pre-effective date year 
shall not be carried forward and included in post-1986 foreign income 
taxes. Post-1986 undistributed earnings may not be reduced by the amount 
of a pre-1987 deficit in earnings and profits computed under section 
964(a). See section 960 and the regulations under that section for rules 
governing the carryforward of deficits and the computation of foreign 
income taxes deemed paid with respect to deemed income inclusions from 
controlled foreign corporations. For translation rules governing 
carryforwards of deficits in pre-1987 accumulated profits to post-1986 
taxable years of a foreign corporation with a dollar functional 
currency, see Sec.  1.985-6(d)(2).
    (2) Effect of pre-effective date deficit. If a foreign corporation 
has a deficit in accumulated profits as of the end of its last pre-
effective date taxable year, then the foreign corporation cannot pay a 
dividend out of pre-effective date years unless there is an adjustment 
made (for example, a refund of foreign taxes paid) that restores section 
902 accumulated profits to a pre-effective date taxable year or years. 
Moreover, if a foreign corporation has a deficit in section 902 
accumulated profits as of the end of its last pre-effective date taxable 
year, then no deficit in post-1986 undistributed earnings will be 
carried back under paragraph (a) of this section. For rules concerning 
carrybacks of eligible deficits from post-1986 undistributed earnings to 
reduce pre-1987 earnings and profits computed under section 964(a), see 
section 960 and the regulations under that section.
    (3) Examples. The following examples illustrate the rules of this 
paragraph (b):

    Example 1. (i) From 1984 through 1988, domestic corporation M owns 
10 percent of the one class of stock of foreign corporation A. The 
remaining 90 percent of Corporation A's stock is owned by Corporation Z, 
a foreign corporation. Corporation A is not a controlled foreign 
corporation and uses the u as its functional currency. 1u equals $1 at 
all relevant times. Both Corporation A and Corporation M use the 
calendar year as the taxable year. Corporation A has pre-1987 
accumulated profits or deficits in accumulated profits and post-1986 
undistributed earnings, pays pre-1987 and post-1986 foreign income 
taxes, and pays dividends as summarized below:

Taxable year..................  1984...........  1985...........  1986..........  1987..........  1988
Current E & P (Deficits) of     25u............  (100u).........  (25u).........  200u..........  100u
 Corp. A.

[[Page 742]]

 
Current Plus Accumulated E & P  25u............  (75u)..........  (100u)........  100u..........  50u
 (Deficits) of Corp. A.
Post-'86 Undistributed          ...............  ...............  ..............  100u..........  50u
 Earnings of Corp. A.
Post-'86 Undistributed          ...............  ...............  ..............  (50u).........  50u
 Earnings of Corp. A Reduced
 By Current Year Dividend
 Distributions (reduced by
 deficit carryforward).
Foreign Income Taxes (Annual)   20u............  5u.............  0.............  $100..........  $50
 of Corp. A.
Post-'86 Foreign Income Taxes   ...............  ...............  ..............  $100..........  $50
 of Corp. A.
12/31 Distributions to Corp. M  0..............  0..............  0.............  15u...........  0
12/31 Distributions to Corp. Z  0..............  0..............  0.............  135u..........  0
 

    (ii) On December 31, 1987, Corporation A distributes a 150u 
dividend, 15u to Corporation M and 135u to Corporation Z. Corporation A 
has 200u of current earnings and profits for 1987, but its post-1986 
undistributed earnings are only 100u as a result of the reduction for 
pre-1987 accumulated deficits required under paragraph (b)(1) of this 
section. Corporation A has $100 of post-1986 foreign income taxes. Only 
100u of the 150u distribution is a dividend out of post-1986 
undistributed earnings. Foreign income taxes deemed paid by Corporation 
M in 1987 with respect to the 10u dividend attributable to post-1986 
undistributed earnings, computed under Sec.  1.902-1(b), are $10 ($100 x 
10%[10u/100u]). Corporation M includes this amount in gross income under 
section 78 as a dividend. Both the income inclusion and the foreign 
taxes deemed paid are subject to a separate limitation for dividends 
from noncontrolled section 902 corporation A. After the distribution, 
Corporation A has (50u) of post-1986 undistributed earnings (100u -150u) 
and -0- post-1986 foreign income taxes, $100 reduced by $100 of foreign 
income taxes paid that would have been deemed paid if both Corporations 
M and Z were eligible to compute an amount of deemed paid taxes on the 
100u dividend distributed by Corporation A out of post-1986 
undistributed earnings ($100 x 100%[100u / 100u]).
    (iii) The remaining 50u of the 150u distribution cannot be deemed 
paid out of accumulated profits of a pre-1987 year because Corporation A 
has an accumulated deficit as of the end of 1986 that eliminated all 
pre-1987 accumulated profits. See paragraph (b)(2) of this section. The 
50u is a dividend out of current earnings and profits under section 
316(a)(2), but Corporation M is not deemed to have paid any additional 
foreign income taxes paid by Corporation A with respect to that 50u 
dividend out of current earnings and profits. See Sec.  1.902-1(b)(4).
    Example 2. (i) From 1986 through 1991, domestic corporation M owns 
10 percent of the one class of stock of foreign corporation A. The 
remaining 90 percent of Corporation A's stock is owned by Corporation Z, 
a foreign corporation. Corporation A is not a controlled foreign 
corporation and uses the u as its functional currency. 1u equals $1 at 
all relevant times. Both Corporation A and Corporation M use the 
calendar year as the taxable year. Corporation A has pre-1987 
accumulated profits or deficits in accumulated profits and post-1986 
undistributed earnings, pays post-1986 foreign income taxes, and pays 
dividends as summarized below:

Taxable year..................  1986...........  1987...........  1988..........  1989..........  1990
Current E & P (Deficits) of     (100u).........  150u...........  (150u)........  100u..........  250u
 Corp. A.
Current Plus Accumulated E & P  (100u).........  50u............  (200u)........  (100u)........  50u
 (Deficits) of Corp. A.
Post-'86 Undistributed          ...............  50u............  (200u)........  (100u)........  50u
 Earnings of Corp. A.
Post-'86 Undistributed          ...............  (50u)..........  (200u)........  (200u)........  0
 Earnings of Corp. A Reduced
 By Current Year Dividend
 Distributions (reduced by
 deficit carryforward).
Foreign Income Taxes (Annual)   0..............  $120...........  0.............  $50...........  $100
 of Corp. A.
Post-'86 Foreign Income Taxes   ...............  $120...........  0.............  $50...........  $150
 of Corp. A.
12/31 Distributions to Corp. M  0..............  10u............  0.............  10u...........  5u
12/31 Distributions to Corp. Z  0..............  90u............  0.............  90u...........  45u
 

    (ii) On December 31, 1987, Corporation A distributes a 10u dividend 
to Corporation M and a 90u dividend to Corporation Z. At the time of the 
distribution, Corporation A has 50u of post-1986 undistributed earnings 
and 150u of current earnings and profits. Thus, 50u of the dividend 
distribution (5u to Corporation M and 45u to Corporation Z) is a 
dividend out of post-1986 undistributed earnings. The remaining 50u is a 
dividend out of current earnings and profits under section 316(a)(2), 
but Corporation M is not deemed to have paid any additional foreign 
income taxes paid by Corporation A with respect to that 50u dividend out 
of current earnings and profits. See Sec.  1.902-1(b)(4). Note that even 
if there were no current earnings and profits in Corporation A, the 
remaining 50u of the 100u distribution cannot be deemed paid out of 
accumulated profits of a pre1987 year because

[[Page 743]]

Corporation A has an accumulated deficit as of the end of 1986 that 
eliminated all pre-1987 accumulated profits. See paragraph (b)(2) of 
this section. Corporation A has $120 of post-1986 foreign income taxes. 
Foreign taxes deemed paid by Corporation M under section 902 with 
respect to the 5u dividend out of post-1986 undistributed earnings are 
$12 ($120 x 10%[5u/50u]). Corporation M includes this amount in gross 
income as a dividend under section 78. Both the foreign taxes deemed 
paid and the deemed dividend are subject to a separate limitation for 
dividends from noncontrolled section 902 corporation A. As of January 1, 
1988, Corporation A has (50u) in its post-1986 undistributed earnings 
(50u-100u) and -0- in its post-1986 foreign income taxes, $120 reduced 
by $120 of foreign taxes that would have been deemed paid if both 
Corporations M and Z were eligible to compute an amount of deemed paid 
taxes on the dividend distributed by Corporation A out of post-1986 
undistributed earnings ($120 x 100%[50u / 50u]).
    (iii) On December 31, 1989, Corporation A distributes a 10u dividend 
to Corporation M and a 90u dividend to Corporation Z. Although the 
distribution is considered a dividend in its entirety out of 1989 
earnings and profits pursuant to section 316(a)(2), post-1986 
undistributed earnings are (100u). Accordingly, for purposes of section 
902, Corporation M is deemed to have paid no post-1986 foreign income 
taxes. See Sec.  1.902-1(b)(4). Corporation A's post-1986 undistributed 
earnings as of January 1, 1990, are (200u) ((100u) - 100u). Corporation 
A's post-1986 foreign income taxes are not reduced because no taxes were 
deemed paid.
    (iv) On December 31, 1990, Corporation A distributes a 5u dividend 
to Corporation M and a 45u dividend to Corporation Z. At that time 
Corporation A has 50u of post-1986 undistributed earnings, and $150 of 
post-1986 foreign income taxes. Foreign taxes deemed paid by Corporation 
M under section 902 with respect to the 5u dividend are $15 ($150 x 
10%[5u / 50u]). Post-1986 undistributed earnings as of January 1, 1991, 
are -0- (50u - 50u). Post-1986 foreign income taxes as of January 1, 
1991, also are -0-, $150 reduced by $150 ($150 x 100%[50u / 50u]) of 
foreign income taxes that would have been deemed paid if both 
Corporations M and Z were eligible to compute an amount of deemed paid 
taxes on the 50u dividend.

[T.D. 8708, 62 FR 937, Jan. 7, 1997, as amended by T.D. 9260, 71 FR 
24526, Apr. 25, 2006; 71 FR 77265, Dec. 26, 2006]



Sec.  1.902-3  Credit for domestic corporate shareholder 
of a foreign corporation for foreign income taxes paid with respect to 
accumulated profits of taxable years of the foreign corporation beginning 
before January 1, 1987.

    (a) Definitions. For purposes of section 902 and Sec. Sec.  1.902-3 
and 1.902-4:
    (1) Domestic shareholder. In the case of dividends received by a 
domestic corporation after December 31, 1964, from a foreign 
corporation, the term ``domestic shareholder'' means a domestic 
corporation which owns at least 10 percent of the voting stock of the 
foreign corporation at the time it receives a dividend from such foreign 
corporation.
    (2) First-tier corporation. In the case of dividends received by a 
domestic shareholder after December 31, 1964, from a foreign 
corporation, the term ``first-tier corporation'' means a foreign 
corporation at least 10 percent of the voting stock of which is owned by 
a domestic shareholder at the time it receives a dividend from such 
foreign corporation. The term ``first-tier corporation'' also means a 
DISC or former DISC, but only with respect to dividends from the DISC or 
former DISC to the extent they are treated under sections 861(a)(2)(D) 
and 862(a)(2) as income from sources without the United States.
    (3) Second-tier corporation. (i) In the case of dividends paid to a 
first-tier corporation by a foreign corporation after January 12, 1971 
(i.e., the date of enactment of Pub. L. 91-684, 84 Stat. 2068), but only 
for purposes of applying this section for a taxable year of a domestic 
shareholder ending after that date, the foreign corporation is a 
``second-tier corporation'' if at least 10 percent of its voting stock 
is owned by the first-tier corporation at the time the first-tier 
corporation receives the dividend.
    (ii) In the case of dividends paid to a first-tier corporation by a 
foreign corporation after January 12, 1971, but only for purposes of 
applying this section for a taxable year of a domestic shareholder 
ending before January 13, 1971, or in the case of any dividend paid to a 
first-tier corporation by a foreign corporation before January 13, 1971, 
the foreign corporation is a ``second-tier

[[Page 744]]

corporation'' if at least 50 percent of its voting stock is owned by the 
first-tier corporation at the time the first-tier corporation receives 
the dividend.
    (4) Third-tier corporation. In the case of dividends paid to a 
second-tier corporation (as defined in paragraph (a)(3) (i) or (ii) of 
this section) by a foreign corporation after January 12, 1971, but only 
for purposes of applying this section for a taxable year of a domestic 
shareholder ending after that date, the foreign corporation is a 
``third-tier corporation'' if at least 10 percent of its voting stock is 
owned by the second-tier corporation at the time the second-tier 
corporation receives the dividend.
    (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.
    (6) Dividend. For the definition of the term ``dividend'' for 
purposes of applying section 902 and this section, see section 316 and 
the regulations thereunder.
    (7) Dividend received. A dividend shall be considered received for 
purposes of section 902 and this section when the cash or other property 
is unqualifiedly made subject to the demands of the distributee. See 
Sec.  1.301-1(b).
    (b) Domestic shareholder owning stock in a first-tier corporation--
(1) In general. (i) If a domestic shareholder receives dividends in any 
taxable year from its first-tier corporation, the credit for foreign 
income taxes allowed by section 901 includes, subject to the conditions 
and limitations of this section, the foreign income taxes deemed, in 
accordance with paragraph (b)(2) of this section, to be paid by such 
domestic shareholder for such year.
    (ii) If dividends are received by a domestic shareholder from more 
than one first-tier corporation, the taxes deemed to be paid by such 
shareholder under section 902(a) and this paragraph (b) shall be 
computed separately with respect to the dividends received from each of 
such first-tier corporations.
    (iii) Any taxes deemed paid by a domestic shareholder for the 
taxable year pursuant to section 902(a) and paragraph (b)(2) of this 
section shall, except as provided in Sec.  1.960-3(b), be included in 
the gross income of such shareholder for such year as a dividend 
pursuant to section 78 and Sec.  1.78-1. For the source of such a 
section 78 dividend, see paragraph (h)(1) of this section.
    (iv) Any taxes deemed, under paragraph (b)(2) of this section, to be 
paid by the domestic shareholder shall be deemed to be paid by such 
shareholder only for purposes of the foreign tax credit allowed under 
section 901. See section 904 for other limitations on the amount of the 
credit.
    (v) For rules relating to reduction of the amount of foreign income 
taxes deemed paid or accrued with respect to foreign mineral income, see 
section 901(e) and Sec.  1.901-3.
    (vi) For the nonrecognition as a foreign income tax for purposes of 
this section of certain income, profits, or excess profits taxes paid or 
accrued to a foreign country in connection with the purchase and sale of 
oil or gas extracted in such country, see section 901(f) and the 
regulations thereunder.
    (vii) For rules relating to reduction of the amount of foreign 
income taxes deemed paid with respect to foreign oil and gas extraction 
income, see section 907(a) and the regulations thereunder.
    (viii) See the regulations under sections 960, 962, and 963 for 
special rules relating to the application of section 902 in computing 
the foreign tax credit of United States shareholders of controlled 
foreign corporations.
    (2) Amount of foreign taxes deemed paid by a domestic shareholder. 
To the extent dividends are paid by a first-tier corporation to its 
domestic shareholder out of accumulated profits, as defined in paragraph 
(e) of this section, for any taxable year, the domestic shareholder 
shall be deemed to have paid the same proportion of any foreign income 
taxes paid, accrued or deemed, in accordance with paragraph (c)(2) of 
this section, to be paid by such first-tier corporation on or with 
respect to such accumulated profits for such year which the amount of 
such dividends (determined without regard to the gross-up under section 
78) bears to the amount by which such accumulated profits exceed the 
amount of such taxes (other than those deemed,

[[Page 745]]

under paragraph (c)(2) of this section, to be paid). For determining the 
amount of foreign income taxes paid or accrued by such first-tier 
corporation on or with respect to the accumulated profits for the 
taxable year of such first-tier corporation, see paragraph (f) of this 
section.
    (c) First-tier corporation owning stock in a second-tier 
corporation--(1) In general. For purposes of applying section 902(a) and 
paragraph (b)(2) of this section, if a first-tier corporation receives 
dividends in any taxable year from its second-tier corporation, the 
foreign income taxes deemed to be paid by the first-tier corporation on 
or with respect to its own accumulated profits for such year shall be 
the amount determined in accordance with paragraph (c)(2) of this 
section. This paragraph (c) shall not apply unless the product of--
    (i) The percentage of voting stock owned by the domestic shareholder 
in the first-tier corporation at the time that the domestic shareholder 
receives dividends from the first-tier corporation in respect of which 
foreign income taxes are deemed to be paid by the domestic shareholder 
under paragraph (b)(1) of this section, and
    (ii) The percentage of voting stock owned by the first-tier 
corporation in the second-tier corporation equals at least 5 percent. 
The percentage under paragraph (c)(1)(ii) of this section of voting 
stock owned by the first-tier corporation in the second-tier corporation 
is determined as of the time that the dividend distributed by the 
second-tier corporation is received by the first-tier corporation and 
thus included in accumulated profits of the first-tier corporation out 
of which dividends referred to in paragraph (c)(1)(i) of this section 
are distributed by the first-tier corporation to the domestic 
shareholder.

    Example. On February 10, 1976, foreign corporation B pays a dividend 
out of its accumulated profits for 1975 to foreign corporation A. On 
February 16, 1976, the date on which it receives the dividend, A 
Corporation owns 40 percent of the voting stock of B Corporation. Both 
corporations use the calendar year as the taxable year. On June 1, 1976, 
A Corporation sells its stock in B Corporation. On January 17, 1977, A 
Corporation pays a dividend out of its accumulated profits for 1976 to 
domestic corporation M. M Corporation owns 30 percent of the voting 
stock of A Corporation on January 20, 1977, the date on which it 
receives the dividend. M Corporation uses a fiscal year ending on April 
30 as the taxable year. On February 16, 1976, A Corporation satisfies 
the 10-percent stock ownership requirement referred to in paragraph 
(a)(3) of this section with respect to B Corporation, and on January 20, 
1977, M Corporation satisfies the 10-percent stock-ownership requirement 
referred to in paragraph (a)(2) of this section with respect to A 
Corporation. The 5-percent requirement of this paragraph (c)(1) is also 
satisfied since 30 percent (the percentage of voting stock owned by M 
Corporation in A Corporation on January 20, 1977), when multiplied by 40 
percent (the percentage of voting stock owned by A Corporation in B 
Corporation on February 16, 1976), equals 12 percent. Accordingly, for 
its taxable year ending on April 30, 1977, M Corporation is entitled to 
a credit for a portion of the foreign income taxes paid, accrued, or 
deemed to be paid, by A Corporation for 1976; and for 1976 A Corporation 
is deemed to have paid a portion of the foreign income taxes paid or 
accrued by B Corporation for 1975.
    (2) Amount of foreign taxes deemed paid by a first-tier corporation. 
A first-tier corporation which receives dividends in any taxable year 
from its second-tier corporation shall be deemed to have paid for such 
year the same proportion of any foreign income taxes paid, accrued, or 
deemed, in accordance with paragraph (d)(2) of this section, to be paid 
by its second-tier corporation on or with respect to the accumulated 
profits, as defined in paragraph (e) of this section, for the taxable 
year of the second-tier corporation from which such dividends are paid 
which the amount of such dividends bears to the amount by which such 
accumulated profits of the second-tier corporation exceed the taxes so 
paid or accrued. For determining the amount of the foreign income taxes 
paid or accrued by such second-tier corporation on or with respect to 
the accumulated profits for the taxable year of such second-tier 
corporation, see paragraph (f) of this section.
    (d) Second-tier corporation owning stock in a third-tier 
corporation--(1) In general. For purposes of applying section 902(b)(1) 
and paragraph (c)(2) of this section, if a second-tier corporation 
receives dividends in any taxable year from its third-tier corporation, 
the foreign income taxes deemed to be

[[Page 746]]

paid by the second-tier corporation on or with respect to its own 
accumulated profits for such year shall be the amount determined in 
accordance with paragraph (d)(2) of this section. This paragraph (d) 
shall not apply unless the product of--
    (i) The percentage of voting stock arrived at in applying the 5-
percent requirement of paragraph (c)(1) of this section with respect to 
dividends received by the first-tier corporation from the second-tier 
corporation, and
    (ii) the percentage of voting stock owned by the second-tier 
corporation in the third-tier corporation equals at least 5 percent. The 
percentage under paragraph (d)(1)(ii) of this section of voting stock 
owned by the second-tier corporation in the third-tier corporation is 
determined as of the time that the dividend distributed by the third-
tier corporation is received by the second-tier corporation and thus 
included in accumulated profits of the second-tier corporation out of 
which dividends referred to in paragraph (d)(1)(i) of this section are 
distributed by the second-tier corporation to the first-tier 
corporation.

    Example. On February 27, 1975, foreign corporation C pays a dividend 
out of its accumulated profits for 1974 to foreign corporation B. On 
March 3, 1975, the date on which it receives the dividend, B Corporation 
owns 50 percent of the voting stock of C Corporation. On February 10, 
1976, B Corporation pays a dividend out of its accumulated profits for 
1975 to foreign corporation A. On February 16, 1976, the date on which 
it receives the dividend, A Corporation owns 40 percent of the voting 
stock of B Corporation. All three corporations use the calendar year as 
the taxable year. On January 17, 1977, A Corporation pays a dividend out 
of its accumulated profits for 1976 to domestic corporation M. M 
Corporation owns 30 percent of the voting stock of A Corporation on 
January 20, 1977, the date on which it receives the dividend. M 
Corporation uses a fiscal year ending on April 30 as the taxable year. 
On February 16, 1976, A Corporation satisfies the 10-percent stock 
ownership requirement referred to in paragraph (a)(3) of this section 
with respect to B Corporation, and on January 20, 1977, M Corporation 
satisfies the 10-percent stock-ownership requirement referred to in 
paragraph (a)(2) of this section with respect to A Corporation. The 5-
percent requirement of paragraph (c)(1) of this section is also 
satisfied since 30 percent (the percentage of voting stock owned by M 
Corporation in A Corporation on January 20, 1977), when multiplied by 40 
percent (the percentage of voting stock owned by A Corporation in B 
Corporation on February 16, 1976), equals 12 percent. On March 3, 1975, 
B Corporation satisfies the 10 percent stock ownership requirement 
referred to in paragraph (a)(4) of this section with respect to C 
Corporation. The 5-percent requirement of this paragraph (d)(1) is also 
satisfied since 12 percent (the percentage of voting stock arrived at in 
applying the 5-percent requirement of paragraph (c)(1) of this section 
with respect to the dividends received by A Corporation from B 
Corporation on February 16, 1976), when multiplied by 50 percent (the 
percentage of voting stock owned by B Corporation in C Corporation on 
March 3, 1975), equals 6 percent. Accordingly, for its taxable year 
ending on April 30, 1977, M Corporation is entitled to a credit for a 
portion of the foreign income taxes paid, accrued, or deemed to be paid, 
by A Corporation for 1976; for 1976 A Corporation is deemed to have paid 
a portion of the foreign income taxes paid, accrued, or deemed to be 
paid, by B Corporation for 1975; and for 1975 B Corporation is deemed to 
have paid a portion of the foreign income taxes paid or accrued by C 
Corporation for 1974.

    (2) Amount of foreign taxes deemed paid by a second-tier 
corporation. For purposes of applying paragraph (c)(2) of this section 
to a first-tier corporation, a second-tier corporation which receives 
dividends in its taxable year from its third-tier corporation shall be 
deemed to have paid for such year the same proportion of any foreign 
income taxes paid or accrued by its third-tier corporation on or with 
respect to the accumulated profits, as defined in paragraph (e) of this 
section, for the taxable year of the third-tier corporation from which 
such dividends are paid which the amount of such dividends bears to the 
amount by which such accumulated profits of the third-tier corporation 
exceed the taxes so paid or accrued. For determining the amount of the 
foreign income taxes paid or accrued by such third-tier corporation on 
or with respect to the accumulated profits for the taxable year of such 
third-tier corporation, see paragraph (f) of this section.
    (e) Determination of accumulated profits of a foreign corporation. 
The accumulated profits for any taxable year of a first-tier corporation 
and the accumulated profits for any taxable year of a second-tier or 
third-tier corporation,

[[Page 747]]

which are taken into account in applying paragraph (c)(2) or (d)(2) of 
this section with respect to such first-tier corporation, shall be the 
sum of--
    (1) The earnings and profits of such corporation for such year, and
    (2) The foreign income taxes imposed on or with respect to the 
gains, profits, and income to which such earnings and profits are 
attributable.
    (f) Taxes paid on or with respect to accumulated profits of a 
foreign corporation. For purposes of this section, the amount of foreign 
income taxes paid or accrued on or with respect to the accumulated 
profits of a foreign corporation for any taxable year shall be the 
entire amount of the foreign income taxes paid or accrued for such year 
on or with respect to such gains, profits, and income. For purposes of 
this paragraph (f), the gains, profits, and income of a foreign 
corporation for any taxable year shall be determined after reduction by 
any income, war profits, or excess profits taxes imposed on or with 
respect to such gains, profits, and income by the United States.
    (g) Determination of earning and profits of a foreign corporation--
(1) Taxable year to which section 963 does not apply. For purposes of 
this section, the earnings and profits of a foreign corporation for any 
taxable year beginning after December 31, 1962, other than a taxable 
year to which paragraph (g)(2) of this section applies, may, if the 
domestic shareholder chooses, be determined under the rules provided by 
Sec.  1.964-1 exclusive of paragraphs (d) and (e) of such section. The 
translation of amounts so determined into United States dollars or other 
foreign currency shall be made at the proper exchange rate for the date 
of distribution with respect to which the determination is made.
    (2) [Reserved]
    (3) Time and manner of making choice. The controlling United States 
shareholders (as defined in Sec.  1.964-1(c)(5)) of a foreign 
corporation shall make the choice referred to in paragraph (g)(1) of 
this section (including the elections permitted by Sec.  1.964-1 (b) and 
(c)) by filing a written statement to such effect with the Director of 
the Internal Revenue Service Center, 11601 Roosevelt Boulevard, 
Philadelphia, Pennsylvania 19155, within 180 days after the close of the 
first taxable year of the foreign corporation during which such 
shareholders receive a distribution of earnings and profits with respect 
to which the benefits of this section are claimed or on or before 
November 15, 1965, whichever is later. For purposes of this paragraph 
(g)(3), the 180-day period shall commence on the date of receipt of any 
distribution which is considered paid from the accumulated profits of a 
preceding year or years under paragraph (g)(4) of this section. See 
Sec.  1.964-1(c)(3) (ii) and (iii) for procedures requiring notification 
of the Director of the Internal Revenue Service Center and 
noncontrolling shareholders of action taken.
    (4) Determination by district director. The district director in 
whose district is filed the income tax return of the domestic 
shareholder claiming a credit under section 901 for foreign income taxes 
deemed, under section 902 and this section, to be paid by such 
shareholder shall have the power to determine, with respect to a foreign 
corporation, from the accumulated profits of what taxable year or years 
the dividends were paid. In making such determination the district 
director shall, unless it is otherwise established to his satisfaction, 
treat any dividends which are paid in the first 60 days of any taxable 
year of such a corporation as having been paid from the accumulated 
profits of the preceding taxable year or years of such corporation and 
shall, in other respects, treat any dividends as having been paid from 
the most recently accumulated profits. For purposes of this paragraph 
(g)(4), in the case of a foreign corporation the foreign income taxes of 
which are determined on the basis of an accounting period of less than 1 
year, the term ``year'' shall mean such accounting period. See sections 
441 (b)(3) and 443.
    (h) Source of income from first-tier corporation and country to 
which tax is deemed paid--(1) Source of income. For purposes of section 
904(a)(1) (relating to the per-country limitation), in the case of a 
dividend received by a domestic shareholder from a first-tier 
corporation there shall be deemed to be derived from sources within the 
foreign country or possession of the United States under the laws of 
which the

[[Page 748]]

first-tier corporation is created or organized the sum of the amounts 
which under paragraph (a)(3)(ii) of Sec.  1.861-3 are treated, with 
respect to such dividend, as income from sources without the United 
States.
    (2) Country to which taxes deemed paid. For purposes of section 904, 
all foreign income taxes paid, or deemed under paragraph (c) of this 
section to be paid, by a first-tier 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 is created or organized.
    (i) United Kingdom income taxes paid with respect to royalties. A 
taxpayer shall not be deemed under section 902 and this section to have 
paid any taxes with respect to which a credit is allowable to such 
taxpayer or any other taxpayer by virtue of section 905(b).
    (j) Information to be furnished. If the credit for foreign income 
taxes claimed under section 901 includes taxes deemed, under paragraph 
(b)(2) of this section, to be paid, the domestic shareholder must 
furnish the same information with respect to such taxes 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 shareholder for the 
annual accounting period of certain foreign corporations ending with or 
within such shareholder's taxable year, and for reduction in the amount 
of foreign income taxes paid or deemed to be paid for failure to furnish 
such information, see section 6038 and the regulations thereunder.
    (k) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. Throughout 1978, domestic corporation M owns all the one 
class of stock of foreign corporation A. Both corporations use the 
calendar year as the taxable year. Corporation A has accumulated 
profits, pays foreign income taxes, and pays dividends for 1978 as 
summarized below. For 1978, M Corporation is deemed, under paragraph 
(b)(2) of this section, to have paid $20 of the foreign income taxes 
paid by A Corporation for 1978 and includes such amount in gross income 
under section 78 as a dividend, determined as follows:

Gains, profits, and income of A Corp..........................      $100
Foreign income taxes imposed on or with respect to gains,             40
 profits, and income..........................................
Accumulated profits...........................................       100
Foreign income taxes paid on or with respect to accumulated           40
 profits (total foreign income taxes).........................
Accumulated profits in excess of foreign income taxes.........        60
Dividends paid to M Corp......................................        30
Foreign income taxes of A Corp. deemed paid by M Corp. under          20
 section 902(a) ($40 x $30/$60)...............................
 

    Example 2. The facts are the same as in example 1, except that M 
Corporation also owns all the one class of stock of foreign corporation 
B which also uses the calendar year as the taxable year. Corporation B 
has accumulated profits, pays foreign income taxes, and pays dividends 
for 1978 as summarized below. For 1978, M Corporation is deemed under 
paragraph (b)(2) of this section, to have paid $20 of the foreign income 
taxes paid by A Corporation for 1978 and to have paid $50 of the foreign 
income taxes paid by B Corporation for 1978, and includes $70 in gross 
income as a dividend under section 78, determined as follows:

                              B Corporation
  Gains, profits and income...................................      $200
  Foreign income taxes imposed on or with respect to gains,          100
   profits, and income........................................
  Accumulated profits.........................................       200
  Foreign income taxes paid by B Corp. on or with respect to         100
   accumulated profits........................................
  Accumulated profits in excess of foreign income taxes.......       100
  Dividends paid to M Corp....................................        50
  Foreign income taxes of B Corporation deemed paid by M              50
   Corporation under section 902(a) ($100 x $50/$100).........
 


                              M Corporation
Foreign income taxes deemed paid under section 902(a):........
  Taxes of A Corp. (from example 1)...........................       $20
  Taxes of B Corp. (as determined above)......................        50
                                                               ---------
     Total....................................................        70
                                                               =========
Foreign income taxes included in gross income under section 78
 as a dividend:
  Taxes of A Corp. (from example 1)...........................        20
  Taxes of B Corp.............................................        50
                                                               ---------
     Total....................................................        70
 

    Example 3. For 1978, domestic corporation M owns all the one class 
of stock of foreign corporation A, which in turn owns all the one class 
of stock of foreign corporation B. All corporations use the calendar 
year as the taxable year. For 1978, M Corporation is deemed under 
paragraph (b)(2) of this section to have paid $50 of the foreign income 
taxes paid, or deemed under paragraph (c)(2) of this section to be paid, 
by A Corporation for such year and includes such amount in gross income 
as a dividend under section 78, determined as follows upon the basis of 
the facts assumed:

B Corp. (second-tier corporation):
  Gains, profits, and income..................................      $300
  Foreign income taxes imposed on or with respect to gains,          120
   profits, and income........................................

[[Page 749]]

 
  Accumulated profits.........................................       300
  Foreign income taxes paid by B Corp. on or with respect to         120
   its accumulated profits (total foreign income taxes).......
  Accumulated profits in excess of foreign income taxes.......       180
  Dividends paid on December 31, 1978 to A Corp...............        90
  Foreign income taxes of B Corp. deemed paid by A Corp. for          60
   1978 under section 902(b)(1) ($120 x $90/$180).............
A Corp. (first-tier corporation):
  Gains, profits, and income:
    Business operations.......................................       200
    Dividends from B Corp.....................................        90
                                                               ---------
     Total....................................................       290
Foreign income taxes imposed on or with respect to gains,             40
 profits, and income..........................................
Accumulated profits...........................................      $290
Foreign income taxes paid by A Corp. on or with respect to its        40
 accumulated profits (total foreign income taxes).............
Accumulated profits in excess of foreign income taxes.........       250
Foreign income taxes paid, and deemed to be paid, by A Corp.         100
 for 1978 on or with respect to its accumulated profits for
 such year ($60 + $40)........................................
Dividends paid on Deember. 31, 1978, to M Corp................       125
M Corp. (domestic shareholder):
  Foreign income taxes of A Corp. deemed paid by M Corp. for          50
   1978 under section 902(a) ($100 x $125/$250)...............
  Foreign income taxes included in gross income of M Corp.            50
   under section 78 as a dividend received from A Corp........
 

    Example 4. Throughout 1978, domestic corporation M owns 50 percent 
of the voting stock of foreign corporation A, not a less developed 
country corporation. A Corporation has owned 40 percent of the voting 
stock of foreign corporation B, since 1970; B Corporation has owned 30 
percent of the voting stock of foreign corporation C, since 1972. B 
Corporation, uses a fiscal year ending on June 30 as its taxable year; 
all other corporations use the calendar year as the taxable year. On 
February 1, 1977, B Corporation receives a dividend from C Corporation 
out of C Corporation's accumulated profits for 1976. On February 15, 
1977, A Corporation receives a dividend from B Corporation out of B 
Corporation's accumulated profits for its fiscal year ending in 1977. On 
February 15, 1978, M Corporation receives a dividend from A Corporation 
out of A Corporation's accumulated profits for 1977. For 1978, M 
Corporation is deemed under paragraph (b)(2) of this section to have 
paid $81.67 of the foreign income taxes paid, or deemed under paragraph 
(c)(2) of this section to be paid, by A Corporation on or with respect 
to its accumulated profits for 1977, and M Corporation includes that 
amount in gross income as a dividend under section 78, determined as 
follows upon the basis of the facts assumed:

C Corp. (third-tier corporation):
  Gains, profits, and income for 1976.......................   $2,000.00
  Foreign income taxes imposed on or with respect to such         800.00
   gains, profits, and income...............................
  Accumulated profits.......................................    2,000.00
  Foreign income taxes paid by C Corp. on or with respect to      800.00
   its accumulated profits (total foreign income taxes).....
  Accumulated profits in excess of foreign income taxes.....    1,200.00
  Dividends paid on Feb. 1, 1977 to B Corp..................      150.00
  Foreign income taxes of C Corp. for 1976 deemed paid by B       100.00
   Corp. for its fiscal year ending in 1977 ($800 x $150/
   $1,200)..................................................
B Corp. (second-tier corporation):
  Gains, profits, and income for fiscal year ending in 1977:
    Business operations.....................................      850.00
    Dividends from C Corp...................................      150.00
                                                             -----------
     Total..................................................    1,000.00
Foreign income taxes imposed on or with respect to gains,         200.00
 profits, and income........................................
Accumulated profits.........................................    1,000.00
Foreign income taxes paid by B Corp. on or with respect to       $200.00
 its accumulated profits (total foreign income taxes).......
Accumulated profits in excess of foreign income taxes.......      800.00
Foreign income taxes paid, and deemed to be paid, by B Corp.      300.00
 for its fiscal year on or with respect to its accumulated
 profits for such year ($100 + $200)........................
Dividends paid on February 15, 1977 to A Corp...............      120.00
Foreign income taxes of B Corp. for its fiscal year deemed         45.00
 paid by A Corp. for 1977 ($300 x $120/$800)................
A Corp. (first-tier corporation):
  Gains, profits, and income for 1977:
    Business operations.....................................      380.00
    Dividends from B Corp...................................      120.00
                                                             -----------
     Total..................................................      500.00
Foreign income taxes imposed on or with respect to gains,         200.00
 profits, and income........................................
Accumulated profits.........................................      500.00
Foreign income taxes paid by A Corp. on or with respect to        200.00
 its accumulated profits (total foreign income taxes).......
Accumulated profits in excess of foreign taxes..............      300.00
Foreign income taxes paid, and deemed to be paid, by A Corp.      245.00
 for 1977 on or with respect to its accumulated profits for
 such year ($45 + $200).....................................
Dividends paid on Feb. 15, 1978 to M Corp...................      100.00
M Corp. (domestic shareholder):
  Foreign income taxes of A Corp. for 1977 deemed paid by M        81.67
   Corp. for 1978 under section 902(a)(1) ($245 x $100/$300)
  Foreign income taxes included in gross income of M Corp.         81.67
   under section 78 as a dividend received from A Corp......
 


    (l) Effective date. Except as provided in Sec.  1.902-4, this 
section applies to any distribution received from a first-tier 
corporation by its domestic shareholder after December 31, 1964, and 
before the beginning of the foreign corporation's first taxable year 
beginning after December 31, 1986. If, however, the first day on which 
the ownership requirements of section 902(c)(3)(B) and Sec.  1.902-
1(a)(1) through (4) are met with respect to the foreign corporation is 
in a taxable year of the foreign corporation beginning after December 
31, 1986,

[[Page 750]]

then this section shall apply to all taxable years beginning after 
December 31, 1964, and before the year in which the ownership 
requirements are first met. See Sec.  1.902-1(a)(13)(i). For 
corresponding rules applicable to distributions received by the domestic 
shareholder prior to January 1, 1965, see Sec.  1.902-5 as contained in 
the 26 CFR part 1 edition revised April 1, 1976.

[T.D. 7481, 42 FR 20125, Apr. 18, 1977, as amended by T.D. 7490, 42 FR 
30497, June 15, 1977; T.D. 7649, 44 FR 60086, Oct. 18, 1979. 
Redesignated and amended by T.D. 8708, 62 FR 927, 940, Jan. 7, 1997; 62 
FR 7155, Feb. 18, 1997; T.D. 9849, 84 FR 9236, Mar. 14, 2019]



Sec.  1.902-4  Rules for distributions attributable to accumulated profits 
for taxable years in which a first-tier corporation was a less developed 
country corporation.

    (a) In general. If a domestic shareholder receives a distribution 
from a first-tier corporation before January 1, 1978, in a taxable year 
of the domestic shareholder beginning after December 31, 1964, which is 
attributable to accumulated profits of the first-tier corporation for a 
taxable year beginning before January 1, 1976, in which the first-tier 
corporation was a less developed country corporation (as defined in 26 
CFR Sec.  1.902-2 revised as of April 1, 1978), then the amount of the 
credit deemed paid by the domestic shareholder with respect to such 
distribution shall be calculated under the rules relating to less 
developed country corporations contained in (26 CFR Sec.  1.902-1 
revised as of April 1, 1978).
    (b) Combined distributions. If a domestic shareholder receives a 
distribution before January 1, 1978, from a first-tier corporation, a 
portion of which is described in paragraph (a) of this section, and a 
portion of which is attributable to accumulated profits of the first-
tier corporation for a year in which the first-tier corporation was not 
a less developed country corporation, then the amount of taxes deemed 
paid by the domestic shareholder shall be computed separately on each 
portion of the dividend. The taxes deemed paid on that portion of the 
dividend described in paragraph (a) shall be computed as specified in 
paragraph (a). The taxes deemed paid on that portion of the dividend 
described in this paragraph (b), shall be computed as specified in Sec.  
1.902-3.
    (c) Distributions of a first-tier corporation attributable to 
certain distributions from second- or third-tier corporations. Paragraph 
(a) shall apply to a distribution received by a domestic shareholder 
before January 1, 1978, from a first-tier corporation out of accumulated 
profits for a taxable year beginning after December 31, 1975, if:
    (1) The distribution is attributable to a distribution received by 
the first-tier corporation from a second- or third-tier corporation in a 
taxable year beginning after December 31, 1975.
    (2) The distribution from the second- or third-tier corporation is 
made out of accumulated profits of the second- or third-tier corporation 
for a taxable year beginning before January 1, 1976, and
    (3) The first-tier corporation would have qualified as a less 
developed country corporation under section 902(d) (as in effect on 
December 31, 1975), in the taxable year in which it received the 
distribution.
    (d) Illustrations. The application of this section may be 
illustrated by the following examples:

    Example 1. M, a domestic corporation owns all of the one class of 
stock of foreign corporation A. Both corporations use the calendar year 
as the taxable year. A Corporation pays a dividend to M Corporation on 
January 1, 1977, partly out of its accumulated profits for calendar year 
1976 and partly out of its accumulated profits for calendar year 1975. 
For 1975 A Corporation qualified as a less developed country corporation 
under the former section 902(d) (as in effect on December 31, 1975). M 
Corporation is deemed under paragraphs (a) and (b) of this section to 
have paid $63 of foreign income taxes paid by A Corporation on or with 
respect to its accumulated profits for 1976 and 1975 and M Corporation 
includes $36 of that amount in gross income as a dividend under section 
78, determined as follows upon the basis of the facts assumed:

                                  1976
Gains, profits, and income of A Corp. for 1976...............    $120.00
Foreign income taxes imposed on or with respect to such            36.00
 gains, profits, and income..................................
Accumulated profits..........................................     120.00
Foreign income taxes paid by A Corp. on or with respect to         36.00
 its accumulated profits (total foreign income taxes)........
Accumulated profits in excess of foreign income taxes........      84.00

[[Page 751]]

 
Dividend to M Corp. out of 1976 accumulated profits..........      84.00
Foreign income taxes of A for 1976 deemed paid by M Corp.          36.00
 ($84/$84 x $36).............................................
Foreign income taxes included in gross income of M Corp.           36.00
 under section 78 as a dividend from A Corp..................
 


                                  1975
Gains, profits, and income of A Corp. for 1975...............    $257.14
Foreign income taxes imposed on or with respect to such            77.14
 gains, profits, and income..................................
Accumulated profits (under section 902(c)(1)(B) as in effect      180.00
 prior to amendment by the Tax Reform Act of 1976)...........
Foreign income taxes paid by A Corp. on or with respect to         54.00
 its accumulated profits ($77.14 x $180/$257.14).............
Dividend to M Corp. out of accumulated profits of A Corp. for      90.00
 1975........................................................
Foreign income taxes of A Corp. for 1975 deemed paid by M          27.00
 Corp. (under section 902(a)(2) as in effect prior to
 amendment by the Tax Reform Act of 1976) ($54 x $90/$180)...
Foreign income taxes included in gross income of M Corp.               0
 under section 78 as a dividend from A Corp..................
 

    Example 2. The facts are the same as in example 1, except that the 
distribution from A Corporation to M Corporation on January 1, 1977, was 
from accumulated profits of A Corporation for 1976. A Corporation's 
accumulated profits for 1976 were made up of income from its trade or 
business, and a dividend paid by B, a second-tier corporation in 1976. 
The dividend from B Corporation to A Corporation was from accumulated 
profits of B Corporation for 1975. A Corporation would have qualified as 
a less developed country corporation for 1976 under the former section 
902(d) (as in effect on December 31, 1975). M Corporation is deemed 
under paragraphs (b) and (c) of this section to have paid $543 of the 
foreign taxes paid or deemed paid by A Corporation on or with respect to 
its accumulated profits for 1976, and M Corporation includes $360 of 
that amount in gross income as a dividend under section 78, determined 
as follows upon the basis of the facts assumed:

Total gains, profits, and income of A Corp. for 1976..........    $1,500
                                                               ---------
  Gains and profits from business operations..................     1,200
  Gains and profits from dividend A Corp. received in 1976           300
   from B Corp. out of accumulated profits of B Corp. for 1975
                                                               ---------
Foreign taxes imposed on or with respect to such profits and         450
 income.......................................................
                                                               ---------
  Foreign taxes paid by A Corp. attributable to gains and            360
   profits from A Corp.'s business operations.................
  Foreign taxes paid by A Corp. attributable to dividend from         90
   B Corp. in 1976............................................
                                                               ---------
Dividends from A Corp. to M Corp. on Jan. 1, 1977.............     1,050
                                                               ---------
  Portion of dividend attributable to gains and profits of A         840
   Corp. from business operations. ($1,200/$1,500 x $1,050)...
  Portion of dividends attributable to gains on profits of A         210
   Corp. from dividend from B Corp. ($300/$1,500 x $1,050)....
 

    (a) Amount of foreign taxes of A Corp. deemed paid by M Corp. on A 
Corp.'s gains and profits for 1976 from business operations.

Gains, profits, and income of A Corp. from business operations    $1,200
Foreign income taxes imposed on or with respect to gains,            360
 profits, and income..........................................
Accumulated profits...........................................     1,200
Foreign income taxes paid by A Corp. on or with respect to its       360
 accumulated profits (total foreign income taxes).............
Accumulated profits in excess of foreign income taxes.........       840
Dividend to M Corp............................................       840
Foreign taxes of A Corp. deemed paid by M Corp. ($360 x $840/        360
 $840)........................................................
Foreign taxes included in gross income of M Corp. under              360
 section 78 as a dividend.....................................
 

    (b) Amount of foreign taxes of A Corp. deemed paid by M Corp. on 
portion of the dividend attributable to B Corp.'s accumulated profits 
for 1975.

B Corp. (second-tier corporation):
  Gains, profits, and income for calendar year 1975...........    $1,000
  Foreign income taxes imposed on or with respect to gains,          400
   profits, and income........................................
  Accumulated profits (under section 902(c)(1)(B) as in effect       600
   prior to amendment by the Tax Reform Act of 1976)..........
  Foreign income taxes paid by B Corp. on or with respect to         240
   its accumulated profits ($400 x $600/$1,000)...............
  Dividend to A Corp. in 1976.................................       300
  Foreign taxes of B Corp. for 1975 deemed paid by A Corp.           120
   (under section 902(b)(1)(B) as in effect prior to amendment
   by the Tax Reform Act of 1976) ($240 x $300/$600)..........
A Corp. (first-tier corporation):
  Gains, profits, and income for 1976 attributable to dividend       300
   from B Corp.'s accumulated profits for 1975................
  Foreign income taxes imposed on or with respect to such             90
   gains, profits, and income.................................
  Accumulated profits (under section 902(c)(1)(B) as in effect       210
   prior to amendment by the Tax Reform Act of 1976)..........
  Foreign taxes paid by A Corp. on or with respect to such            63
   accumulated profits ($90 x $210/$300)......................
  Foreign income taxes paid and deemed to be paid by A Corp.         183
   for 1976 on or with respect to such accumulated profits
   ($120 + $63)...............................................
  Dividend paid to M Corp. attributable to dividend from B           210
   Corp. out of accumulated profits for 1975).................
  Foreign taxes of A Corp. deemed paid by M Corp. (under             183
   section 902(a)(2) as in effect prior to amendment by the
   Tax Reform Act of 1976) ($183 x $210/$210).................
  Amount included in gross income of M Corp. under section 78.         0
 


[T.D. 7649, 44 FR 60087, Oct. 18, 1979. Redesignated and amended by T.D. 
8708, 62 FR 927, 940, Jan. 7, 1997]

[[Page 752]]



Sec.  1.903-1  Taxes in lieu of income taxes.

    (a) In general. Section 903 provides that the term ``income, war 
profits, and excess profits taxes'' shall include a tax paid in lieu of 
a tax on income, war profits, or excess profits (``income tax'') 
otherwise generally imposed by any foreign country. For purposes of this 
section and Sec. Sec.  1.901-2 and 1.901-2A, such a tax is referred to 
as a ``tax in lieu of an income tax''; and the terms ``paid'' and 
``foreign country'' are defined in Sec.  1.901-2(g). A foreign levy 
(within the meaning of Sec.  1.901-2(g)(3)) is a tax in lieu of an 
income tax if and only if--
    (1) It is a tax within the meaning of Sec.  1.901-2(a)(2); and
    (2) It meets the substitution requirement as set forth in paragraph 
(b) of this section.


The foreign country's purpose in imposing the foreign tax (e.g., whether 
it imposes the foreign tax because of administrative difficulty in 
determining the base of the income tax otherwise generally imposed) is 
immaterial. It is also immaterial whether the base of the foreign tax 
bears any relation to realized net income. The base of the tax may, for 
example, be gross income, gross receipts or sales, or the number of 
units produced or exported. Determinations of the amount of a tax in 
lieu of an income tax that is paid by a person and determinations of the 
person by whom such tax is paid are made under Sec.  1.901-2 (e) and 
(f), respectively, substituting the phrase ``tax in lieu of an income 
tax'' for the phrase ``income tax'' wherever the latter appears in those 
sections. Section 1.901-2A contains additional rules applicable to dual 
capacity taxpayers (as defined in Sec.  1.901-2(a)(2)(ii) (A)). The 
rules of this section are applied independently to each separate levy 
(within the meaning of Sec. Sec.  1.901-2(d) and 1.901-2A (a)) imposed 
by the foreign country. Except as otherwise provided in paragraph (b)(2) 
of this section, a foreign tax either is or is not a tax in lieu of an 
income tax in its entirety for all persons subject to the tax.
    (b) Substitution--(1) In general. A foreign tax satisfies the 
substitution requirement if the tax in fact operates as a tax imposed in 
substitution for, and not in addition to, an income tax or a series of 
income taxes otherwise generally imposed. However, not all income 
derived by persons subject to the foreign tax need be exempt from the 
income tax. If, for example, a taxpayer is subject to a generally 
imposed income tax except that, pursuant to an agreement with the 
foreign country, the taxpayer's income from insurance is subject to a 
gross receipts tax and not to the income tax, then the gross receipts 
tax meets the substitution requirement notwithstanding the fact that the 
taxpayer's income from other activities, such as the operation of a 
hotel, is subject to the generally imposed income tax. A comparison 
between the tax burden of this insurance gross receipts tax and the tax 
burden that would have obtained under the generally imposed income tax 
is irrelevant to this determination.
    (2) Soak-up taxes. A foreign tax satisfies the substitution 
requirement only to the extent that liability for the foreign tax is not 
dependent (by its terms or otherwise) on the availability of a credit 
for the foreign tax against income tax liability to another country. If, 
without regard to this paragraph (b)(2), a foreign tax satisfies the 
requirement of paragraph (b)(1) of this section (including for this 
purpose any foreign tax that both satisfies such requirement and also is 
an income tax within the meaning of Sec.  1.901-2(a)(1)), liability for 
the foreign tax is dependent on the availability of a credit for the 
foreign tax against income tax liability to another country only to the 
extent of the lesser of--
    (i) The amount of foreign tax that would not be imposed on the 
taxpayer but for the availability of such a credit to the taxpayer 
(within the meaning of Sec.  1.901-2(c)), or
    (ii) The amount, if any, by which the foreign tax paid by the 
taxpayer exceeds the amount of foreign income tax that would have been 
paid by the taxpayer if it had instead been subject to the generally 
imposed income tax of the foreign country.
    (3) Examples. The provisions of this paragraph (b) may be 
illustrated by the following examples:

    Example 1. Country X has a tax on realized net income that is 
generally imposed except

[[Page 753]]

that nonresidents are not subject to that tax. Nonresidents are subject 
to a gross income tax on income from country X that is not attributable 
to a trade or business carried on in country X. The gross income tax 
imposed on nonresidents satisfies the substitution requirement set forth 
in this paragraph (b). See also examples 1 and 2 of Sec.  1.901-
2(b)(4)(iv).
    Example 2. The facts are the same as in example 1, with the 
additional fact that payors located in country X are required by country 
X law to withhold the gross income tax from payments they make to 
nonresidents, and to remit such withheld tax to the government of 
country X. The result is the same as in example 1.
    Example 3. The facts are the same as in example 2, with the 
additional fact that the gross income tax on nonresidents applies to 
payments for technical services performed by them outside of country X. 
The result is the same as in example 2.
    Example 4. Country X has a tax that is generally imposed on the 
realized net income of nonresident corporations that is attributable to 
a trade or business carried on in country X. The tax applies to all 
nonresident corporations that engage in business in country X except for 
such corporations that engage in contracting activities, each of which 
is instead subject to two different taxes. The taxes applicable to 
nonresident corporations that engage in contracting activities satisfy 
the substitution requirement set forth in this paragraph (b).
    Example 5. Country X imposes both an excise tax and an income tax. 
The excise tax, which is payable independently of the income tax,is 
allowed as a credit against the income tax. For 1984 A has a tentative 
income tax liability of 100u (units of country X currency) but is 
allowed a credit for 30u of excise tax that it has paid. Pursuant to 
paragraph (e)(4)(i) of Sec.  1.901-2, the amount of excise tax A has 
paid to country X is 30u and the amount of income tax A has paid to 
country X is 70u. The excise tax paid by A does not satisfy the 
substitution requirement set forth in this paragraph (b) because the 
excise tax is imposed on A in addition to, and not in substitution for, 
the generally imposed income tax.
    Example 6. Pursuant to a contract with country X, A, a domestic 
corporation engaged in manufacturing activities in country X, must pay 
tax to country X equal to the greater of (i) 5u (units of country X 
currency) per item produced, or (ii) the maximum amount creditable by A 
against its U.S. income tax liability for that year with respect to 
income from its country X operations. Also pursuant to the contract, A 
is exempted from country X's otherwise generally imposed income tax. A 
produces 16 items in 1984 and the maximum amount creditable by A against 
its U.S. income tax liability for 1984 is 125u. If A had been subject to 
country X's otherwise generally imposed income tax it would have paid a 
tax of 150u. Pursuant to paragraph (b)(2) of this section, the amount of 
tax paid by A that is dependent on the availability of a credit against 
income tax of another country is 0 (lesser of (i) 45u, the amount that 
would not be imposed but for the availability of a credit (125u-80u), or 
(ii) 0, the amount by which the contractual tax (125u) exceeds the 
generally imposed income tax (150u)).
    Example 7. The facts are the same as in example 6 except that, of 
the 150u A would have paid if it had been subject to the otherwise 
generally imposed income tax, 60u is dependent on the availability of a 
credit against income tax of another country. The amount of tax actually 
paid by A (i.e., 125u) that is dependent on the availability of a credit 
against income tax of another country is 35u (lesser of (i) 45u, 
computed as in example , Sec.  6, or (ii) 35u, the amount by which the 
contractual tax (125u) exceeds the amount A would have paid as income 
tax if it had been subject to the otherwise generally imposed income tax 
(90u, i.e., 150u-60u).

    (c) Effective date. The effective date of this section is as 
provided in Sec.  1.901-2(h).

[T.D. 7918, 48 FR 46295, Oct. 12, 1983; 48 FR 52033, Nov. 16, 1983]



Sec.  1.904-0  Outline of regulation provisions for section 904.

    This section lists the headings for Sec. Sec.  1.904-1 through 
1.904-7.

          Sec.  1.904-1 Limitation on credit for foreign taxes.

    (a) Per-country limitation.
    (1) General.
    (2) Illustration of principles.
    (b) Overall limitation.
    (1) General.
    (2) Illustration of principles.
    (c) Special computation of taxable income.
    (d) Election of overall limitation.
    (1) In general.
    (i) Manner of making election.
    (ii) Revocation for first taxable year beginning after December 31, 
1969.
    (2) Method of making the initial election.
    (3) Method of revoking an election and making a new election.
    (e) Joint return.
    (1) General.
    (2) Electing the overall limitation.

      Sec.  1.904-2 Carryback and carryover of unused foreign tax.

    (a) Credit for foreign tax carryback or carryover.
    (b) Years to which carried.
    (1) General.

[[Page 754]]

    (2) Definitions.
    (3) Taxable years beginning before January 1, 1958.
    (c) Tax deemed paid or accrued.
    (1) Unused foreign tax for per-country limitation year.
    (2) Unused foreign tax for overall limitation year.
    (3) Unused foreign tax with respect to foreign mineral income.
    (d) Determination of excess limitation for certain years.
    (e) Periods of less than 12 months.
    (f) Statement with tax return.
    (g) Illustration of carrybacks and carryovers.
    (h) Transition rules for carryovers and carrybacks of pre-2003 and 
post-2002 unused foreign tax paid or accrued with respect to dividends 
from noncontrolled section 902 corporations.
    (1) Carryover of unused foreign tax.
    (2) Carryback of unused foreign tax.
    (i) Transition rules for carryovers and carrybacks of pre-2007 and 
post-2006 unused foreign tax.
    (1) Carryover of unused foreign tax.
    (i) General rule.
    (ii) Safe harbor.
    (2) Carryback of unused foreign tax.
    (i) General rule.
    (ii) Safe harbor.
    (3) Effective/applicability date.

 Sec.  1.904-3 Carryback and carryover of unused foreign tax by husband 
                                and wife.

    (a) In general.
    (b) Joint unused foreign tax and joint excess limitation.
    (c) Continuous use of joint return.
    (d) From separate to joint return.
    (e) Amounts carried from or through a joint return year to or 
through a separate return year.
    (f) Allocation of unused foreign tax and excess limitation.
    (1) Limitation.
    (i) Per-country limitation.
    (ii) Overall limitation.
    (2) Unused foreign tax.
    (i) Per-country limitation.
    (ii) Overall limitation.
    (3) Excess limitation.
    (i) Per-country limitation taxpayer.
    (ii) Overall limitation.
    (4) Excess limitation to be applied.
    (5) Reduction of excess limitation.
    (6) Spouses using different limitations.
    (g) Illustrations.

   Sec.  1.904-4 Separate application of section 904 with respect to 
                      certain categories of income.

    (a) In general.
    (b) Passive category income.
    (1) In general.
    (2) Passive income.
    (i) In general.
    (ii) Exceptions.
    (iii) Active rents or royalties.
    (A) In general.
    (B) Active conduct of trade or business.
    (iv) Examples.
    (3) Specified passive category income.
    (c) High-taxed income.
    (1) In general.
    (2) Grouping of items of income in order to determine whether 
passive income is high-taxed income.
    (i) Effective dates.
    (A) In general.
    (B) Application to prior periods.
    (ii) Grouping rules.
    (A) Initial allocation and apportionment of deductions and taxes.
    (B) Reallocation of loss groups.
    (3) Amounts received or accrued by United States persons.
    (4) Dividends and inclusions from controlled foreign corporations, 
dividends from noncontrolled section 902 corporations, and income of 
foreign QBUs.
    (5) Special rules.
    (i) Certain rents and royalties.
    (ii) Treatment of partnership income.
    (iii) Currency gain or loss.
    (iv) Coordination with section 954(b)(4).
    (6) Application of this paragraph to additional taxes paid or deemed 
paid in the year of receipt of previously taxed income.
    (i) Determination made in year of inclusion.
    (ii) Exception.
    (iii) Allocation of foreign taxes imposed on distributions of 
previously taxed income.
    (iv) Increase in taxes paid by successors.
    (A) General rule.
    (B) Exception for U.S. shareholders not entitled to look-through.
    (7) Application of this paragraph to certain reductions of tax on 
distributions of income.
    (i) In general.
    (ii) Allocation of reductions of foreign tax.
    (iii) Interaction with section 954(b)(4).
    (8) Examples.
    (d) [Reserved]
    (e) Financial services income.
    (1) In general.
    (2) Active financing income.
    (i) Income included.
    (3) Financial services entities.
    (i) In general.
    (ii) Special rule for affiliated groups.
    (iii) Treatment of partnerships and other pass-through entities.
    (A) Rule.
    (B) Examples.
    (iv) Examples.
    (4) Definition of incidental income.
    (i) In general.
    (A) Rule.
    (B) Examples.
    (ii) Income that is not incidental income.
    (5) Exceptions.

[[Page 755]]

    (f)-(g) [Reserved]
    (h) Export financing interest.
    (1) Definitions.
    (i) Export financing.
    (ii) Fair market value.
    (iii) Related person.
    (2) Treatment of export financing interest.
    (3) Exception.
    (4) Examples.
    (5) Income eligible for section 864(d)(7) exception (same country 
exception) from related person factoring treatment.
    (i) Income other than interest.
    (ii) Interest income.
    (iii) Examples.
    (i) Interaction of section 907(c) and income described in this 
section.
    (j) Special rule for certain currency gains and losses.
    (k) Special rule for alternative minimum tax foreign tax credit.
    (l) Priority rule.
    (m) Income treated as allocable to an additional separate category.

   Sec.  1.904-5 Look-through rules as applied to controlled foreign 
                    corporations and other entities.

    (a) Definitions.
    (b) In general.
    (c) Rules for specific types of inclusions and payments.
    (1) Subpart F inclusions.
    (i) Rule.
    (ii) Examples.
    (2) Interest.
    (i) In general.
    (ii) Allocating and apportioning expenses including interest paid to 
a related person.
    (iii) Allocating and apportioning expenses of a noncontrolled 
section 902 corporation.
    (iv) Definitions.
    (A) Value of assets and reduction in value of assets and gross 
income.
    (B) Related person debt allocated to passive assets.
    (v) Examples.
    (3) Rents and royalties.
    (4) Dividends.
    (i) Look-through rule for controlled foreign corporations.
    (ii) Special rule for dividends attributable to certain loans.
    (iii) Look-through rule for noncontrolled section 902 corporations.
    (iv) Examples.
    (d) Effect of exclusions from Subpart F income.
    (1) De minimis amount of Subpart F income.
    (2) Exception for certain income subject to high foreign tax.
    (3) Examples.
    (e) Treatment of Subpart F income in excess of 70 percent of gross 
income.
    (1) Rule.
    (2) Example.
    (f) Modifications of look-through rules for certain income.
    (1) High withholding tax interest.
    (i) Rule.
    (ii) Example.
    (2) Distributions from a FSC.
    (3) Example.
    (g) Application of the look-through rules to certain domestic 
corporations.
    (h) Application of the look-through rules to partnerships and other 
pass-through entities.
    (1) General rule.
    (2) Exception for certain partnership interests.
    (i) Rule.
    (ii) Exceptions.
    (3) Income from the sale of a partnership interest.
    (i) In general.
    (ii) Exception for sale by 25-percent owner.
    (4) Value of a partnership interest.
    (i) Application of look-through rules to related entities.
    (1) In general.
    (2) Exception for distributive shares of partnership income.
    (3) Special rule for dividends between controlled foreign 
corporations.
    (4) Payor and recipient of dividend are members of the same 
qualified group.
    (5) Examples.
    (j) Look-through rules applied to passive foreign investment company 
inclusions.
    (k) Ordering rules.
    (1) In general.
    (2) Specific rules.
    (l) Examples.
    (m) Application of section 904(h).
    (1) In general.
    (2) Treatment of interest payments.
    (i) Interest payments from controlled foreign corporations.
    (ii) Interest payments from noncontrolled section 902 corporations.
    (3) Examples.
    (4) Treatment of dividend payments.
    (i) Rule.
    (ii) Determination of earnings and profits from United States 
sources.
    (iii) Example.
    (5) Treatment of inclusions under sections 951(a)(1)(A) and 1293.
    (i) Rule.
    (ii) Example.
    (6) Treatment of section 78 amount.
    (7) Coordination with treaties.
    (i) Rule.
    (ii) Example.
    (n) Order of application of sections 904(d) and (h).
    (o) Effective date.
    (1) Rules for controlled foreign corporations and other look-through 
entities.
    (2) Rules for noncontrolled section 902 corporations.

[[Page 756]]

    (3) Rules for income from the sale of a partnership interest.

          Sec.  1.904-6 Allocation and apportionment of taxes.

    (a) Allocation and apportionment of taxes to a separate category or 
categories of income.
    (1) Allocation of taxes to a separate category or categories of 
income.
    (i) Taxes related to a separate category of income.
    (ii) Apportionment of taxes related to more than one separate 
category.
    (iii) Apportionment of taxes for purposes of applying the high tax 
income test.
    (iv) Special rule for base and timing differences.
    (2) Reserved.
    (b) Application of paragraph (a) to sections 902 and 960.
    (1) Determination of foreign taxes deemed paid.
    (2) Distributions received from foreign corporations that are 
excluded from gross income under section 959(b).
    (3) Application of section 78.
    (4) Increase in limitation.
    (c) Examples.

                     Sec.  1.904-7 Transition rules.

    (a) Characterization of distributions and section 951(a)(1)(A) (ii) 
and (iii) and (B) inclusions of earnings of a controlled foreign 
corporation accumulated in taxable years beginning before January 1, 
1987, during taxable years of both the payor controlled foreign 
corporation and the recipient which begin after December 31, 1986.
    (1) Distributions and section 951(a)(1)(A) (ii) and (iii) and (B) 
inclusions.
    (2) Limitation on establishing the character of earnings and 
profits.
    (b) Application of look-through rules to distributions (including 
deemed distributions) and payments by an entity to a recipient when 
one's taxable year begins before January 1, 1987 and the other's taxable 
year begins after December 31, 1986.
    (1) In general.
    (2) Payor of interest, rents, or royalties is subject to the Act and 
recipient is not subject to the Act.
    (3) Recipient of interest, rents, or royalties is subject to the Act 
and payor is not subject to the Act.
    (4) Recipient of dividends and subpart F inclusions is subject to 
the Act and payor is not subject to the Act.
    (5) Examples.
    (c) Installment sales.
    (d) Special effective date for high withholding tax interest earned 
by persons with respect to qualified loans described in section 
1201(e)(2) of the Act.
    (e) Treatment of certain recapture income.
    (f) Treatment of non-look-through pools of a noncontrolled section 
902 corporation or a controlled foreign corporation in post-2002 taxable 
years.
    (1) Definition of non-look-through pools.
    (2) Treatment of non-look-through pools of a noncontrolled section 
902 corporation.
    (3) Treatment of non-look-through pools of a controlled foreign 
corporation.
    (4) Substantiation of look-through character of undistributed 
earnings and taxes in a non-look-through pool.
    (i) Reconstruction of earnings and taxes pools.
    (ii) Safe harbor method.
    (iii) Inadequate substantiation.
    (iv) Examples.
    (5) Treatment of a deficit accumulated in a non-look-through pool.
    (6) Treatment of pre-1987 accumulated profits.
    (7) Treatment of post-1986 undistributed earnings or a deficit of a 
controlled foreign corporation attributable to dividends from a 
noncontrolled section 902 corporation paid in taxable years beginning 
before January 1, 2003.
    (i) Look-through treatment of post-1986 undistributed earnings at 
controlled foreign corporation level.
    (ii) Look-through treatment of deficit in post-1986 undistributed 
earnings at controlled foreign corporation level.
    (iii) Substantiation required for look-through treatment.
    (8) Treatment of distributions received by an upper-tier corporation 
from a lower-tier noncontrolled section 902 corporation, including when 
the corporations do not have the same taxable years.
    (i) Rule.
    (ii) Example.
    (9) Election to apply pre-AJCA rules to 2003 and 2004 taxable years.
    (i) Definition.
    (ii) Time, manner, and form of election.
    (iii) Treatment of non-look-through pools in taxable years beginning 
after December 31, 2004.
    (iv) Carryover of unused foreign tax.
    (v) Carryback of unused foreign tax.
    (vi) Recapture of overall foreign loss or separate limitation loss 
in the single category for dividends from all noncontrolled section 902 
corporations.
    (vii) Recapture of separate limitation losses in other separate 
categories.
    (viii) Treatment of undistributed earnings in an upper-tier 
corporation-level single category for dividends from lower-tier 
noncontrolled section 902 corporations.
    (ix) Treatment of a deficit in the single category for dividends 
from lower-tier noncontrolled section 902 corporations.
    (10) Effective/applicability date.
    (g) Treatment of earnings and foreign taxes of a controlled foreign 
corporation or a

[[Page 757]]

noncontrolled section 902 corporation accumulated in taxable years 
beginning before January 1, 2007.
    (1) Definitions.
    (i) Pre-2007 pools.
    (ii) Pre-2007 separate categories.
    (iii) Post-2006 separate categories.
    (2) Treatment of pre-2007 pools of a controlled foreign corporation 
or a noncontrolled section 902 corporation.
    (3) Substantiation of post-2006 character of earnings and taxes in a 
pre-2007 pool.
    (i) Reconstruction of earnings and taxes pools.
    (ii) Safe harbor method.
    (A) In general.
    (B) General safe harbor method.
    (C) Interest apportionment safe harbor.
    (iii) Consistency rule.
    (4) Treatment of pre-1987 accumulated profits.
    (5) Treatment of earnings and foreign taxes in pre-2007 pools of a 
lower-tier controlled foreign corporation or noncontrolled section 902 
corporation.
    (6) Effective/applicability date.

[T.D. 8412, 57 FR 20642, May 14, 1992, as amended by T.D. 8627, 60 FR 
56119, Nov. 7, 1995; T.D. 8805, 64 FR 1515, Jan. 11, 1999; T.D. 8916, 66 
FR 274, Jan. 3, 2001; T.D. 9141, 69 FR 43306, July 20, 2004; T.D. 9260, 
71 FR 24528, Apr. 25, 2006; 71 FR 77265, Dec. 26, 2006; T.D. 9368, 72 FR 
72587, 72596, Dec. 21, 2007; T.D. 9452, 74 FR 27876, June 11, 2009; T.D. 
9521, 76 FR 19269, Apr. 7, 2011]



Sec.  1.904-1  Limitation on credit for foreign taxes.

    (a) Per-country limitation--(1) General. In the case of any taxpayer 
who does not elect the overall limitation under section 904(a)(2), the 
amount allowable as a credit for income or profits taxes paid or accrued 
to a foreign country or a possession of the United States is subject to 
the per-country limitation prescribed in section 904(a)(1). Such 
limitation provides that the credit for such taxes paid or accrued 
(including those deemed to have been paid or accrued other than by 
reason of section 904(d)) to each foreign country or possession of the 
United States shall not exceed that proportion of the tax against which 
credit is taken which the taxpayer's taxable income from sources within 
such country or possession (but not in excess of the taxpayer's entire 
taxable income) bears to his entire taxable income for the same taxable 
year. For special rules regarding the application of the per-country 
limitation when the taxpayer has derived section 904(f) interest or 
section 904(f) dividends, see Sec.  1.904-4 or Sec.  1.904-5.
    (2) Illustration of principles. The operation of the per-country 
limitation under section 904(a)(1) on the credit for foreign taxes paid 
or accrued may be illustrated by the following examples:

    Example 1. The credit for foreign taxes allowable for 1954 in the 
case of X, an unmarried citizen of the United States who in 1954 
received the income shown below and had three exemptions under section 
151, is $14,904, computed as follows:

Taxable income (computed without deductions for personal         $50,000
 exemptions) from sources within the United States...........
Taxable income (computed without deductions for personal          25,000
 exemptions) from sources within Great Britain...............
                                                              ----------
   Total taxable income......................................     75,000
United States income tax (based on taxable income computed        44,712
 with the deductions for personal exemptions)................
British income and profits taxes.............................     18,000
Per-country limitation (25,000/75,000 of $44,712)............     14,904
Credit for British income and profits taxes (total British        14,904
 income and profits taxes, reduced in accordance with the per-
 country limitation).........................................
 

    Example 2. Assume the same facts as in example 1, except that the 
sources of X's income and taxes paid are as shown below. The credit for 
foreign taxes allowable to X is $13,442.40, computed as follows:

Taxable income (computed without deductions for personal         $50,000
 exemptions) from sources within the United States...........
Taxable income (computed without deductions for personal          15,000
 exemptions) from sources within Great Britain...............
Taxable income (computed without deductions for personal          10,000
 exemptions) from sources within Canada......................
                                                              ----------
   Total taxable income......................................     75,000
United States income tax (based on taxable income computed        44,712
 with the deductions for personal exemptions)................
British income and profits taxes.............................     10,800
Per-country limitation on British income and profits taxes      8,942.40
 (15,000/75,000 of $44,712)..................................
Credit for British income and profits taxes as limited by per-  8,942.40
 country limitation..........................................
Canadian income and profits taxes............................   4,500.00
Per-country limitation on Canadian income and profits taxes     5,961.60
 (10,000/75,000 of $44,712)..................................
Credit for Canadian income and profits taxes (total Canadian    4,500.00
 income and profits taxes, since such amount does not exceed
 the per-country limitation).................................
                                                              ----------
    Total amount of credit allowable (sum of credits--         18,442.40
     $8,942.40 plus $4,500)..................................
 

    Example 3. A domestic corporation realized taxable income in 1954 in 
the amount of $100,000, consisting of $50,000 from United States sources 
and dividends of $50,000 from a Brazilian corporation, more than 10 
percent of whose voting stock it owned. The

[[Page 758]]

Brazilian corporation paid income and profits taxes to Brazil on its 
income and in addition paid a dividend tax for the account of its 
shareholders on income distributed to them, the latter tax being 
withheld and paid at the source. The domestic corporation's credit for 
foreign taxes is $23,250, computed as follows:

Taxable income from sources within the United States.  .......   $50,000
Taxable income from sources within Brazil............  .......    50,000
                                                      ----------
   Total taxable income..............................  .......   100,000
United States income tax.............................  .......    46,500
Dividend tax paid at source to Brazil................  .......    19,000
Income and profits taxes deemed under section 902 to
 have been paid to Brazil, computed as follows:
  Dividends received from Brazilian corporation        .......    50,000
   during 1954.......................................
  Income of Brazilian corporation during 1954........  .......   200,000
  Income and profits taxes paid to Brazil on $200,000  .......    30,000
  Accumulated profits ($200,000 minus $30,000).......  .......   170,000
  Brazilian taxes applicable to accumulated profits
   distributed:
    50,000/170,000 of 170,000/200,000 of $30,000.....  .......     7,500
                                                      ----------
    Total income and profits taxes paid and deemed to   26,500
     have been paid to Brazil........................
Per-country limitation (50,000/100,000 of $46,500)............    23,250
Credit for Brazilian income and profits taxes as limited by       23,250
 per-country limitation.......................................
 


    (b) Overall limitation--(1) General. In the case of any taxpayer who 
elects the overall limitation provided by section 904(a)(2), the total 
credit for taxes paid or accrued (including those deemed to have been 
paid or accrued other than by reason of section 904(d)) shall not exceed 
that proportion of the tax against which such credit is taken which the 
taxpayer's taxable income from sources without the United States (but 
not in excess of the taxpayer's entire taxable income) bears to his 
entire taxable income for the same taxable year. For special rules 
regarding the application of the overall limitation when the taxpayer 
has derived section 904(f) interest or section 904(f) dividends, see 
Sec.  1.904-4 or Sec.  1.904-5.
    (2) Illustration of principles. The operation of the overall 
limitation under section 904(a)(2) may be illustrated by the following 
example:

    Example. Corporation X, a domestic corporation, for its taxable year 
beginning January 1, 1961, elects the overall limitation provided by 
section 904(a)(2). For taxable year 1961 corporation X has taxable 
income of $275,000 of which $200,000 is from sources without the United 
States. The United States income tax is $137,500. During the taxable 
year corporation X pays or accrues to foreign countries $105,000 in 
income and profits taxes, consisting of $45,000 paid or accrued to 
foreign country Y and $60,000 to foreign country Z. The credit for such 
foreign taxes is limited to $100,000, i.e., 200,000 / 275,000 x 
$137,500. The limitation would be the same whether or not some portion 
of the $200,000 of the taxable income from sources without the United 
States is from sources on the high seas or in a foreign country (other 
than Y and Z) which imposed no taxes allowable as a credit.

    (c) Special computation of taxable income. For purposes of computing 
the limitations under paragraphs (a) and (b) of this section, the 
taxable income in the case of an individual, estate, or trust shall be 
computed without any deduction for personal exemptions under section 151 
or 642(b).
    (d) Election of overall limitation--(1) In general--(i) Manner of 
making election. The initial election under section 904(b) of the 
overall limitation provided by section 904(a)(2) may be made by the 
taxpayer for any taxable year beginning after December 31, 1960, without 
securing the consent of the Commissioner. The taxpayer may, for the 
first taxable year for which the election is to be made, make such 
election at any time before the expiration of the period referred to in 
paragraph (d) of Sec.  1.901-1 for choosing the benefits of section 901 
for such taxable year. Having made the initial election, the taxpayer 
may, within the time prescribed for making such election for such 
taxable year, revoke such election without the consent of the 
Commissioner. If such revocation is timely and properly made, the 
taxpayer may make his initial election of the overall limitation for a 
later taxable year without the consent of the Commissioner. If, however, 
the taxpayer makes the initial election for a taxable year and the 
period prescribed for making such election for such taxable year 
expires, the taxpayer must continue the election of the overall 
limitation for all subsequent taxable years (whether or not foreign 
taxes were paid or accrued for any such year and notwithstanding that a 
deduction for foreign taxes under section 164 was claimed for any

[[Page 759]]

such year) until revoked with the consent of the Commissioner. See 
section 904(b)(1). If the election for any taxable year is revoked with 
the consent of the Commissioner, the taxpayer may not make a new 
election for such taxable year or for any subsequent taxable year 
without the consent of the Commissioner. If the election of the overall 
limitation is revoked for a taxable year, the per-country limitation 
shall apply to such taxable year and to all taxable years thereafter 
unless a new election of the overall limitation is made, either with or 
without the consent of the Commissioner in accordance with this section.
    (ii) Revocation for first taxable year beginning after December 31, 
1969. Notwithstanding subdivision (i) of this subparagraph, if the 
taxpayer has made an initial election under section 904(b) of the 
overall limitation for a taxable year beginning before January 1, 1970, 
and the period prescribed for making such election for such taxable year 
has expired, or if he has made a new election for such a taxable year 
with the consent of the Commissioner, he may revoke such election 
effective with respect to his first taxable year beginning after 
December 31, 1969, without the consent of the Commissioner. Such 
revocation may be made within the time prescribed for making an initial 
election for such first taxable year beginning after December 31, 1969. 
If such revocation is timely and properly made, the taxpayer may make a 
new election of the overall limitation for a later taxable year without 
the consent of the Commissioner. Such new election for a later taxable 
year may be made at any time before the expiration of the period 
referred to in paragraph (d) of Sec.  1.901-1 for choosing the benefits 
of section 901 for such taxable year. The revocation of an election, or 
the making of a new election, pursuant to this subdivision shall be made 
in the same manner provided in subparagraph (2) of this paragraph for 
revoking or making an initial election. This subdivision applies even 
though the taxpayer is not required under section 901(e) and Sec.  
1.901-3 to reduce the amount of any foreign taxes paid, accrued, or 
deemed to be paid with respect to foreign mineral income for any taxable 
year beginning after December 31, 1969.
    (2) Method of making the initial election. The initial election of 
the overall limitation under section 904(b) shall be made on Form 1116 
in the case of an individual or on Form 1118 in the case of a 
corporation. The form shall be attached to the appropriate income tax 
return for the taxable year to which such election applies. Such 
election may be made, however, only for a taxable year for which the 
taxpayer chooses to claim a credit under section 901. If the taxpayer 
revokes the initial election without the consent of the Commissioner, he 
must file amended Form 1116 or 1118 and amended income tax returns or 
claims for refund, where applicable, for the taxable years to which the 
revocation applies. For rules relating to the filing of such forms, see 
paragraph (a) of Sec.  1.905-2.
    (3) Method of revoking an election and making a new election. A 
request to revoke an election of the overall limitation under section 
904(b) when such revocation requires the consent of the Commissioner, or 
to make a new election when such election requires the consent of the 
Commissioner, shall be in writing and shall be addressed to the 
Commissioner of Internal Revenue, Washington, D.C. 20224. The request 
shall include the name and address of the taxpayer and shall be signed 
by the taxpayer or his duly authorized representative. It must specify 
the taxable year for which the revocation or new election is to be 
effective and shall be mailed within 75 days after the close of the 
first taxable year for which it is desired to make the change. It must 
be accompanied by a statement specifying the nature of the taxpayer's 
business, the countries in which the business is carried on, or expected 
to be carried on, within the taxable year of the requested change, and 
grounds considered as justifying the requested revocation or new 
election. The Commissioner may require such other information as may be 
necessary in order to determine whether the proposed change will be 
permitted. Generally, a request for consent to revoke an election or 
make a new election will be granted if the basic nature of the 
taxpayer's business changes or if there are

[[Page 760]]

changes in conditions in a foreign country which substantially affect 
the taxpayer's business. For example, a taxpayer who enters substantial 
operations in a new foreign country or who loses an existing investment 
due to nationalization, expropriation, or war would be granted consent 
to revoke an election or make a new election.
    (e) Joint return--(1) General. In the case of a husband and wife 
making a joint return, the applicable limitation prescribed by section 
904(a) on the credit for taxes paid or accrued to foreign countries and 
possessions of the United States shall be applied with respect to the 
aggregate taxable income from sources within each such country or 
possession, or from sources without the United States, as the case may 
be, and the aggregate taxable income from all sources, of the spouses.
    (2) Electing the overall limitation. If a husband and wife make a 
joint return for the current taxable year, but made a separate return 
for the preceding taxable year and the overall limitation applied for 
such preceding taxable year to one spouse or to both spouses (whether or 
not then married), then, unless revoked with the consent of the 
Commissioner, the overall limitation shall apply for the current taxable 
year and for subsequent taxable years of both spouses, whether or not 
they remain married, whether or not joint returns are filed for such 
subsequent taxable years, and whether or not one of such spouses could 
have elected the overall limitation for the current taxable year only 
with the consent of the Commissioner if he had filed a separate return 
for such year.

[T.D. 6789, 29 FR 19243, Dec. 31, 1964, as amended by T.D. 7294, 38 FR 
33080, Nov. 30, 1973; T.D. 7490, 42 FR 30497, June 15, 1977; 42 FR 
32536, June 27, 1977]



Sec.  1.904-2  Carryback and carryover of unused foreign tax.

    (a) Credit for foreign tax carryback or carryover. A taxpayer who 
chooses to claim a credit under section 901 for a taxable year is 
allowed a credit under that section not only for taxes otherwise 
allowable as a credit but also for taxes deemed paid or accrued in that 
year as a result of a carryback or carryover of an unused foreign tax 
under section 904(c). However, the taxes so deemed paid or accrued shall 
not be allowed as a deduction under section 164(a). Paragraphs (b) 
through (g) of this section and Sec.  1.904-3, providing rules for the 
computation of carryovers and carrybacks, do not reflect a number of 
intervening statutory amendments, including the redesignation of section 
904(d) as section 904(c) for taxable years beginning after 1975, 
amendments to sections 904(d) and (f) regarding the application of 
separate limitations in taxable years beginning after 1986, the 
limitation of the carryback period to one year for unused foreign taxes 
arising in taxable years beginning after October 22, 2004, and the 
extension of the carryover period to ten years for unused foreign taxes 
that may be carried to any taxable year ending after October 22, 2004. 
However, the principles of paragraphs (b) through (g) of this section 
and Sec.  1.904-3(b) through (g) shall apply in determining carrybacks 
and carryovers of unused foreign taxes, modified so as to take into 
account the effect of statutory amendments. For transition rules 
relating to the carryover and carryback of unused foreign tax paid with 
respect to dividends from noncontrolled section 902 corporations, see 
paragraph (h) of this section. For special rules regarding these 
computations in case of taxes paid, accrued, or deemed paid with respect 
to foreign oil and gas extraction income or foreign oil related income, 
see section 907(f) and the regulations under that section.
    (b) Years to which carried--(1) General. If the taxpayer chooses the 
benefits of section 901 for a taxable year beginning after December 31, 
1957, any unused foreign tax (as defined in subparagraph (2) of this 
paragraph) for such year shall, under section 904(d), be carried to the 
second preceding taxable year, the first preceding taxable year, and the 
first, second, third, fourth, and fifth succeeding taxable years, in 
that order and to the extent not absorbed as taxes deemed paid or 
accrued, under paragraph (c) of this section, in a prior taxable year. 
The entire unused foreign tax for any taxable year shall first be 
carried to the earliest of the taxable years to which, under the 
preceding sentence, such unused foreign tax may

[[Page 761]]

be carried. Any portion of such unused foreign tax not deemed paid or 
accrued under paragraph (c) of this section in such earliest taxable 
year shall then be carried to the next earliest taxable year to which 
such unused foreign tax may be carried, and any portion not absorbed in 
that year shall then be carried to the next earliest year, and so on.
    (2) Definitions. (i) When used with reference to a taxable year for 
which the per-country limitation provided in section 904(a)(1) applies, 
the term ``unused foreign tax'' means, with respect to a particular 
foreign country or possession of the United States, the excess of (a) 
the income, war profits, and excess profits taxes paid or accrued (or 
deemed paid or accrued other than by reason of section 904(d)) in such 
year to such foreign country or possession, over (b) the applicable per-
country limitation under section 904(a)(1) for such year.
    (ii) When used with reference to a taxable year for which the 
overall limitation provided in section 904(a)(2) applies, the term 
``unused foreign tax'' means the excess of (a) the income, war profits, 
and excess profits taxes paid or accrued (or deemed paid or accrued 
other than by reason of section 904(d)) in such year to all foreign 
countries and possessions of the United States, over (b) the overall 
limitation under section 904(a)(2) for such year.
    (iii) The term ``unused foreign tax'' does not include any amount by 
which the income, war profits, and excess profits taxes paid or accrued, 
or deemed to be paid, to any foreign country or possession of the United 
States with respect to foreign mineral income are reduced under section 
901(e)(1) and Sec.  1.901-3(b)(1).
    (3) Taxable years beginning before January 1, 1958. For purposes of 
this paragraph, the terms ``second preceding taxable year'' and ``first 
preceding taxable year'' do not include any taxable year beginning 
before January 1, 1958.
    (c) Tax deemed paid or accrued--(1) Unused foreign tax for per-
country limitation year. (i) The amount of an unused foreign tax with 
respect to a particular foreign country or possession of the United 
States, for a taxable year for which the per-country limitation under 
section 904(a)(1) applies, which shall be deemed paid or accrued in any 
taxable year to which such unused foreign tax may be carried under 
paragraph (b) of this section shall, except as provided in subdivision 
(iii) of this subparagraph, be equal to the smaller of--
    (a) The portion of such unused foreign tax which, under paragraph 
(b) of this section, is carried to such taxable year, or
    (b) Any excess limitation for such taxable year with respect to such 
unused foreign tax (as determined under subdivision (ii) of this 
subparagraph).
    (ii) The excess limitation for any taxable year (hereinafter called 
the ``excess limitation year'') with respect to an unused foreign tax in 
respect of a particular foreign country or possession of the United 
States for another taxable year (hereinafter called the ``year of 
origin'') shall be the amount, if any, by which the limitation for the 
excess limitation year with respect to that foreign country or 
possession (computed under section 904(a)(1)) exceeds the sum of--
    (a) The income, war profits, and excess profits taxes actually paid 
or accrued to such foreign country or possession in the excess 
limitation year,
    (b) The income, war profits, and excess profits taxes deemed paid or 
accrued in such year to such foreign country or possession other than by 
reason of section 904(d), and
    (c) The portion of the unused foreign tax, with respect to such 
foreign country or possession for any taxable year earlier than the year 
of origin, which is absorbed as taxes deemed paid or accrued in the 
excess limitation year under subdivision (i) of this subparagraph.
    (iii) An unused foreign tax for a taxable year for which the per-
country limitation provided in section 904(a)(1) applies shall not be 
deemed paid or accrued in a taxable year for which the overall 
limitation provided in section 904(a)(2) applies, notwithstanding that 
under paragraph (b) of this section such overall limitation year is 
counted as one of the years to which such unused foreign tax may be 
carried.
    (iv) Any portion of an unused foreign tax with respect to a 
particular foreign country or possession of the United

[[Page 762]]

States which is deemed paid or accrued under section 904(d) in the year 
to which it is carried shall be deemed paid or accrued to the same 
foreign country or possession to which such foreign tax was paid or 
accrued (or deemed paid or accrued other than by reason of section 
904(d)) for the year in which it originated.
    (v) For determination of excess limitation for a year for which the 
taxpayer does not choose to claim a credit under section 901, see 
paragraph (d) of this section.
    (2) Unused foreign tax for overall limitation year. (i) The amount 
of an unused foreign tax with respect to all foreign countries and 
possessions of the United States, for a taxable year for which the 
overall limitation provided in section 904(a)(2) applies, which shall be 
deemed paid or accrued in any taxable year to which such unused foreign 
tax may be carried under paragraph (b) of this section shall, except as 
provided in subdivision (iii) of this subparagraph, be equal to the 
smaller of--
    (a) The portion of such unused foreign tax which, under paragraph 
(b) of this section is carried to such taxable year, or
    (b) Any excess limitation for such taxable year with respect to such 
unused foreign tax (as determined under subdivision (ii) of this 
subparagraph).
    (ii) The excess limitation for any taxable year (hereinafter called 
the ``excess limitation year'') with respect to an unused foreign tax in 
respect of all foreign countries and possessions of the United States 
for another taxable year (hereinafter called the ``year of origin'') 
shall be the amount, if any, by which the limitation for the excess 
limitation year with respect to all foreign countries and possessions of 
the United States (computed under section 904(a)(2)) exceeds the sum 
of--
    (a) The income, war profits, and excess profits taxes actually paid 
or accrued to all foreign countries and possessions in the excess 
limitation year,
    (b) The income, war profits, and excess profits taxes deemed paid or 
accrued in such year to all foreign countries and possessions other than 
by reason of section 904(d), and
    (c) The portion of the unused foreign tax, with respect to all 
foreign countries and possessions for any taxable year earlier than the 
year of origin, which is absorbed as taxes deemed paid or accrued in the 
excess limitation year under subdivision (i) of this subparagraph.
    (iii) An unused foreign tax for a taxable year for which the overall 
limitation provided in section 904(a)(2) applies shall not be deemed 
paid or accrued in a taxable year for which the per-country limitation 
provided in section 904(a)(1) applies, notwithstanding that under 
paragraph (b) of this section such per-country limitation year is 
counted as one of the years to which such unused foreign tax may be 
carried.
    (iv) For determination of excess limitation for a year for which the 
taxpayer does not choose to claim a credit under section 901, see 
paragraph (d) of this section.
    (3) Unused foreign tax with respect to foreign mineral income. If 
any portion of an unused foreign tax for any taxable year beginning 
after December 31, 1969, consists of tax paid or accrued, or deemed to 
be paid, with respect to foreign mineral income, as defined in Sec.  
1.901-3(c), such portion shall not be deemed paid or accrued with 
respect to foreign mineral income in the taxable year to which it is 
carried under section 904(d).
    (d) Determination of excess limitation for certain years. An excess 
limitation for a taxable year may exist, and may absorb all or some 
portion of an unused foreign tax, even though the taxpayer does not 
choose to claim a credit under section 901 for such year. In such case, 
the amount of the excess limitation, if any, for such year (hereinafter 
called the ``deduction year'') shall be determined in the same manner as 
though the taxpayer had chosen to claim a credit under section 901 for 
that year. For purposes of the preceding sentence--
    (1) If the taxpayer has not chosen the benefits of section 901 for 
any taxable year before the deduction year, the per-country limitation 
under section 904 (a)(1) shall be considered to be applicable for such 
year, and
    (2) If the taxpayer has chosen the benefits of section 901 for any 
taxable year before the deduction year, the

[[Page 763]]

limitation (per-country or overall) applicable for the last taxable year 
(preceding such deduction year for) which a credit was claimed under 
section 901 shall be considered to be applicable for such deduction 
year.
    (e) Periods of less than 12 months. A fractional part of a year 
which is a taxable year under sections 441(b) and 7701(a)(23) is a 
preceding or a succeeding taxable year for the purpose of determining 
under section 904(d) the years to which the unused foreign tax may be 
carried, and any unused foreign tax or excess limitation for such 
fractional part of a year is the unused foreign tax or excess limitation 
for a taxable year.
    (f) Statement with tax return. Every taxpayer claiming the benefit 
of a carryback or carryover of the unused foreign tax to any taxable 
year for which he chooses to claim a credit under section 901 shall file 
with his return (or with his claim for refund, if appropriate) for that 
year as an attachment to his Form 1116 or 1118, as the case may be, a 
statement setting forth the unused foreign tax deemed paid or accrued 
under this section and all material and pertinent facts relative 
thereto, including a detailed schedule showing the computation of the 
unused foreign tax so carried back or over.
    (g) Illustration of carrybacks and carryovers. The application of 
this section may be illustrated by the following examples:

    Example 1. (i) A, a calendar year taxpayer using the cash receipts 
and disbursements method of accounting, chooses to claim a credit under 
section 901 for each of the taxable years set forth below. Based upon 
the taxes actually paid to country X, and the section 904(a)(1) 
limitation applicable in respect of country X, in each of the taxable 
years, the unused foreign tax deemed paid under section 904(d) in each 
of the appropriate taxable years is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                       Taxable years
                                         -----------------------------------------------------------------------
                                           1958    1959    1960    1961    1962    1963    1964    1965    1966
----------------------------------------------------------------------------------------------------------------
Per-country limitation..................    $175    $150    $100    $100    $100    $300    $400    $200    $600
Taxes actually paid to country X in           75      60     830     170     150     100     200     140     400
 taxable year...........................
                                         -----------------------------------------------------------------------
Unused foreign tax to be carried back or  ......  ......     730      70      50  ......  ......  ......  ......
 over from year of origin...............
Excess limitation with respect to unused
 foreign tax for--
  1960..................................   (100)    (90)  ......  ......  ......   (200)   (200)    (60)  ......
  1961..................................  ......  ......  ......  ......  ......  ......  ......  ......   (200)
  1962..................................  ......  ......  ......  ......  ......  ......  ......  ......   (130)
Unused foreign tax absorbed as taxes
 deemed paid under the carryback and
 carryover provisions as carried from--
  1960..................................     100      90  ......  ......  ......     200     200      60  ......
  1961..................................  ......  ......  ......  ......  ......  ......  ......  ......      70
  1962..................................  ......  ......  ......  ......  ......  ......  ......  ......      50
----------------------------------------------------------------------------------------------------------------

    (ii) The excess limitation for 1958, 1959, 1963, 1964, and 1965, 
respectively, which is available to absorb the unused foreign tax for 
1960 is the amount by which the per- country limitation for each of 
those years exceeds the taxes actually paid to country X in each such 
year. The unused foreign tax for 1961 and 1962 are not taken into 
account, since neither of those years is a year earlier than 1960, the 
year of origin in respect of which the excess limitation is being 
determined. Thus, for example, the excess limitation for 1963 is $200, 
unreduced by the unused foreign tax for 1961 and 1962. There is no 
excess limitation for 1966 with respect to the unused foreign tax for 
1960, since the unused foreign tax may be carried forward only 5 taxable 
years. The unused foreign tax ($730) for 1960 is thus absorbed as taxes 
deemed paid to the extent of the excess limitation for each of the 
taxable years 1958, 1959, 1963, 1964, and 1965, respectively, and in 
that order, leaving unused foreign tax in the amount of $80 which cannot 
be absorbed because it cannot be carried beyond 1965.
    (iii) The amount of unused foreign tax for 1961 which is deemed paid 
in 1966 is $70, the smaller of (a) that portion of the unused foreign 
tax carried to 1966 ($70), or (b) the excess limitation for 1966 with 
respect to such unused foreign tax ($200). The unused foreign tax for 
1962 ($50) is not taken into account for such purposes, since that year 
is not a year earlier than 1961, the year of origin in respect of which 
the excess limitation for 1966 is being determined.

[[Page 764]]

    (iv) The excess limitation for 1966 with respect to the unused 
foreign tax for 1962 is $130, the amount by which the limitation 
applicable under section 904(a)(1) for 1966 ($600) exceeds the sum of 
the taxes actually paid ($400) to country X in that year and the unused 
foreign tax ($70) for 1961 which is absorbed in 1966 as taxes deemed 
paid and which is carried from a taxable year earlier than 1962, the 
year of origin in respect of which the excess limitation is being 
determined. The unabsorbed part ($80) of the unused foreign tax for 
1960, a year earlier than 1962, is not taken into account in computing 
the excess limitation for 1966, since the unused foreign tax for 1960 
may not be carried beyond 1965. The unused foreign tax ($50) for 1962 is 
thus absorbed in full in 1966 as taxes deemed paid, since the unused 
foreign tax does not exceed the excess limitation ($130) for that year.
    Example 2. Assume the same facts as those in example 1 except that 
the taxpayer does not choose to have the benefits of section 901 for 
1961. In that case there is no unused foreign tax for that year to carry 
back or over to be absorbed in other taxable years as taxes deemed paid. 
Moreover, the excess limitation for 1966 which is available to absorb 
the unused foreign tax for 1962 is $200, instead of $130, that is, the 
amount by which the limitation applicable under section 904(a)(1) for 
1966 ($600) exceeds the taxes actually paid ($400) to country X in that 
year. The amount of the unused foreign tax absorbed in each taxable year 
as taxes deemed paid is the same as in example 1 except for 1966. In 
that year only the unused foreign tax ($50) for 1962 is absorbed as 
taxes deemed paid.
    Example 3. Assume the same facts as those in example 1 except that 
the taxpayer does not choose the benefits of section 901 for 1959. Since 
the excess limitation for a taxable year for which the taxpayer does not 
claim a credit under section 901 is determined in the same manner as 
though the taxpayer had chosen such credit, the excess limitation for 
1959 is determined to be $90 just as in example 1. Moreover, even though 
such excess limitation absorbs a carryback of $90 from the unused tax 
for 1960, none of such $90 so deemed paid in 1959 is allowed as a 
deduction under section 164 or as a credit under section 901 for 1959 or 
for any other taxable year.
    Example 4. (i) B, a calendar year taxpayer using the cash receipts 
and disbursements methods of accounting, chooses the benefits of section 
901 for each of the taxable years 1957, 1958, and 1959. Based upon the 
taxes actually paid to country Y and the per-country limitation 
applicable with respect to country Y, in each of the taxable years, the 
unused foreign tax deemed paid under section 904(d) for taxable year 
1959 is as follows:

------------------------------------------------------------------------
                                                        Taxable years
                                                   ---------------------
                                                     1957   1958   1959
------------------------------------------------------------------------
Per-country limitation on credit for taxes paid to   $300   $200    $250
 Y................................................
Taxes actually paid to Y in taxable year..........    200    300     150
                                                   ---------------------
Unused foreign tax to be carried back or over from  .....    100  ......
 year of origin...................................
Excess limitation applicable to unused credit.....  .....  .....   (100)
Unused foreign tax absorbed as taxes deemed paid..  .....  .....     100
------------------------------------------------------------------------

    (ii) Since a taxable year beginning before January 1, 1958, cannot 
constitute a preceding taxable year in which the unused foreign tax for 
1958 may be absorbed as taxes deemed paid, the entire unused foreign tax 
($100) is absorbed as taxes deemed paid in 1959.
    Example 5. (i) C, a calendar year taxpayer using an accrual method 
of accounting, accrues foreign taxes for the first time in 1961. C 
chooses the benefits of section 901 for each of the taxable years set 
forth below and for 1962 elects the overall limitation provided by 
section 904(a)(2) which, with the Commissioner's consent, is revoked for 
1966. Based upon the taxes actually accrued with respect to foreign 
countries X and Y for each of the taxable years, the unused foreign tax 
deemed accrued under section 904(d) in the appropriate taxable years is 
as follows:

----------------------------------------------------------------------------------------------------------------
                                                   Per                                                    Per
                                                 country    Overall    Overall    Overall    Overall    country
----------------------------------------------------------------------------------------------------------------
Taxable years.................................       1961       1962       1963       1964       1965       1966
                                               -----------------------------------------------------------------
Limitation:
  Country X...................................       $175  .........  .........  .........  .........       $290
  Country Y...................................        125  .........  .........  .........  .........         95
  Overall.....................................  .........       $250       $800       $300       $400  .........
Taxes actually accrued:
  Country X...................................        325  .........  .........  .........  .........        200
  Country Y...................................         85  .........  .........  .........  .........        100
  Aggregate...................................  .........        350        380        425        450  .........
                                               -----------------------------------------------------------------
Unused foreign tax to be carried back or over
 from year of origin:
  Country X...................................        150  .........  .........  .........  .........  .........

[[Page 765]]

 
  Country Y...................................  .........  .........  .........  .........  .........          5
  Aggregate...................................  .........        100  .........        125         50  .........
Excess limitation:
  Country X...................................  .........  .........  .........  .........  .........         90
  Country Y...................................         40  .........  .........  .........  .........  .........
  Overall.....................................  .........  .........        420  .........  .........  .........
Unused foreign tax absorbed as taxes deemed
 accrued under section 904(d) and carried
 from--
  1961 (Country X)............................  .........  .........  .........  .........  .........       (90)
  1962 (Overall)..............................  .........  .........      (100)  .........  .........  .........
  1964 (Overall)..............................  .........  .........      (125)  .........  .........  .........
  1965 (Overall)..............................  .........  .........       (50)  .........  .........  .........
----------------------------------------------------------------------------------------------------------------

    (ii) Since the per-country limitation is applicable for 1961 and 
1966 only, any unused foreign tax with respect to such years may not be 
deemed accrued in 1962, 1963, 1964, or 1965, years for which the overall 
limitation applies. However, the excess limitation for 1966 with respect 
to country X ($90) is available to absorb a part of the unused foreign 
tax for 1961 with respect to country X. The difference with respect to 
country X between the unused foreign tax for 1961 ($150) and the amount 
absorbed as taxes deemed accrued ($90) in 1966, or $60, may not be 
carried beyond 1966 since the unused foreign tax may be carried forward 
only 5 taxable years. There is no excess limitation with respect to 
country Y for 1961 in respect of the unused foreign tax of country Y for 
1966, since the unused foreign tax may be carried back only 2 taxable 
years.
    (iii) Since the overall limitation is applicable for 1962, 1963, 
1964, and 1965, any unused foreign tax with respect to such years may 
not be absorbed as taxes deemed accrued in 1961 or 1966, years for which 
the per-country limitation applies. However, the excess limitation for 
1963 ($420) computed on the basis of the overall limitation is available 
to absorb the unused foreign tax for 1962 ($100), the unused foreign tax 
for 1964 ($125), and the unused foreign tax for 1965 ($50), leaving an 
excess limitation above such absorption of $145 ($420-$275).
    (h) Transition rules for carryovers and carrybacks of pre-2003 and 
post-2002 unused foreign tax paid or accrued with respect to dividends 
from noncontrolled section 902 corporations--(1) Carryover of unused 
foreign tax. Except as provided in Sec. Sec.  1.904-7(f)(9)(iv) and 
1.904(f)-12(g)(3), the rules of this paragraph (h)(1) apply to 
reallocate to the taxpayer's other separate categories any unused 
foreign taxes (as defined in paragraph (b)(2) of this section) that were 
paid or accrued or deemed paid under section 902 with respect to a 
dividend from a noncontrolled section 902 corporation paid in a taxable 
year of the noncontrolled section 902 corporation beginning before 
January 1, 2003, which taxes were subject to a separate limitation for 
dividends from that noncontrolled section 902 corporation. To the extent 
any such unused foreign taxes are carried forward to a taxable year of a 
domestic shareholder beginning on or after the first day of the 
noncontrolled section 902 corporation's first taxable year beginning 
after December 31, 2002, such taxes shall be allocated among the 
taxpayer's separate categories in the same proportions as the related 
dividend would have been assigned had such dividend been eligible for 
look-through treatment when paid. Accordingly, the taxes shall be 
allocated in the same percentages as the reconstructed earnings in the 
noncontrolled section 902 corporation's non-look-through pool and pre-
1987 accumulated profits that were accumulated in taxable years 
beginning before January 1, 2003, out of which the dividend was paid, in 
accordance with the rules of Sec.  1.904-7(f), or, if the taxpayer uses 
the safe harbor method of Sec.  1.904-7(f)(4)(ii), in the same 
percentages as the taxpayer properly characterizes the stock of the 
noncontrolled section 902 corporation for purposes of apportioning its 
interest expense in its first taxable year ending after the first day of 
the noncontrolled section 902 corporation's first taxable year beginning 
after December 31, 2002. See Sec.  1.904-7(f)(2) and (4). In the case of 
unused foreign taxes allocable to dividends from a noncontrolled section 
902 corporation with respect to which the taxpayer was no longer a 
domestic shareholder (as defined in Sec.  1.902-1(a)) as of the first 
day of such taxable year, such taxes shall be allocated among the 
taxpayer's separate categories in

[[Page 766]]

the same percentages as the earnings in the noncontrolled section 902 
corporation's non-look-through pool or pre-1987 accumulated profits 
would have been assigned had they been distributed and eligible for 
look-through treatment in the last taxable year in which the taxpayer 
was a domestic shareholder in such corporation. The unused foreign taxes 
that are carried forward shall be treated as allocable to general 
limitation income to the extent that such taxes would otherwise have 
been allocable to passive income, either on a look-through basis or as a 
result of inadequate substantiation under the rules of Sec.  1.904-
7(f)(4).
    (2) Carryback of unused foreign tax. The rules of this paragraph 
(h)(2) apply to any unused foreign taxes that were paid or accrued or 
deemed paid under section 902 with respect to a dividend from a 
noncontrolled section 902 corporation paid in a taxable year of the 
noncontrolled section 902 corporation ending on or after April 20, 2009, 
which dividends were eligible for look-through treatment. See 26 CFR 
Sec.  1.904-2T(h)(2) (revised as of April 1, 2009) for rules applicable 
to such unused foreign taxes with respect to a dividend from a 
noncontrolled section 902 corporation paid in a taxable year of the 
noncontrolled section 902 corporation beginning after December 31, 2002 
and ending before April 20, 2009, which dividends were eligible for 
look-through treatment. To the extent any such unused foreign taxes are 
carried back to a prior taxable year of a domestic shareholder, a credit 
for such taxes shall be allowed only to the extent of the excess 
limitation in the same separate category or categories to which the 
related look-through dividend was assigned and not in any separate 
category for dividends from noncontrolled section 902 corporations.
    (i) Transition rules for carryovers and carrybacks of pre-2007 and 
post-2006 unused foreign tax--(1) Carryover of unused foreign tax--(i) 
General rule. For purposes of this paragraph (i), the terms post-2006 
separate category and pre-2007 separate category have the meanings set 
forth in Sec.  1.904-7(g)(1)(ii) and (iii). The rules of this paragraph 
(i)(1) apply to reallocate to the taxpayer's post-2006 separate 
categories for general category income and passive category income any 
unused foreign taxes (as defined in Sec.  1.904-2(b)(2)) that were paid 
or accrued or deemed paid under section 902 with respect to income in a 
pre-2007 separate category (other than a category described in Sec.  
1.904-4(m)). To the extent any such unused foreign taxes are carried 
forward to a taxable year beginning after December 31, 2006, such taxes 
shall be allocated to the taxpayer's post-2006 separate categories to 
which those taxes would have been allocated if the taxes were paid or 
accrued in a taxable year beginning after December 31, 2006. For 
example, any foreign taxes paid or accrued or deemed paid with respect 
to financial services income in a taxable year beginning before January 
1, 2007, that are carried forward to a taxable year beginning after 
December 31, 2006, will be allocated to the general category because the 
financial services income to which those taxes relate would have been 
allocated to the general category if it had been earned in a taxable 
year beginning after December 31, 2006.
    (ii) Safe harbor. In lieu of applying the rules of paragraph 
(i)(1)(i) of this section, a taxpayer may allocate all unused foreign 
taxes in the pre-2007 separate category for passive income to the post-
2006 separate category for passive category income, and allocate all 
other unused foreign taxes described in paragraph (i)(1)(i) of this 
section to the post-2006 separate category for general category income. 
A taxpayer may choose to use the safe harbor method on a timely filed 
(original or amended) tax return or during an audit. A taxpayer that 
uses the safe harbor method on an amended return or in the course of an 
audit must make appropriate adjustments to eliminate any double benefit 
arising from application of the safe harbor method to years that are not 
open for assessment. A taxpayer's choice to use the safe harbor method 
is evidenced by employing the method. The taxpayer need not file any 
separate statement.
    (2) Carryback of unused foreign tax--(i) General rule. The rules of 
this paragraph (i)(2) apply to any unused foreign taxes that were paid 
or accrued or deemed paid under section 902 with respect to income in a 
post-2006 separate

[[Page 767]]

category (other than a category described in Sec.  1.904-4(m)). To the 
extent any such unused foreign taxes are carried back to a taxable year 
beginning before January 1, 2007, a credit for such taxes shall be 
allowed only to the extent of the excess limitation in the pre-2007 
separate category, or categories, to which the taxes would have been 
allocated if the taxes were paid or accrued in a taxable year beginning 
before January 1, 2007. For example, any foreign taxes paid or accrued 
or deemed paid with respect to income in the general category in a 
taxable year beginning after December 31, 2006, that are carried back to 
a taxable year beginning before January 1, 2007, will be allocated to 
the same separate categories to which the income would have been 
allocated if such income had been earned in a taxable year beginning 
before January 1, 2007.
    (ii) Safe harbor. In lieu of applying the rules of paragraph 
(i)(2)(i) of this section, a taxpayer may allocate all unused foreign 
taxes in the post-2006 separate category for passive category income to 
the pre-2007 separate category for passive income, and may allocate all 
other unused foreign taxes described in paragraph (i)(2)(i) of this 
section to the pre-2007 separate category for general limitation income. 
A taxpayer may choose to use the safe harbor method on a timely filed 
(original or amended) tax return or during an audit. A taxpayer that 
uses the safe harbor method on an amended return or in the course of an 
audit must make appropriate adjustments to eliminate any double benefit 
arising from application of the safe harbor method to years that are not 
open for assessment. A taxpayer's choice to use the safe harbor method 
is evidenced by employing the method. The taxpayer need not file any 
separate statement.
    (3) Effective/applicability date. This paragraph (i) applies to 
taxable years beginning after December 31, 2006 and ending on or after 
December 21, 2007.

[T.D. 6789, 29 FR 19244, Dec. 31, 1964, as amended by T.D. 7294, 38 FR 
33081, Nov. 30, 1973; T.D. 7292, 38 FR 33292, Dec. 3, 1973; T.D. 7490, 
42 FR 30497, June 15, 1977; T.D. 7961, 49 FR 26225, June 27, 1984; 49 FR 
29594, July 23, 1984; T.D. 9260, 71 FR 24529, Apr. 25, 2006; T.D. 9368, 
72 FR 72587, Dec. 21, 2007; T.D. 9452, 74 FR 27877, June 11, 2009; T.D. 
9521, 76 FR 19270, Apr. 7, 2011]



Sec.  1.904-3  Carryback and carryover of unused foreign tax 
by husband and wife.

    (a) In General. This section provides rules, in addition to those 
prescribed in Sec.  1.904-2, for the carryback and carryover of the 
unused foreign tax paid or accrued to a foreign country or possession by 
a husband and wife making a joint return for one or more of the taxable 
years involved in the computation of the carryback or carryover.
    (b) Joint unused foreign tax and joint excess limitation. In the 
case of a husband and wife the joint unused foreign tax or the joint 
excess limitation for a taxable year for which a joint return is made 
shall be computed on the basis of the combined income, deductions, 
taxes, and credit of both spouses as if the combined income, deductions, 
taxes, and credit were those of one individual.
    (c) Continuous use of joint return. If a husband and wife make a 
joint return for the current taxable year, and also make joint returns 
for each of the other taxable years involved in the computation of the 
carryback or carryover of the unused foreign tax to the current taxable 
year, the joint carryback or the joint carryover to the current taxable 
year shall be computed on the basis of the joint unused foreign tax and 
the joint excess limitations.
    (d) From separate to joint return. If a husband and wife make a 
joint return for the current taxable year, but make separate returns for 
all of the other taxable years involved in the computation of the 
carryback or carryover of the unused foreign tax to the current taxable 
year, the separate carrybacks or separate carryovers shall be a joint 
carryback or a joint carryover to the current taxable year. If for such 
current year the per-country limitation applies, then only the unused 
foreign

[[Page 768]]

tax for a taxable year of a spouse for which the per-country limitation 
applied to such spouse may constitute a carryover or carryback to the 
current taxable year. If for such current taxable year the overall 
limitation applies, then only the unused foreign tax for a taxable year 
of a spouse for which the overall limitation applied to such spouse may 
constitute a carryover or carryback to the current taxable year.
    (e) Amounts carried from or through a joint return year to or 
through a separate return year. It is necessary to allocate to each 
spouse his share of an unused foreign tax or excess limitation for any 
taxable year for which the spouses filed a joint return if--
    (1) The husband and wife file separate returns for the current 
taxable year and an unused foreign tax is carried thereto from a taxable 
year for which they filed a joint return;
    (2) The husband and wife file separate returns for the current 
taxable year and an unused foreign tax is carried to such taxable year 
from a year for which they filed separate returns but is first carried 
through a year for which they filed a joint return; or
    (3) The husband and wife file a joint return for the current taxable 
year and an unused foreign tax is carried from a taxable year for which 
they filed joint returns but is first carried through a year for which 
they filed separate returns.


In such cases, the separate carryback or carryover of each spouse to the 
current taxable year shall be computed in the manner described in Sec.  
1.904-2 but with the modifications set forth in paragraph (f) of this 
section. Where applicable, appropriate adjustments shall be made to take 
into account the fact that, for any taxable year involved in the 
computation of the carryback or the carryover, either spouse has 
interest income described in section 904(f)(2) with respect to which the 
provisions of section 904(f) and Sec.  1.904-4 apply, or dividends 
described in section 904(f)(1)(B) with respect to which the provisions 
of section 904(f) and Sec.  1.904-5 apply, or foreign oil related income 
described in section 907(c) with respect to which the separate 
limitation in section 907(b) applies.
    (f) Allocation of unused foreign tax and excess limitation--(1) 
Limitation--(i) Per-country limitation. The per-country limitation of a 
particular spouse with respect to a foreign country or United States 
possession for a taxable year for which a joint return is made shall be 
the portion of the limitation on the joint return which bears the same 
ratio to such limitation as such spouse's taxable income (with gross 
income and deductions taken into account to the same extent as taken 
into account on the joint return) from sources within such country or 
possession (but not in excess of the joint taxable income from sources 
within such country or possession) bears to the joint taxable income 
from such sources.
    (ii) Overall limitation. The overall limitation of a particular 
spouse for a taxable year for which a joint return is made shall be the 
portion of the limitation on the joint return which bears the same ratio 
to such limitation as such spouse's taxable income (with gross income 
and deductions taken into account to the same extent as taken into 
account on the joint return) from sources without the United States (but 
not in excess of the joint taxable income from such sources) bears to 
the joint taxable income from such sources.
    (2) Unused foreign tax--(i) Per-country limitation. The unused 
foreign tax of a particular spouse with respect to a foreign country or 
United States possession for a taxable year for which a joint return is 
made shall be the excess of his tax paid or accrued to such country or 
possession over his limitation determined under subparagraph (1)(i) of 
this paragraph.
    (ii) Overall limitation. The unused foreign tax of a particular 
spouse for a taxable year to which the overall limitation applies and 
for which a joint return is made shall be the excess of his tax paid or 
accrued to foreign countries and United States possessions over his 
limitation determined under subparagraph (1)(ii) of this paragraph.
    (3) Excess limitation--(i) Per-country limitation taxpayer. A 
spouse's excess limitation with respect to a foreign country or 
possession for a taxable year for which a joint return is made

[[Page 769]]

shall be the excess of his limitation determined under subparagraph 
(1)(i) of this paragraph over his taxes paid or accrued to such country 
or possession for such taxable year.
    (ii) Overall limitation. A spouse's excess limitation for a taxable 
year to which the overall limitation applies and for which a joint 
return is made shall be the excess of his limitation determined under 
subparagraph (1)(ii) of this paragraph over his taxes paid or accrued to 
foreign countries and United States possessions for such taxable year.
    (4) Excess limitation to be applied. The excess limitation of the 
particular spouse for any taxable year which is applied against the 
unused foreign tax of that spouse for another taxable year in order to 
determine the amount of the unused foreign tax which shall be carried 
back or over to a third taxable year shall be, in a case in which the 
excess limitation is determined on a joint return, the sum of the 
following amounts:
    (i) Such spouse's excess limitation determined under subparagraph 
(3) of this paragraph reduced as provided in subparagraph (5)(i) of this 
paragraph, and
    (ii) The excess limitation of the other spouse determined under 
subparagraph (3) of this paragraph for that taxable year reduced as 
provided in subparagraphs (5) (i) and (ii) of this paragraph.
    (5) Reduction of excess limitation. (i) The part of the excess 
limitation which is attributable to each spouse for the taxable year, as 
determined under subparagraph (3) of this paragraph, shall be reduced by 
absorbing as taxes deemed paid or accrued under section 904(d) in that 
year the unabsorbed separate unused foreign tax of such spouse, and the 
unabsorbed unused foreign tax determined under subparagraph (2) of this 
paragraph of such spouse, for taxable years which begin before the 
beginning of the year of origin of the unused foreign tax of the 
particular spouse against which the excess limitation so determined is 
being applied.
    (ii) In addition, the part of the excess limitation which is 
attributable to the other spouse for the taxable year, as determined 
under subparagraph (3) of this paragraph, shall be reduced by absorbing 
as taxes deemed paid or accrued under section 904(d) in that year the 
unabsorbed unused foreign tax, if any, of such other spouse for the 
taxable year which begins on the same date as the beginning of the year 
of origin of the unused foreign tax of the particular spouse against 
which the excess limitation so determined is being applied.
    (6) Spouses using different limitations. If an unused foreign tax is 
carried through a taxable year for which spouses made a joint return and 
the credit under section 901 for such taxable year is not claimed, and 
in the prior taxable year separate returns are made in which the per-
country limitation applies to one spouse and the overall limitation 
applies to the other spouse, the amount treated as absorbed in the 
taxable year for which a joint return is made--
    (i) With respect to the spouse for which the per-country limitation 
applies shall be determined on the basis of the excess limitation which 
would be allocated to such spouse under subparagraph (3)(i) of this 
paragraph had the per-country limitation applied for such year to both 
spouses;
    (ii) With respect to the other spouse for which the overall 
limitation applies shall be determined on the basis of the excess 
limitation which would be allocated to such spouse under subparagraph 
(3)(ii) of this paragraph had the overall limitation applied for such 
year to both spouses.


This subparagraph shall be applied without regard to subparagraph 
(4)(ii) of this paragraph.
    (g) Illustrations. This section may be illustrated by the following 
examples:

    Example 1. (a) H and W, calendar year taxpayers, file joint returns 
for 1961 and 1963, and separate returns for 1962, 1964, and 1965; and 
for each of those taxable years they choose to claim a credit under 
section 901. For the taxable years involved, they had unused foreign 
tax, excess limitations, and carrybacks and carryovers of unused foreign 
tax as set forth below. The overall limitation applies to both spouses 
for all taxable years involved in this example. Neither H nor W had an 
unused foreign tax or excess limitation for any year before 1961 or 
after 1965. For purposes of this example, any reference to an excess 
limitation means such a limitation as determined under paragraph 
(c)(2)(ii)

[[Page 770]]

of Sec.  1.904-2 but without regard to any taxes deemed paid or accrued 
under section 904(d):

----------------------------------------------------------------------------------------------------------------
                                                                              Taxable year
                                                       ---------------------------------------------------------
                                                           1961       1962       1963        1964        1965
----------------------------------------------------------------------------------------------------------------
Return................................................      Joint   Separate       Joint    Separate    Separate
                                                       ---------------------------------------------------------
H's unused foreign tax to be carried over or back, or        $500       $250      ($650)        $400      ($500)
 excess limitation (enclosed in parentheses)..........
W's unused foreign tax to be carried over or back, or         300      (200)       (300)         150       (100)
 excess limitation (enclosed in parentheses)..........
                                                       ---------------------------------------------------------
   Total..............................................        800  .........       (950)  ..........  ..........
                                                       =========================================================
Carryovers absorbed:
  W's, from 1961......................................  .........   \1\ 200W        100W  ..........  ..........
  H's, from 1961......................................  .........  .........    \2\ 500H  ..........  ..........
  H's, from 1962......................................  .........  .........        150H  ..........  ..........
                                                        .........  .........        100W  ..........  ..........
  W's, from 1964......................................  .........  .........  ..........  ..........         50W
  H's, from 1964......................................  .........  .........  ..........  ..........        400H
Carrybacks absorbed:
  W's, from 1964......................................  .........          0        100W  ..........  ..........
  H's, from 1964......................................  .........  .........           0  ..........  ..........
----------------------------------------------------------------------------------------------------------------
\1\ W--absorbed by W's excess limitation.
\2\ H--absorbed by H's excess limitation.

    (b) Two hundred dollars of the $300 constituting W's part of the 
joint unused foreign tax for 1961 is absorbed by her separate excess 
limitation of $200 for 1962, and the remaining $100 of such part is 
absorbed by her part ($300) of the joint excess limitation for 1963. The 
excess limitation of $300 for 1963 is not required first to be reduced 
by any amount, since neither H nor W has any unused foreign tax for 
taxable years beginning before 1961.
    (c) H's part ($500) of the joint unused foreign tax for 1961 is 
absorbed by his part ($650) of the joint excess limitation for 1963. The 
excess limitation of $650 for 1963 is not required first to be reduced 
by any amount, since neither H nor W has any unused foreign tax for 
taxable years beginning before 1961.
    (d) H's unused foreign tax of $250 for 1962 is first absorbed (to 
the extent of $150) by H's part of the joint excess limitation for 1963, 
which must first be reduced from $650 to $150 by the absorption as taxes 
deemed paid or accrued in 1963 of H's unused foreign tax of $500 for 
1961, which is a taxable year beginning before 1962. The remaining part 
($100) of H's unused foreign tax for 1962 is then absorbed by W's part 
of the joint excess limitation for 1963, which must first be reduced 
from $300 to $200 by the absorption as taxes deemed paid or accrued in 
1963 of the unabsorbed part $100 of W's unused foreign tax for 1961, 
which is a taxable year beginning before 1962.
    (e) W's unused foreign tax of $150 for 1964 is first absorbed (to 
the extent of $100) by W's part of the joint excess limitation for 1963, 
which must first be reduced from $300 to $100 by the absorption as taxes 
deemed paid or accrued in 1963 of the unabsorbed part ($100) of W's 
unused foreign tax for 1961 and the unabsorbed part ($100) of H's unused 
foreign tax for 1962, which are taxable years beginning before 1964. No 
part of W's unused foreign tax for 1964 is absorbed by H's part of the 
joint excess limitation for 1963, since H's part of that excess must 
first be reduced from $650 to $0 by the absorption as taxes deemed paid 
or accrued in 1963 of H's unused foreign tax of $500 for 1961 and of the 
unabsorbed part ($150) of H's unused foreign tax for 1962, which are 
taxable years beginning before 1964. The unabsorbed part ($50) of W's 
unused foreign tax for 1964 is then absorbed by W's excess limitation of 
$100 for 1965. No part of W's unused foreign tax for 1964 is absorbed by 
W's excess limitation for 1962, since that excess limitation must first 
be reduced from $200 to $0 by W's unused foreign tax for 1961, which is 
a taxable year beginning before 1964.
    (f) No part of H's unused foreign tax of $400 for 1964 is absorbed 
by H's part of the joint excess limitation for 1963, since H's part of 
that excess must first be reduced from $650 to $0 by the absorption as 
taxes deemed paid or accrued in 1963 of H's unused foreign tax of $500 
for 1961 and of a part ($150) of H's unused foreign tax for 1962, which 
are taxable years beginning before 1964. Moreover, no part of H's unused 
foreign tax of $400 for 1964 is absorbed by W's part of the joint excess 
limitation for 1963, since W's part of that excess must first be reduced 
from $300 to $0 by the absorption as taxes deemed paid or accrued in 
1963 of the unabsorbed part ($100) of W's unused foreign tax for 1961 
and of the unabsorbed part ($100) of H's unused foreign tax for 1962, 
which are taxable years beginning before 1964, and also by the 
absorption

[[Page 771]]

of a part ($100) of W's unused foreign tax of $150 for 1964, which is a 
taxable year beginning on the same date as the beginning of H's taxable 
year 1964. The unabsorbed part ($400) of H's unused foreign tax for 1964 
is then absorbed by H's excess limitation of $500 for 1965.
    Example 2. (a) Assume the same facts as those in example 1 except 
that for 1964 W's unused foreign tax is $20, instead of $150. The 
carrybacks and carryovers absorbed are the same as in example 1 except 
as indicated in paragraphs (b) and (c) of this example.
    (b) No part of W's unused foreign tax of $20 for 1964 is absorbed by 
W's excess limitation for 1962, since that excess must first be reduced 
from $200 to $0 by W's unused foreign tax for 1961, which is a taxable 
year beginning before 1964. W's unused foreign tax of $20 for 1964 is 
absorbed by W's part of the joint excess limitation for 1963, which must 
first be reduced from $300 to $100 by the absorption as taxes deemed 
paid or accrued in 1963 of the unabsorbed part ($100) of W's unused 
foreign tax for 1961 and the unabsorbed part ($100) of H's unused 
foreign tax for 1962, which are taxable years beginning before 1964.
    (c) For the reason given in paragraph (f) of example 1, no part of 
H's unused foreign tax of $400 for 1964 is absorbed by H's part of the 
joint excess limitation for 1963. H's unused foreign tax of $400 for 
1964 is first absorbed (to the extent of $80) by W's part of the joint 
excess limitation for 1963, which must first be reduced from $300 to $80 
by the absorption as taxes deemed paid or accrued in 1963 of the 
unabsorbed part ($100) of W's unused foreign tax for 1961 and of the 
unabsorbed part ($100) of H's unused foreign tax for 1962, which are 
taxable years beginning before 1964, and also by the absorption of W's 
unused foreign tax of $20 for 1964, which is a taxable year beginning on 
the same date as the beginning of H's taxable year 1964. The unabsorbed 
part ($320) of H's unused foreign tax for 1964 is then absorbed by H's 
excess limitation of $500 for 1965.
    Example 3. The facts are the same as in example 1 except that the 
per-country limitation applies to both spouses for all taxable years 
involved in the example and that excess limitations and the unused 
foreign taxes relate to a single foreign country. The carryovers and 
carrybacks are the same as in example 1.

[T.D. 6789, 29 FR 19246, Dec. 31, 1964, as amended by T.D. 7292, 38 FR 
33292, Dec. 3, 1973; T.D. 7490, 42 FR 30497, June 15, 1977; T.D. 7961, 
49 FR 26225, June 27, 1984]



Sec.  1.904-4  Separate application of section 904 with respect to 
certain categories of income.

    (a) In general. A taxpayer is required to compute a separate foreign 
tax credit limitation for income received or accrued in a taxable year 
that is described in section 904(d)(1)(A) (passive category income), 
904(d)(1)(B) (general category income), or Sec.  1.904-4(m) (additional 
separate categories).
    (b) Passive category income--(1) In general. The term passive 
category income means passive income and specified passive category 
income.
    (2) Passive income--(i) In general. The term passive income means 
any--
    (A) Income received or accrued by any person that is of a kind that 
would be foreign personal holding company income (as defined in section 
954(c)) if the taxpayer were a controlled foreign corporation, including 
any amount of gain on the sale or exchange of stock in excess of the 
amount treated as a dividend under section 1248; or
    (B) Amount includible in gross income under section 1293.
    (ii) Exceptions. Passive income does not include any export 
financing interest (as defined in section 904(d)(2)(G) and paragraph (h) 
of this section), any high-taxed income (as defined in section 
904(d)(2)(F) and paragraph (c) of this section), or any active rents and 
royalties (as defined in paragraph (b)(2)(iii) of this section). In 
addition, passive income does not include any income that would 
otherwise be passive but is characterized as income in another separate 
category under the look-through rules of section 904(d)(3), (d)(4), and 
(d)(6)(C) and the regulations under those provisions. In determining 
whether any income is of a kind that would be foreign personal holding 
company income, the rules of section 864(d)(5)(A)(i) and (6) (treating 
related person factoring income of a controlled foreign corporation as 
foreign personal holding company income that is not eligible for the 
export financing income exception to the separate limitation for passive 
income) shall apply only in the case of income of a controlled foreign 
corporation (as defined in section 957). Thus, income earned directly by 
a United States person that is related person factoring income may be 
eligible for the exception for export financing interest.
    (iii) Active rents or royalties--(A) In general. For rents and 
royalties paid or

[[Page 772]]

accrued after September 20, 2004, passive income does not include any 
rents or royalties that are derived in the active conduct of a trade or 
business, regardless of whether such rents or royalties are received 
from a related or an unrelated person. Except as provided in paragraph 
(b)(2)(iii)(B) of this section, the principles of section 954(c)(2)(A) 
and the regulations under that section shall apply in determining 
whether rents or royalties are derived in the active conduct of a trade 
or business. For this purpose, the term taxpayer shall be substituted 
for the term controlled foreign corporation if the recipient of the 
rents or royalties is not a controlled foreign corporation.
    (B) Active conduct of trade or business. Rents and royalties are 
considered derived in the active conduct of a trade or business by a 
United States person or by a controlled foreign corporation (or other 
entity to which the look-through rules apply) for purposes of section 
904 (but not for purposes of section 954) if the requirements of section 
954(c)(2)(A) are satisfied by one or more corporations that are members 
of an affiliated group of corporations (within the meaning of section 
1504(a), determined without regard to section 1504(b)(3)) of which the 
recipient is a member. For purposes of this paragraph (b)(2)(iii)(B), an 
affiliated group includes only domestic corporations and foreign 
corporations that are controlled foreign corporations in which domestic 
members of the affiliated group own, directly or indirectly, at least 80 
percent of the total voting power and value of the stock. For purposes 
of this paragraph (b)(2)(iii)(B), indirect ownership shall be determined 
under section 318 and the regulations under that section.
    (iv) Examples. The following examples illustrate the application of 
paragraph (b)(2) of this section.

    Example 1. P is a domestic corporation with a branch in foreign 
country X. P does not have any financial services income. For 2008, P 
has a net foreign currency gain that would not constitute foreign 
personal holding company income if P were a controlled foreign 
corporation because the gain is directly related to the business needs 
of P. The currency gain is, therefore, general category income to P 
because it is not income of a kind that would be foreign personal 
holding company income.
    Example 2. Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. S is regularly engaged in the 
restaurant franchise business. P licenses trademarks, tradenames, 
certain know-how, related services, and certain restaurant designs for 
which S pays P an arm's length royalty. P is regularly engaged in the 
development and licensing of such property. The royalties received by P 
for the use of its property are allocable under the look-through rules 
of Sec.  1.904-5 to the royalties S receives from the franchisees. Some 
of the franchisees are unrelated to S and P. Other franchisees are 
related to S or P and use the licensed property outside of S's country 
of incorporation. S does not satisfy, but P does satisfy, the active 
trade or business requirements of section 954(c)(2)(A) and the 
regulations under that section. The royalty income earned by S with 
regard to both its related and unrelated franchisees is foreign personal 
holding company income because S does not satisfy the active trade or 
business requirements of section 954(c)(2)(A) and, in addition, the 
royalty income from the related franchisees does not qualify for the 
same country exception of section 954(c)(3). However, all of the royalty 
income earned by S is general category income to S under Sec.  1.904-
4(b)(2)(iii) because P, a member of S's affiliated group (as defined 
therein), satisfies the active trade or business test (which is applied 
without regard to whether the royalties are paid by a related person). 
S's royalty income that is taxable to P under subpart F and the 
royalties paid to P are general category income to P under the look-
through rules of Sec.  1.904-5(c)(1)(i) and (c)(3), respectively.

    (3) Specified passive category income means--
    (i) Dividends from a DISC or former DISC (as defined in section 
992(a)) to the extent such dividends are treated as income from sources 
without the United States;
    (ii) Taxable income attributable to foreign trade income (within the 
meaning of section 923(b)); or
    (iii) Distributions from a FSC (or a former FSC) out of earnings and 
profits attributable to foreign trade income (within the meaning of 
section 923(b)) or interest or carrying charges (as defined in section 
927(d)(1)) derived from a transaction which results in foreign trade 
income (as defined in section 923(b)).
    (c) High-taxed income--(1) In general. Income received or accrued by 
a United

[[Page 773]]

States person that would otherwise be passive income shall not be 
treated as passive income if the income is determined to be high-taxed 
income. Income shall be considered to be high-taxed income if, after 
allocating expenses, losses and other deductions of the United States 
person to that income under paragraph (c)(2)(ii) of this section, the 
sum of the foreign income taxes paid or accrued by the United States 
person with respect to such income and the foreign taxes deemed paid or 
accrued by the United States person with respect to such income under 
section 902 or section 960 exceeds the highest rate of tax specified in 
section 1 or 11, whichever applies (and with reference to section 15 if 
applicable), multiplied by the amount of such income (including the 
amount treated as a dividend under section 78). If, after application of 
this paragraph (c), income that would otherwise be passive income is 
determined to be high-taxed income, such income shall be treated as 
general category income, and any taxes imposed on that income shall be 
considered related to general category income under Sec.  1.904-6. If, 
after application of this paragraph (c), passive income is zero or less 
than zero, any taxes imposed on the passive income shall be considered 
related to general category income. For additional rules regarding 
losses related to passive income, see paragraph (c)(2) of this section. 
Income and taxes shall be translated at the appropriate rates, as 
determined under sections 986, 987 and 989 and the regulations under 
those sections, before application of this paragraph (c). For purposes 
of allocating taxes to groups of income, United States source passive 
income is treated as any other passive income. In making the 
determination whether income is high-taxed, however, only foreign source 
income, as determined under United States tax principles, is relevant. 
See paragraph (c)(8) Examples 10 through 13 of this section for examples 
illustrating the application of this paragraph (c)(1) and paragraph 
(c)(2) of this section. This paragraph (c)(1) is applicable for taxable 
years beginning after March 12, 1999.
    (2) Grouping of items of income in order to determine whether 
passive income is high-taxed income
    (i) Grouping rules--Initial allocation and apportionment of 
deductions and taxes. For purposes of determining whether passive income 
is high-taxed, expenses, losses and other deductions shall be allocated 
and apportioned initially to each of the groups of passive income 
(described in paragraphs (c)(3), (4), and (5) of this section) under the 
rules of Sec. Sec.  1.861-8 through 1.861-14T and 1.865-1 through 1.865-
2. Taxpayers that allocate and apportion interest expense on an asset 
basis may nevertheless apportion passive interest expense among the 
groups of passive income on a gross income basis. Foreign taxes are 
allocated to groups under the rules of Sec.  1.904-6(a)(1)(iii). If a 
loss on a disposition of property gives rise to foreign tax (i.e., the 
transaction giving rise to the loss is treated under foreign law as 
having given rise to a gain), the foreign tax shall be allocated to the 
group of passive income to which gain on the sale would have been 
assigned under paragraph (c)(3) or (4) of this section. A determination 
of whether passive income is high-taxed shall be made only after 
application of paragraph (c)(2)(ii) of this section (if applicable).
    (ii) Reallocation of loss groups. If, after allocation and 
apportionment of expenses, losses and other deductions under paragraph 
(c)(2)(i) of this section, the sum of the allocable deductions exceeds 
the gross income in one or more groups, the excess deductions shall 
proportionately reduce income in the other groups (but not below zero).
    (3) Amounts received or accrued by United States persons. Except as 
otherwise provided in paragraph (c)(5) of this section, all passive 
income received by a United States person shall be subject to the rules 
of this paragraph (c)(3). However, subpart F inclusions that are passive 
income, dividends from a controlled foreign corporation or noncontrolled 
section 902 corporation that are passive income, and income that is 
earned by a United States person through a foreign QBU that is passive 
income shall be subject to the rules of this paragraph only to the 
extent provided in paragraph (c)(4) of this section. For purposes of 
this section, a

[[Page 774]]

foreign QBU is a qualified business unit (as defined in section 989(a)), 
other than a controlled foreign corporation or noncontrolled section 902 
corporation, that has its principal place of business outside the United 
States. These rules shall apply whether the income is received from a 
controlled foreign corporation of which the United States person is a 
United States shareholder, from a noncontrolled section 902 corporation 
of which the United States person is a domestic corporation meeting the 
stock ownership requirements of section 902(a), or from any other 
person. For purposes of determining whether passive income is high-taxed 
income, the following rules apply:
    (i) All passive income received during the taxable year that is 
subject to a withholding tax of fifteen percent or greater shall be 
treated as one item of income.
    (ii) All passive income received during the taxable year that is 
subject to a withholding tax of less than fifteen percent (but greater 
than zero) shall be treated as one item of income.
    (iii) All passive income received during the taxable year that is 
subject to no withholding tax or other foreign tax shall be treated as 
one item of income.
    (iv) All passive income received during the taxable year that is 
subject to no withholding tax but is subject to a foreign tax other than 
a withholding tax shall be treated as one item of income.
    (4) Dividends and inclusions from controlled foreign corporations, 
dividends from noncontrolled section 902 corporations, and income of 
foreign QBUs. Except as provided in paragraph (c)(5) of this section, 
all dividends and all amounts included in gross income of a United 
States shareholder under section 951(a)(1) with respect to the foreign 
corporation that (after application of the look-through rules of section 
904(d)(3) and Sec.  1.904-5) are attributable to passive income received 
or accrued by a controlled foreign corporation, all dividends from a 
noncontrolled section 902 corporation that are received or accrued by a 
domestic corporate shareholder meeting the stock ownership requirements 
of section 902(a) that (after application of the look-through rules of 
section 904(d)(4) and Sec.  1.904-5) are treated as passive income, and 
all amounts of passive income received or accrued by a United States 
person through a foreign QBU shall be subject to the rules of this 
paragraph (c)(4). This paragraph (c)(4) shall be applied separately to 
dividends and inclusions with respect to each controlled foreign 
corporation of which the taxpayer is a United States shareholder and to 
dividends with respect to each noncontrolled section 902 corporation of 
which the taxpayer is a domestic corporate shareholder meeting the stock 
ownership requirements of section 902(a). This paragraph (c)(4) also 
shall be applied separately to income attributable to each foreign QBU 
of a controlled foreign corporation, noncontrolled section 902 
corporation, or any other look-through entity as defined in Sec.  1.904-
5(i), except that if the entity subject to the look-through rules is a 
United States person, then this paragraph (c)(4) shall be applied 
separately only to each foreign QBU of that United States person.
    (i) Income from sources within the QBU's country of operation. 
Passive income from sources within the QBU's country of operation shall 
be treated as one item of income.
    (ii) Income from sources without the QBU's country of operation. 
Passive income from sources without the QBU's country of operation shall 
be grouped on the basis of the tax imposed on that income as provided in 
Sec.  1.904-4T(c)(3)(i) through (iv).
    (iii) Determination of the source of income. For purposes of this 
paragraph (c)(4), income will be determined to be from sources within or 
without the QBU's country of operation under the laws of the foreign 
country of the payor of the income.
    (5) Special rules--(i) Certain rents and royalties. All items of 
rent or royalty income to which an item of rent or royalty expense is 
directly allocable shall be treated as a single item of income and shall 
not be grouped with other amounts.
    (ii) Treatment of partnership income. A partner's distributive share 
of income from a foreign or United States partnership that is not 
subject to the look-through rules and that is treated as

[[Page 775]]

passive income under Sec.  1.904-5(h)(2)(i) (generally providing that a 
less than 10 percent partner's distributive share of partnership income 
is passive income) shall be treated as a single item of income and shall 
not be grouped with other amounts. A distributive share of income from a 
foreign partnership that is treated as passive income under the look-
through rules shall be grouped according to the rules in paragraph 
(c)(4) of this section. A distributive share of income from a United 
States partnership that is treated as passive income under the look-
through rules shall be grouped according to the rules in paragraph 
(c)(3) of this section, except that the portion, if any, of the 
distributive share of income attributable to income earned by a United 
States partnership through a foreign QBU shall be grouped under the 
rules of paragraph (c)(4) of this section.
    (iii) Currency gain or loss--(A) Section 986(c). Any currency gain 
or loss with respect to a distribution received by a United States 
shareholder (other than a foreign QBU of that shareholder) of previously 
taxed earnings and profits that is recognized under section 986(c) and 
that is treated as an item of passive income shall be subject to the 
rules provided in paragraph (c)(3)(iii) of this section. If that item, 
however, is received or accrued by a foreign QBU of the United States 
shareholder, it shall be treated as an item of passive income from 
sources within the QBU's country of operation for purposes of paragraph 
(c)(4)(i) of this section. This paragraph (c)(5)(iii)(A) shall be 
applied separately for each foreign QBU of a United States shareholder.
    (B) Section 987(3). Any currency gain or loss with respect to 
remittances or transfers of property between QBUs of a United States 
shareholder that is recognized under section 987(3)(B) and that is 
treated as an item of passive income shall be subject to the rules 
provided in paragraph (c)(3)(iii) of this section. If that item, 
however, is received or accrued by a foreign QBU of the United States 
shareholder, it shall be treated as an item of passive income from 
sources within the QBU's country of operation for purposes of paragraph 
(c)(4)(i) of this section. This paragraph (c)(5)(iii)(B) shall be 
applied separately for each foreign QBU of a United States shareholder.
    (C) Example. The following example illustrates the provisions of 
this paragraph (c)(5)(iii).

    Example. P, a domestic corporation, owns all of the stock of S, a 
controlled foreign corporation that uses x as its functional currency. 
In 1993, S earns 100x of passive foreign personal holding company 
income. When included in P's income under subpart F, the exchange rate 
is 1x equals $1. Therefore, P's subpart F inclusion is $100. At the end 
of 1993, S has previously taxed earnings and profits of 100x and P's 
basis in those earnings is $100. In 1994, S has no earnings and 
distributes 100x to P. The value of the earnings when distributed is 
$150. Assume that under section 986(c), P must recognize $50 of passive 
income attributable to the appreciation of the previously taxed income. 
Country X does not recognize any gain or loss on the distribution. 
Therefore, the section 986(c) gain is not subject to any foreign 
withholding tax or other foreign tax. Thus, under paragraph (c)(3)(iii) 
of this section, the section 986(c) gain shall be grouped with other 
items of P's income that are subject to no withholding tax or other 
foreign tax.

    (iv) Coordination with section 954(b)(4). For rules relating to 
passive income of a controlled foreign corporation that is exempt from 
subpart F treatment because the income is subject to high foreign tax, 
see section 904(d)(3)(E), Sec.  1.904-4(c)(7)(iii), and Sec.  1.904-
5(d)(2).
    (6) Application of this paragraph to additional taxes paid or deemed 
paid in the year of receipt of previously taxed income--(i) 
Determination made in year of inclusion. The determination of whether an 
amount included in gross income under section 951(a) is high-taxed 
income shall be made in the taxable year the income is included in the 
gross income of the United States shareholder under section 951(a) 
(hereinafter the ``taxable year of inclusion''). Any increase in foreign 
taxes paid or accrued, or deemed paid or accrued, when the taxpayer 
receives an amount that is excluded from gross income under section 
959(a) and that is attributable to a controlled foreign corporation's 
earnings and profits relating to the amount previously included in gross 
income will not be considered in determining whether the amount included 
in income in the taxable year of inclusion is high-taxed income.

[[Page 776]]

    (ii) Exception. Paragraph (c)(6)(i) of this section shall not apply 
to an increase in tax in a case in which the taxpayer is required to 
adjust its foreign taxes in the year of inclusion under section 905(c).
    (iii) Allocation of foreign taxes imposed on distributions of 
previously taxed income. If an item of income is considered high-taxed 
income in the year of inclusion and paragraph (c)(6)(i) of this section 
applies, then any increase in foreign income taxes imposed with respect 
to that item shall be considered to be related to general category 
income. If an item of income is not considered to be high-taxed income 
in the taxable year of inclusion and paragraph (c)(6)(i) of this section 
applies, the following rules shall apply. The taxpayer shall treat an 
increase in taxes paid or accrued, or deemed paid or accrued, on any 
distribution of the earnings and profits attributable to the amount 
included in gross income in the taxable year of inclusion as taxes 
related to passive income to the extent of the excess of the product of 
(A) the highest rate of tax in section 11 (determined with regard to 
section 15 and determined as of the year of inclusion) and (B) the 
amount of the inclusion (after allocation of parent expenses) over (C) 
the taxes paid or accrued, or deemed paid or accrued, in the year of 
inclusion. The taxpayer shall treat any taxes paid or accrued, or deemed 
paid or accrued, on the distribution in excess of this amount as taxes 
related to general category income. If these additional taxes are not 
creditable in the year of distribution the carryover rules of section 
904(c) apply. For purposes of this paragraph, the foreign tax on a 
subpart F inclusion shall be considered increased on distribution of the 
earnings and profits associated with that inclusion if the total of 
taxes paid and deemed paid on the inclusion and the distribution (taking 
into account any reductions in tax and any withholding taxes) is greater 
than the total taxes deemed paid in the year of inclusion. Any foreign 
currency loss associated with the earnings and profits that are 
distributed with respect to the inclusion is not to be considered as 
giving rise to an increase in tax.
    (iv) Increase in taxes paid by successors--(A) General rule. Except 
as provided in paragraph (c)(6)(iv)(B) of this section, if passive 
earnings and profits previously included in income of a United States 
shareholder are distributed to a person that was not a United States 
shareholder of the distributing corporation in the year the earnings 
were included, any increase in foreign taxes paid or accrued, or deemed 
paid or accrued, on that distribution shall be treated as taxes related 
to general category income, regardless of whether the previously-taxed 
income was considered high-taxed income under section 904(d)(2)(F) in 
the year of inclusion.
    (B) Exception. For a special rule applicable to distributions prior 
to August 6, 1997, to U.S. shareholders not entitled to look-through 
treatment, see 26 CFR 1.904-4(c)(6)(iv)(B) (revised as of April 1, 
2006).
    (C) Effective date. This paragraph (c)(6)(iv) applies to taxable 
years beginning after December 31, 1986. However, for taxable years 
beginning before January 1, 2001, taxpayers may rely on Sec.  1.904-
4(c)(6)(iv) of regulations project INTL-1-92, published at 1992-1 C.B. 
1209. See Sec.  601.601(d)(2) of this chapter.
    (7) Application of this paragraph to certain reductions of tax on 
distributions of income--(i) In general. If the effective rate of tax 
imposed by a foreign country on income of a foreign corporation that is 
included in a taxpayer's gross income is reduced under foreign law on 
distribution of such income, the rules of this paragraph (c) apply at 
the time that the income is included in the taxpayer's gross income 
without regard to the possibility of subsequent reduction of foreign tax 
on the distribution. If the inclusion is considered to be high-taxed 
income, then the taxpayer shall treat the inclusion as general category 
income. When the foreign corporation distributes the earnings and 
profits to which the inclusion was attributable and the foreign tax on 
the inclusion is reduced, then the taxpayer shall redetermine whether 
the inclusion should be considered to be high-taxed income provided that 
a redetermination of United States tax liability is required under 
section 905(c). If, taking into account the reduction in foreign tax, 
the

[[Page 777]]

inclusion would not have been considered high-taxed income, then the 
taxpayer, in redetermining its United States tax liability for the year 
or years affected, shall treat the inclusion and the associated taxes 
(as reduced on the distribution) as passive income and taxes. See 
section 905(c) and the regulations thereunder regarding the method of 
adjustment. For this purpose, the foreign tax on a subpart F inclusion 
shall be considered reduced on distribution of the earnings and profits 
associated with the inclusion if the total of taxes paid and deemed paid 
on the inclusion and the distribution (taking into account any 
reductions in tax and any withholding taxes) is less that the total 
taxes deemed paid in the year of inclusion. Any foreign currency gain 
associated with the earnings and profits that are distributed with 
respect to the inclusion is not to be considered a reduction of tax.
    (ii) Allocation of reductions of foreign tax. For purposes of 
paragraph (c)(7)(i) of this section, reductions in foreign tax shall be 
allocated among the separate categories under the same principles as 
those of Sec.  1.904-6 for allocating taxes among the separate 
categories. Thus, for purposes of determining to which year's taxes the 
reduction in taxes relates, foreign law shall apply. If, however, 
foreign law does not attribute a reduction in taxes to a particular year 
or years, then the reduction in taxes shall be attributable, on an 
annual last in-first out (LIFO) basis, to foreign taxes potentially 
subject to reduction that are associated with previously taxed income, 
then on a LIFO basis to foreign taxes associated with income that under 
paragraph (c)(7)(iii) of this section remains as passive income but that 
was excluded from subpart F income under section 954(b)(4), and finally 
on a LIFO basis to foreign taxes associated with other earnings and 
profits. Furthermore, in applying the ordering rules of section 959(c), 
distributions shall be considered made on a LIFO basis first out of 
earnings described in section 959(c) (1) and (2), then on a LIFO basis 
out of earnings and profits associated with income that remains passive 
income under paragraph (c)(7)(iii) of this section but that was excluded 
from subpart F under section 954(b)(4), and finally on a LIFO basis out 
of other earnings and profits. For purposes of this paragraph 
(c)(7)(ii), foreign law is not considered to attribute a reduction in 
tax to a particular year or years if foreign law attributes the tax 
reduction to a pool or group containing income from more than one 
taxable year and such pool or group is defined based on a characteristic 
of the income (for example, the rate of tax paid with respect to the 
income) rather than on the taxable year in which the income is derived.
    (iii) Interaction with section 954(b)(4). If the effective rate of 
tax imposed by a foreign country on income of a foreign corporation is 
reduced under foreign law on distribution of that income, the rules of 
section 954(b)(4) shall be applied without regard to the possibility of 
subsequent reduction of foreign tax. If a taxpayer excludes passive 
income from a controlled foreign corporation's foreign personal holding 
company income under these circumstances, then, notwithstanding the 
general rule of Sec.  1.904-5(d)(2), the income shall be considered to 
be passive income until distribution of that income. At that time, the 
rules of this paragraph shall apply to determine whether the income is 
high-taxed income and, therefore, general category income. For purposes 
of determining whether a reduction in tax is attributable to taxes on 
income excluded under section 954(b)(4), the rules of paragraph 
(c)(7)(ii) of this section apply. The rules of paragraph (c)(7)(ii) of 
this section shall apply for purposes of ordering distributions to 
determine whether such distributions are out of earnings and profits 
associated with such excluded income. For an example illustrating the 
operation of this paragraph (c)(7)(iii), see paragraph (c)(8) Example 
(7) of this section.
    (8) Examples. The following examples illustrate the application of 
this paragraph (c).

    Example 1. Controlled foreign corporation S is a wholly-owned 
subsidiary of domestic corporation P. S is a single qualified business 
unit (QBU) operating in foreign country X. In 1988, S earns $130 of 
gross passive royalty income from country X sources, and incurs $30 of 
expenses that do not include any payments to P. S's $100 of net passive 
royalty income is subject to $30 of foreign tax,

[[Page 778]]

and is included under section 951 in P's gross income for the taxable 
year. P allocates $50 of expenses to the $100 (consisting of the $70 
section 951 inclusion and $30 section 78 amount), resulting in a net 
inclusion of $50. After application of the high-tax kick-out rules of 
paragraph (c)(1) of this section, the $50 inclusion is treated as 
general category income, and the $30 of taxes deemed paid are treated as 
taxes imposed on general category income, because the foreign taxes paid 
and deemed paid on the income exceed the highest United States tax rate 
multiplied by the $50 inclusion ($30$17 (.34 x $50)).
    Example 2. The facts are the same as in Example (1) except that 
instead of earning $130 of gross passive royalty income, S earns $65 of 
gross passive royalty income from country X sources and $65 of gross 
passive interest income from country Y sources. S incurs $15 of expenses 
and $5 of foreign tax with regard to the royalty income and incurs $15 
of expenses and $10 of foreign tax with regard to the interest income. P 
allocates $50 of expenses pro rata to the $50 inclusion ($45 section 951 
inclusion and $5 section 78 amount) attributable to the royalty income 
earned by S and the $50 inclusion ($40 section 951 inclusion and $10 
section 78 amount) attributable to the interest income earned by S. 
Under paragraph (c)(4) of this section, the high-tax test is applied 
separately to the section 951 inclusion attributable to the income from 
X sources and the section 951 inclusion attributable to the income from 
Y sources. Therefore, after allocation of P's $50 of expenses, the 
resulting $25 inclusion attributable to the royalty income from X 
sources is still treated as passive income because the foreign taxes 
paid and deemed paid on the income do not exceed the highest United 
States tax rate multiplied by the $25 inclusion ($5<$8.50 (.34 x $25)). 
The $25 inclusion attributable to the interest income from Y sources is 
treated as general category income because the foreign taxes paid and 
deemed paid exceed the highest United States tax rate multiplied by the 
$25 inclusion ($10$8.50 (.34 x $25)).
    Example 3. Controlled foreign corporation S is a whollyowned 
subsidiary of domestic corporation P. S is incorporated and operating in 
country Y and has a branch in country Z. S has two QBUs (QBU Y and QBU 
Z). In 1988, S earns $65 of gross passive royalty income in country Y 
through QBU Y and $65 of gross passive royalty income in country Z 
through QBU Z. S allocates $15 of expenses to the gross passive royalty 
income earned by each QBU, resulting in net income of $50 in each QBU. 
Country Y imposes $5 of foreign tax on the royalty income earned in Y, 
and country Z imposes $10 of tax on royalty income earned in Z. All of 
S's income constitutes subpart F foreign personal holding company income 
that is passive income and is included in P's gross income for the 
taxable year. P allocates $50 of expenses pro rata to the $100 subpart F 
inclusion attributable to the QBUs (consisting of the $45 section 951 
inclusion derived through QBU Y, the $5 section 78 amount attributable 
to QBU Y, the $40 section 951 inclusion derived through QBU Z, and the 
$10 section 78 amount attributable to QBU Z), resulting in a net 
inclusion of $50. Pursuant to paragraph (c)(4) of this section, the 
high-tax kickout rules must be applied separately to the subpart F 
inclusion attributable to the income earned by QBU Y and the income 
earned by QBU Z. After application of the high-tax kickout rules, the 
$25 inclusion attributable to Y will still be treated as passive income 
because the foreign taxes paid and deemed paid on the income do not 
exceed the highest United States tax rate multiplied by the $25 
inclusion ($5<$8.50 (.34 x $25)). The $25 inclusion attributable to Z 
will be treated as general category income because the foreign taxes 
paid and deemed paid on the income exceed the highest United States tax 
rate multiplied by the $25 inclusion ($10<=$8.50 (.34 x $25)).
    Example 4. Domestic corporation M operates in branch form in foreign 
countries X and Y. The branches are qualified business units (QBUs), 
within the meaning of section 989(a). In 1988, QBU X earns passive 
royalty income, interest income and rental income. All of the QBU X 
passive income is from Country Z sources. The royalty income is not 
subject to a withholding tax, and is not taxed by Country X, and the 
interest and the rental income are subject to a 4 percent and 10 percent 
withholding tax, respectively. QBU Y earns interest income in Country Y 
that is not subject to foreign tax. For purposes of determining whether 
M's foreign source passive income is high-taxed income, the rental 
income and the interest income earned in QBU X are treated as one item 
of income pursuant to paragraphs (c) (4)(ii) and (3)(ii) of this 
section. The interest income earned in QBU Y and the royalty income 
earned in QBU X are each treated as a separate item of income under 
paragraphs (c)(4)(i) (with respect to QBU Y's interest income) and (c) 
(4)(ii) and (3)(iii) (with respect to QBU X's royalty income) of this 
section.
    Example 5. S, a controlled foreign corporation incorporated in 
foreign country R, is a wholly-owned subsidiary of P, a domestic 
corporation. For 1988, P is required under section 951(a) to include in 
gross income $80 (not including the section 78 amount) attributable to 
the earnings and profits of S for such year, all of which is foreign 
personal holding company income that is passive rent or royalty income. 
S does not make any distributions in 1988 or 1989. Foreign income taxes 
paid by S for 1988 that are deemed paid by P for such year under section 
960(a) with respect to the section 951(a) inclusion equal $20. Twenty 
dollars ($20) of P's expenses are

[[Page 779]]

properly allocated to the section 951(a) inclusion. The foreign income 
tax paid with respect to the section 951(a) inclusion does not exceed 
the highest United States tax rate multiplied by the amount of income 
after allocation of parent expenses ($20<$27.20 (.34 x $80)). Thus, P's 
section 951(a) inclusion for 1988 is included in P's passive income and 
the $20 of taxes attributable to that inclusion are treated as taxes 
related to passive income. In 1990, S distributes $80 to P, and under 
section 959 that distribution is treated as attributable to the earnings 
and profits with respect to the amount included in income by P in 1988 
and is excluded from P's gross income. Foreign country R imposes a 
withholding tax of $15 on the distribution in 1990. Under paragraph 
(c)(6)(i) of this section, the withholding tax in 1990 does not affect 
the characterization of the 1988 inclusion as passive income nor does it 
affect the characterization of the $20 of taxes paid in 1988 as taxes 
paid with respect to passive income. No further parent expenses are 
allocable to the receipt of that distribution. In 1990, the foreign 
taxes paid ($15) exceed the product of the highest United States tax 
rate and the amount of the inclusion reduced by taxes deemed paid in the 
year of inclusion ($15((.34 x $80)-$20)). Thus, under 
paragraph (c)(6)(iii) of this section, $7.20 ((.34 x $80)-$20)) of the 
$15 withholding tax paid in 1990 is treated as taxes related to passive 
income and the remaining $7.80 ($15-$7.20) of the withholding tax is 
treated as related to general category income.
    Example 6. S, a controlled foreign corporation, is a wholly-owned 
subsidiary of P, a domestic corporation. P and S are calendar year 
taxpayers. In 1987, S's only earnings consist of $200 of passive income 
that is foreign personal holding company income that is earned in a 
foreign country X. Under country X's tax system, the corporate tax on 
particular earnings is reduced on distribution of those earnings and no 
withholding tax is imposed. In 1987, S pays $100 of foreign tax. P does 
not elect to exclude this income from subpart F under section 954(b)(4) 
and includes $200 in gross income ($100 of net foreign personal holding 
company income and $100 of the section 78 amount). At the time of the 
inclusion, the income is considered to be high-taxed income under 
paragraphs (c)(1) and (c)(6)(i) of this section and is general category 
income to P. S does not distribute any of its earnings in 1987. In 1988, 
S has no earnings. On December 31, 1988, S distributes the $100 of 
earnings from 1987. At that time, S receives a $50 refund from X 
attributable to the reduction of the country X corporate tax imposed on 
those earnings. Under paragraph (c)(7)(i) of this section, P must 
redetermine whether the 1987 inclusion should be considered to be high-
taxed income. By taking into account the reduction in foreign tax, the 
inclusion would not have been considered high-taxed income. Therefore, P 
must redetermine its foreign tax credit for 1987 and treat the inclusion 
and the taxes associated with the inclusion as passive income and taxes. 
P must follow the appropriate section 905(c) procedures.
    Example 7. The facts are the same as in Example 6 except that P 
elects to apply section 954(b)(4) to S's passive income that is subpart 
F income. Although the income is not considered to be subpart F income, 
it remains passive income until distribution. In 1988, S distributes 
$150 to P. The distribution is a dividend to P because S has $150 of 
accumulated earnings and profits (the $100 of earnings in 1987 and the 
$50 refund in 1988). P has no expenses allocable to the dividend from S. 
In 1988, the income is subject to the high-tax kick-out rules under 
paragraph (c)(7)(iii) of this section. The income is passive income to P 
because the foreign taxes paid and deemed paid by P with respect to the 
income do not exceed the highest United States tax rate on that income.
    Example 8. The facts are the same as in Example 6 except that the 
distribution in 1988 is subject to a withholding tax of $25. Under 
paragraph (c)(7)(i) of this section, P must redetermine whether the 1987 
inclusion should be considered to be high-taxed income because there is 
a net $25 reduction of foreign tax. By taking into account both the 
reduction in foreign corporate tax and the withholding tax, the 
inclusion would continue to be considered high-taxed income. P must 
follow the appropriate section 905(c) procedures. P must redetermine its 
foreign tax credit for 1987, but the inclusion and the $75 taxes ($50 of 
deemed paid tax and $25 withholding tax) will continue to be treated as 
general category income and taxes.
    Example 9. (i) S, a controlled foreign corporation operating in 
country G, is a wholly-owned subsidiary of P, a domestic corporation. P 
and S are calendar year taxpayers. Country G imposes a tax of 50 percent 
on S's earnings. Under country G's system, the foreign corporate tax on 
particular earnings is reduced on distribution of those earnings to 30 
percent and no withholding tax is imposed. Under country G's law, 
distributions are treated as made out of a pool of undistributed 
earnings subject to the 50 percent tax rate. For 1987, S's only earnings 
consist of passive income that is foreign personal holding company 
income that is earned in foreign country G. S has taxable income of $110 
for United States purposes and $100 for country G purposes. Country G, 
therefore, imposes a tax of $50 on the 1987 earnings of S. P does not 
elect to exclude this income from subpart F under section 954(b)(4) and 
includes $110 in gross income ($60 of net foreign personal holding 
company income and $50 of the section 78 amount). At the time of the 
inclusion, the income is considered to be high-taxed income under 
paragraph (c) of

[[Page 780]]

this section and is general category income to P. S does not distribute 
any of its taxable income in 1987.
    (ii) In 1988, S earns general category income that is not subpart F 
income. S again has $110 in taxable income for United States purposes 
and $100 in taxable income for country G purposes, and S pays $50 of tax 
to foreign country G. In 1989, S has no taxable income or earnings. On 
December 31, 1989, S distributes $60 of earnings and receives a refund 
of foreign tax of $24. Country G treats the distribution of earnings as 
out of the 50% tax rate pool of earnings accumulated in 1987 and 1988. 
However, under paragraph (c)(7)(ii) of this section, the distribution, 
and, therefore, the reduction of tax is treated as first attributable to 
the $60 of passive earnings attributable to income previously taxed in 
1987. However, because, under foreign law, only 40 percent (the 
reduction in tax rates from 50 percent to 30 percent is a 40 percent 
reduction in the tax) of the $50 of foreign taxes on the passive 
earnings can be refunded, $20 of the $24 foreign tax refund reduces 
foreign taxes on passive earnings. The other $4 of the tax refund 
reduces the general category taxes from $50 to $46 (even though for 
United States purposes the $60 distribution is entirely out of passive 
earnings).
    (iii) Under paragraph (c)(7) of this section, P must redetermine 
whether the 1987 inclusion should be considered to be high-taxed income. 
By taking into account the reduction in foreign tax, the inclusion would 
not have been considered high-taxed income ($30<.34 x $110). Therefore, 
P must redetermine its foreign tax credit for 1987 and treat the 
inclusion and the taxes associated with the inclusion as passive income 
and taxes. P must follow the appropriate section 905(c) procedures.
    Example 10. P, a domestic corporation, earns $100 of passive royalty 
income from sources within the United States. Under the laws of Country 
X, however, that royalty is considered to be from sources within Country 
X and Country X imposes a 10 percent withholding tax on the payment of 
the royalty. P also earns $100 of passive foreign source dividend income 
subject to a 10 percent withholding tax to which $15 of expenses are 
allocated. In determining whether P's passive income is high-taxed, the 
$10 withholding tax on P's royalty income is allocated to passive 
income, and within the passive category to the group of income described 
in paragraph (c)(3)(ii) of this section (passive income subject to a 
withholding tax of less than 15 percent (but greater than zero)). For 
purposes of determining whether the income is high-taxed, however, only 
the foreign source dividend income is taken into account. The foreign 
source dividend income will still be treated as passive income because 
the foreign taxes paid on the passive income in the group ($20) do not 
exceed the highest United States tax rate multiplied by the $85 of net 
foreign source income in the group ($20 is less than $28.90 ($100-$15) x 
.34).
    Example 11. In 2001, P, a U.S. citizen with a tax home in Country X, 
earns the following items of gross income: $400 of foreign source, 
passive limitation interest income not subject to foreign withholding 
tax but subject to Country X income tax of $100, $200 of foreign source, 
passive limitation royalty income subject to a 5 percent foreign 
withholding tax (foreign tax paid is $10), $1,300 of foreign source, 
passive limitation rental income subject to a 25 percent foreign 
withholding tax (foreign tax paid is $325), $500 of foreign source, 
general category income that gives rise to a $250 foreign tax, and 
$2,000 of U.S. source capital gain that is not subject to any foreign 
tax. P has a $900 deduction allocable to its passive rental income. P's 
only other deduction is a $700 capital loss on the sale of stock that is 
allocated to foreign source passive limitation income under Sec.  1.865-
2(a)(3)(i). The $700 capital loss is initially allocated to the group of 
passive income subject to no withholding tax but subject to foreign tax 
other than withholding tax. The $300 amount by which the capital loss 
exceeds the income in the group must be reapportioned to the other 
groups under paragraph (c)(2)(ii)(B) of this section. The royalty income 
is thus reduced by $100 to $100 ($200 - ($300 x (200/600))) and the 
rental income is thus reduced by $200 to $200 ($400 - ($300 x (400/
600))). The $100 royalty income is not high-taxed and remains passive 
income because the foreign taxes do not exceed the highest United States 
rate of tax on that income. Under the high-tax kick-out, the $200 of 
rental income and the $325 of associated foreign tax are assigned to the 
general category category.
    Example 12. The facts are the same as in Example 11 except the 
amount of the capital loss that is allocated under Sec.  1.865-
2(a)(3)(i) and paragraph (c)(2) of this section to the group of foreign 
source passive income subject to no withholding tax but subject to 
foreign tax other than withholding tax is $1,200. Under paragraph 
(c)(2)(ii)(B) of this section, the excess deductions of $800 must be 
reapportioned to the $200 of net royalty income subject to a 5 percent 
withholding tax and the $400 of net rental income subject to a 15 
percent or greater withholding tax. The income in each of these groups 
is reduced to zero, and the foreign taxes imposed on the rental and 
royalty income are considered related to general category income. The 
remaining loss of $200 constitutes a separate limitation loss with 
respect to passive income.
    Example 13. In 2001, P, a domestic corporation, earns a $100 
dividend that is foreign source passive limitation income subject to a 
30-percent withholding tax. A foreign tax

[[Page 781]]

credit for the withholding tax on the dividend is disallowed under 
section 901(k). A deduction for the tax is allowed, however, under 
sections 164 and 901(k)(7). In determining whether P's passive income is 
high-taxed, the $100 dividend and the $30 deduction are allocated to the 
first group of income described in paragraph (c)(3)(iv) of this section 
(passive income subject to no withholding tax or other foreign tax).

    (d) [Reserved]
    (e) Financial services income--(1) In general. The term ``financial 
services income'' means income derived by a financial services entity, 
as defined in paragraph (e)(3) of this section, that is:
    (i) Income derived in the active conduct of a banking, insurance, 
financing, or similar business (active financing income as defined in 
paragraph (e)(2) of this section), except income described in paragraph 
(e)(2)(i)(W) of this section (high withholding tax interest);
    (ii) Passive income as defined in section 904(d) (2) (A) and 
paragraph (b) of this section as determined before the application of 
the exception for high-taxed income;
    (iii) Export financing interest as defined in section 904(d)(2)(G) 
and paragraph (h) of this section that, but for section 
904(d)(2)(B)(ii), would also meet the definition of high withholding tax 
interest; or
    (iv) Incidental income as defined in paragraph (e)(4) of this 
section.
    (2) Active financing income--(i) Income included. For purposes of 
paragraph (e)(1) and (e)(3) of this section, income is active financing 
income only if it is described in any of the following subdivisions.
    (A) Income that is of a kind that would be insurance income as 
defined in section 953(a) (including related party insurance income as 
defined in section 953(c)(2)) and determined without regard to those 
provisions of section 953(a)(1)(A) that limit insurance income to income 
from countries other than the country in which the corporation was 
created or organized.
    (B) Income from the investment by an insurance company of its 
unearned premiums or reserves ordinary and necessary to the proper 
conduct of the insurance business, income from providing services as an 
insurance underwriter, income from insurance brokerage or agency 
services, and income from loss adjuster and surveyor services.
    (C) Income from investing funds in circumstances in which the 
taxpayer holds itself out as providing a financial service by the 
acceptance or the investment of such funds, including income from 
investing deposits of money and income earned investing funds received 
for the purchase of traveler's checks or face amount certificates.
    (D) Income from making personal, mortgage, industrial, or other 
loans.
    (E) Income from purchasing, selling, discounting, or negotiating on 
a regular basis, notes, drafts, checks, bills of exchange, acceptances, 
or other evidences of indebtedness.
    (F) Income from issuing letters of credit and negotiating drafts 
drawn thereunder.
    (G) Income from providing trust services.
    (H) Income from arranging foreign exchange transactions, or engaging 
in foreign exchange transactions.
    (I) Income from purchasing stock, debt obligations, or other 
securities from an issuer or holder with a view to the public 
distribution thereof or offering or selling stock, debt obligations, or 
other securities for an issuer or holder in connection with the public 
distribution thereof, or participating in any such undertaking.
    (J) Income earned by broker-dealers in the ordinary course of 
business (such as commissions) from the purchase or sale of stock, debt 
obligations, commodities futures, or other securities or financial 
instruments and dividend and interest income earned by broker dealers on 
stock, debt obligations, or other financial instruments that are held 
for sale.
    (K) Service fee income from investment and correspondent banking.
    (L) Income from interest rate and currency swaps.
    (M) Income from providing fiduciary services.
    (N) Income from services with respect to the management of funds.
    (O) Bank-to-bank participation income.
    (P) Income from providing charge and credit card services or for 
factoring

[[Page 782]]

receivables obtained in the course of providing such services.
    (Q) Income from financing purchases from third parties.
    (R) Income from gains on the disposition of tangible or intangible 
personal property or real property that was used in the active financing 
business (as defined in paragraph (e)(3)(i) of this section) but only to 
the extent that the property was held to generate or generated active 
financing income prior to its disposition.
    (S) Income from hedging gain with respect to other active financing 
income.
    (T) Income from providing traveller's check services.
    (U) Income from servicing mortgages.
    (V) Income from a finance lease. For this purpose, a finance lease 
is any lease that is a direct financing lease or a leveraged lease for 
accounting purposes and is also a lease for tax purposes.
    (W) High withholding tax interest that would otherwise be described 
as active financing income.
    (X) Income from providing investment advisory services, custodial 
services, agency paying services, collection agency services, and stock 
transfer agency services.
    (Y) Any similar item of income that is disclosed in the manner 
provided in the instructions to the Form 1118 or 1116 or that is 
designated as a similar item of income in guidance published by the 
Internal Revenue Service.
    (3) Financial services entities--(i) In general. The term 
``financial services entity'' means an individual or entity that is 
predominantly engaged in the active conduct of a banking, insurance, 
financing, or similar business (active financing business) for any 
taxable Year. Except as provided in paragraph (e)(3)(ii) of this 
section, a determination of whether an entity is a financial services 
entity shall be done on an entity-by-entity basis. An individual or 
entity is predominantly engaged in the active financing business for any 
year if for that year at least 80 percent of its gross income is income 
described in paragraph (e)(2)(i) of this section. For this purpose, 
gross income includes all income realized by an individual or entity, 
whether includible or excludible from gross income under other operative 
provisions of the Code, but excludes gain from the disposition of stock 
of a corporation that prior to the disposition of its stock is related 
to the transferor within the meaning of section 267(b). For this 
purpose, income received from a related person that is a financial 
services entity shall be excluded if such income is characterized under 
the look-through rules of section 904(d)(3) and Sec.  1.904-5. In 
addition, income received from a related person that is not a financial 
services entity but that is characterized as financial services income 
under the look-through rules shall be excluded. See paragraph (e)(3)(iv) 
Example 5 of this section. Any income received from a related person 
that is characterized under the look-through rules and that is not 
otherwise excluded by this paragraph will retain its character either as 
active financing income or other income in the hands of the recipient 
for purposes of determining if the recipient is a financial services 
entity and if the income is financial services income to the recipient. 
For purposes of this paragraph, related person is defined in Sec.  
1.904-5(i)(1).
    (ii) Special rule for affiliated groups. In the case of any 
corporation that is not a financial services entity under paragraph 
(e)(3)(i) of this section, but is a member of an affiliated group, such 
corporation will be deemed to be a financial services entity if the 
affiliated group as a whole meets the requirements of paragraph 
(e)(3)(i) of this section. For purposes of this paragraph (e)(3)(ii), 
affiliated group means an affiliated group as defined in section 
1504(a), determined without regard to section 1504(b)(3). In counting 
the income of the group for purposes of determining whether the group 
meets the requirements of paragraph (e)(3)(i) of this section, the 
following rules apply. Only the income of group members that are United 
States corporations or foreign corporations that are controlled foreign 
corporations in which United States members of the affiliated group own, 
directly or indirectly, at least 80 percent of the total voting power 
and value of the stock shall be

[[Page 783]]

included. For purposes of this paragraph (e)(3)(ii), indirect ownership 
shall be determined under section 318 and the regulations under that 
section. The income of the group will not include any income from 
transactions with other members of the group. Passive income will not be 
considered to be active financing income merely because that income is 
earned by a member of the group that is a financial services entity 
without regard to the rule of this paragraph (e)(3)(ii). This paragraph 
(e)(3)(ii) applies to taxable years beginning after December 31, 2000.
    (iii) Treatment of partnerships and other pass-through entities For 
purposes of determining whether a partner (including a partnership that 
is a partner in a second partnership) is a financial services entity, 
all of the partner's income shall be taken into account, except that 
income that is excluded under paragraph (e)(3)(i) of this section shall 
not be taken into account. Thus, if a partnership is determined to be a 
financial services entity none of the income of the partner received 
from the partnership that is characterized under the look-through rules 
shall be included for purpose of determining if the partner is a 
financial services entity. If a partnership is determined not to be a 
financial services entity, then income of the partner from the 
partnership that is characterized under the look-through rules will be 
taken into account (unless such income is financial services income) and 
such income will retain its character either as active financing income 
or as other income in the hands of the partner for purposes of 
determining if the partner is a financial service entity and if the 
income is financial services income to the partner. If a partnership is 
a financial services entity and the partner's income from the 
partnership is characterized as financial services income under the 
look-through rules, then, for purposes of determining a partner's 
foreign tax credit limitation, the income from the partnership shall be 
considered to be financial services income to the partner regardless of 
whether the partner is itself a financial services entity. The rules of 
this paragraph (e)(3)(iii) will appIy for purposes of determining 
whether an owner of an interest in any other pass-through entity the 
character of the income of which is preserved when such income is 
included in the income of the owner of the interest is a financial 
services entity.
    (iv) Examples. The principles of paragraph (e)(3) of this section 
are illustrated by the following examples.

    Example 1. P is a domestic corporation that owns 100 percent of the 
stock of S, a controlled foreign corporation incorporated in Country X. 
For the 1990 taxable year, 60 percent of S's income is active financing 
income that consists of income that will be considered general 
limitation or passive income if S is not a financial services entity. 
The other 40 percent of S's income is passive non-active financing 
income. S is not a financial services entity and its active financing 
income thus retains its character as general limitation and passive 
income. S makes an interest payment to P in 1990 that is characterized 
under the look-through rules. Although the interest is not financial 
services income to S under the look-through rules, it retains its 
character as active financing income when paid to P and P must take that 
income into account in determining whether it is a financial services 
entity under paragraph (e)(3)(i) of this section. If P is determined to 
be a financial services entity, both the portion of the interest payment 
characterized as active financing income (whether general limitation or 
passive income in S's hands) and the portion characterized as passive 
non-active financing income received from S will be recharacterized as 
financial services income.
    Example 2. Foreign corporation A, which is not a controlled foreign 
corporation, owns 100 percent of the stock of domestic corporation B, 
which owns 100 percent of the stock of domestic corporation C. A also 
owns 100 percent of the stock of foreign corporation D. D owns 100 
percent of the stock of domestic corporation E, which owns 100 percent 
of the stock of controlled foreign corporation F. All of the 
corporations are members of an affiliated group within the meaning of 
section 1504(a) (determined without regard to section 1504(b)(3)). 
Pursuant to paragraph (e)(3)(ii) of this section, however, only the 
income of B, C, E, and F is counted in determining whether the group 
meets the requirements of paragraph (e)(3)(i) of this section. For the 
2001 taxable year, B's income consists of $95 of active financing income 
and $5 of passive non-active financing income. C has $40 of active 
financing income and $20 of passive non-active financing income. E has 
$70 of active financing income and $15 of passive non-active financing 
income. F has $10

[[Page 784]]

of passive income. B and E qualify as financial services entities under 
the entity test of paragraph (e)(3)(i) of this section. Therefore, B and 
E are financial services entities without regard to whether the group as 
a whole is a financial services entity and all of the income of B and E 
shall be treated as financial services income. C and F do not qualify as 
financial services entities under the entity test of paragraph (e)(3)(i) 
of this section. However, under the affiliated group test of paragraph 
(e)(3)(ii) of this section, C and F are financial services entities 
because at least 80 percent of the group's total income consists of 
active financing income ($205 of active financing income is 80.4 percent 
of $255 total income). B's and E's passive income is not treated as 
active financing income for purposes of the affiliated group test of 
paragraph (e)(3)(ii) of this section even though it is treated as 
financial services income without regard to whether the group satisfies 
the affiliated group test. Once C and F are determined to be financial 
services entities under the affiliated group test, however, all of the 
passive income of the group is treated as financial services income. 
Thus, 100 percent of the income of B, C, E, and F for 2001 is financial 
services income.
    Example 3. PS is a domestic partnership operating in branch form in 
foreign country X. PS has two equal general partners, A and B. A and B 
are domestic corporations that each operate in branch form in foreign 
countries Y and Z. All of A's income, except that derived through PS, is 
manufacturing income. All of B's income, except that derived through PS, 
is active financing income. A and B's only income from PS are 
distributive shares of PS's income. PS is a financial services entity 
and all of its income is financial services income. The income from PS 
is excluded in determining if A or B are financial services entities. 
Thus, A is not a financial services entity because none of A's income is 
active financing income and B is a financial services entity because all 
of B's income is active financing income. However, both A and B's 
distributive shares of PS's taxable income consist of financial services 
income even though A is not a financial services entity.
    Example 4. PS is a domestic partnership operating in foreign country 
X. A and B are domestic corporations that are equal general partners in 
PS and, therefore, the look-through rules apply for purposes of 
characterizing A's and B's distributive shares of PS's income. Fifty 
(50) percent of PS's gross income is active financing income that is not 
high withholding tax interest. The active financing income includes 
income that also meets the definition of passive income and income that 
meets the definition of general limitation income. The other 50 percent 
of PS's income is from manufacturing. PS is, therefore, not a financial 
services entity. A s and B's distributive shares of partnership taxable 
income consist of general limitation manufacturing income and active 
financing income. Under paragraph (c)(3)(i) of this section, the active 
financing income shall be financial services income to A or B if either 
A or B is determined to be a financial services entity. If A or B is not 
a financial services entity, the distributive shares of income from PS 
will not be financial services income to A or B and will consist of 
passive and general limitation income. All of the income from PS is 
included in determining if A or B are financial services entities.
    Example 5. P is a United States corporation that is not a financial 
services entity. P owns 100 percent of the stock of S, a controlled 
foreign corporation that is not a financial services entity. S owns 100 
percent of the stock of T, a controlled foreign corporation that is a 
financial services entity. In 1991, T pays a dividend to S. The dividend 
from T is characterized under the look-through rules of section 
904(d)(3). Pursuant to paragraph (e)(3)(i) of this section, the dividend 
from T is excluded in determining whether S is a financial services 
entity. S is determined not to be a financial services entity but the 
dividend retains its character as financial services income in S's 
hands. Any subpart F inclusion or dividend to P out of earnings and 
profits attributable to the dividend from T will be excluded in 
determining whether P is a financial services entity but the inclusion 
or dividend will retain its character as financial services income.

    (4) Definition of incidental income--(i) In general--(A) Rule. 
Incidental income is income that is integrally related to active 
financing income of a financial services entity. Such income includes, 
for example, income from precious metals trading and commodity trading 
that is integrally related to futures income. If securities, shares of 
stock, or other types of property are acquired by a financial services 
entity as an ordinary and necessary incident to the conduct of an active 
financing business, the income from such property will be considered to 
be financial services income but only so long as the retention of such 
property remains an ordinary or necessary incident to the conduct of 
such business. Thus property, including stock, acquired as the result 
of, or in order to prevent, a loss in an active financing business upon 
a loan held by the taxpayer in the ordinary course of such business will 
be considered ordinary and necessary to the conduct of such business, 
but income from such property will be considered financial

[[Page 785]]

services income only so long as the holding of such property remains an 
ordinary and necessary incident to the conduct of such business. If an 
entity holds such property for five years or less then the property is 
considered held incident to the financial services business. If an 
entity holds such property for more than five years, a presumption will 
be established that the entity is not holding such property incident to 
its financial services business. An entity will be able to rebut the 
presumption by demonstrating that under the facts and circumstances it 
is not holding the property as an investment. However, the fact that an 
entity holds the property for more than five years and is not able to 
rebut the presumption that it is not holding the property incident to 
its financial services business will not affect the characterization of 
any income received from the property during the first five years as 
financial services income.
    (B) Examples. The following examples illustrate the application of 
paragraph (e)(4)(i) of this section.

    Example 1. X is a financial services entity within the meaning of 
paragraph (e)(3)(i) of this section. In 1987, X made a loan in the 
ordinary course of its business to an unrelated foreign corporation, Y. 
As security for that loan, Y pledged certain operating assets. Those 
assets generate income of a type that would be subject to the general 
limitation. In January 1989, Y defaulted on the loan and forfeited the 
collateral. During the period X held the assets, X earned operating 
income generated by those assets. This income was applied in partial 
satisfaction of Y's obligation. In 1993, X sold the forfeited assets. 
The sales proceeds were in excess of the remainder of Y's obligation. 
The operating income received in the period from 1989 to 1993 and the 
income on the sale of the assets in 1993 are financial services income 
of X.
    Example 2. The facts are the same as in Example 1, except that 
instead of pledging its operating assets as collateral for the loan, Y 
pledged the stock of its operating subsidiary Z. In 1993 X sold the 
stock of Z in complete satisfaction of Y's obligation. X's income from 
the sale of Z stock in satisfaction of Y's obligation is financial 
services income.
    Example 3. P, a domestic corporation, is a financial services entity 
within the meaning of paragraph (e)(3)(i) of this section. P holds a 
United States dollar denominated debt (the ``obligation'') of the 
Central Bank of foreign country X. The obligation evidences a loan of 
$100 made by P to the Central Bank. In 1988, pursuant to a program of 
country X, P delivers the obligation to the Central Bank which credits 
70 units of country X currency to M, a country X corporation. M issues 
all of its only class of capital stock to P. M invests the 70 units of 
country X currency in the construction and operation of a new hotel in 
X. In 1994, M distributes 10 units of country X currency to P as a 
dividend. P is not able to rebut the presumption that it is not holding 
the stock of M incident to its financial services business. The dividend 
to P is, therefore, not financial services income.

    (ii) Income that is not incidental income. Income that is 
attributable to non-financial activity is not incidental income within 
the meaning of paragraph (e)(4) (i) and (ii) of this section solely 
because such income represents a relatively small proportion of the 
taxpayer's total income or that the taxpayer engages in non-financial 
activity on a sporadic basis. Thus, for example, income from data 
processing services provided to related or unrelated parties or income 
from the sale of goods or non-financial services (for example travel 
services) is not financial services income, even if the recipient is a 
financial services entity.
    (5) Exceptions. Financial services income does not include income 
that is:
    (i) Export financing interest as defined in section 904(d)(2)(G) and 
paragraph (h) of this section unless that income would be high 
withholding tax interest as defined in section 904(d)(2)(B) but for 
paragraph (d)(2)(B)(ii) of that section;
    (ii) High withholding tax interest as defined in section 
904(d)(2)(B) unless that income also meets the definition of export 
financing interest; and
    (iii) Dividends from noncontrolled section 902 corporations as 
defined in section 904(d)(2)(E) paid in taxable years beginning before 
January 1, 2003.
    (f)-(g) [Reserved]
    (h) Export financing interest--(1) Definitions--(i) Export financing 
interest. The term ``export financing interest'' means any interest 
derived from financing the sale (or other disposition) for use or 
consumption outside the United States of any property that is 
manufactured, produced, grown, or extracted in the United States by the 
taxpayer or a related person, and not more than 50 percent of the fair 
market

[[Page 786]]

value of which is attributable to products imported into the United 
States. For purposes of this paragraph, the term ``United States'' 
includes the fifty States, the District of Columbia, and the 
Commonwealth of Puerto Rico.
    (ii) Fair market value. For purposes of this paragraph, the fair 
market value of any property imported into the United States shall be 
its appraised value, as determined by the Secretary under section 402 of 
the Tariff Act of 1930 (19 U.S.C. 1401a) in connection with its 
importation. For purposes of determining the foreign content of an item 
of property imported into the United States, see section 927 and the 
regulations thereunder.
    (iii) Related person. For purposes of this paragraph, the term 
``related person'' has the meaning given it by section 954(d)(3) except 
that such section shall be applied by substituting ``the person with 
respect to whom the determination is being made'' for ``controlled 
foreign corporation'' each place it applies.
    (2) Treatment of export financing interest. Except as provided in 
paragraph (h)(3) of this section, if a taxpayer (including a financial 
services entity) receives or accrues export financing interest from an 
unrelated person, then that interest shall be treated as general 
category income.
    (3) Exception. Unless it is received or accrued by a financial 
services entity, export financing interest shall be treated as passive 
category income if that income is also related person factoring income. 
For this purpose, related person factoring income is--
    (i) Income received or accrued by a controlled foreign corporation 
that is income described in section 864(d)(6) (income of a controlled 
foreign corporation from a loan for the purpose of financing the 
purchase of inventory property of a related person); or
    (ii) Income received or accrued by any person that is income 
described in section 864(d)(1) (income from a trade receivable acquired 
from a related person).
    (4) Examples. The following examples illustrate the operation of 
paragraph (h)(3) of this section:

    Example 1. Controlled foreign corporation S is a wholly-owned 
subsidiary of domestic corporation P. S is not a financial services 
entity and has accumulated cash reserves. P has uncollected trade and 
service receivables of foreign obligors. P sells the receivables at a 
discount (``factors'') to S. The income derived by S on the receivables 
is related person factoring income. The income is also export financing 
interest. Because the income is related person factoring income, the 
income is passive income to S.
    Example 2. Domestic corporation S is a wholly-owned subsidiary of 
domestic corporation P. S is not a financial services entity and has 
accumulated cash reserves. P has uncollected trade and service 
receivables of foreign obligors. P factors the receivables to S. The 
income derived by S on the receivables is related person factoring 
income. The income is also export financing interest. The income will be 
passive income to S.
    Example 3. The facts are the same as in Example 2except that instead 
of factoring P's receivables, S finances the sales of P's goods by 
making loans to the purchasers of P's goods. The interest derived by S 
on these loans is export financing interest and is not related person 
factoring income. The income will be general category income to S.

    (5) Income eligible for section 864(d)(7) exception (same country 
exception) from related person factoring treatment--(i) Income other 
than interest. If any foreign person receives or accrues income that is 
described in section 864(d)(7) (income on a trade or service receivable 
acquired from a related person in the same foreign country as the 
recipient) and such income would also meet the definition of export 
financing interest if section 864(d)(1) applied to such income (income 
on a trade or service receivable acquired from a related person treated 
as interest), then the income shall be considered to be export financing 
interest and shall be treated as general category income.
    (ii) Interest income. If export financing interest is received or 
accrued by any foreign person and that income would otherwise be treated 
as related person factoring income under section 864(d)(6) if section 
864(d)(7) did not apply, section 904(d)(2)(B)(iii)(I) shall apply, and 
the interest shall be treated as general category income unless the 
interest is received or accrued by a financial services entity. If that 
interest is received or accrued by a financial services entity, section 
904(d)(2)(C)(iii)(III) shall apply and the interest shall be treated 
asgeneral category income.

[[Page 787]]

    (iii) Examples. The following examples illustrate the operation of 
this paragraph (h)(5):

    Example 1. Controlled foreign corporation S is a wholly-owned 
subsidiary of domestic corporation P. Controlled foreign corporation T 
is a wholly-owned subsidiary of controlled foreign corporation S. S and 
T are incorporated in Country M. In 1987, P sells tractors to T, which T 
sells to X, an unrelated foreign corporation organized in country M. The 
tractors are to be used in country M. T uses a substantial part of its 
assets in its trade or business located in Country M. T has uncollected 
trade receivables from X that it factors to S. S derived more than 20 
percent of its gross income for 1987 other than from an active financing 
business and the income derived by S from the receivables is not derived 
in an active financing business. Thus, pursuant to paragraph (e)(3)(i) 
of this section, S is not a financial services entity. The income is not 
related person factoring income because it is described in section 
864(d)(7) (income eligible for the same country exception). If section 
864(d)(1) applied, the income S derived from the receivables would meet 
the definition of export financing interest. The income, therefore, is 
considered to be export financing interest and is general category 
income to S.
    Example 2. Controlled foreign corporation S is a wholly-owned 
subsidiary of domestic corporation, P. Controlled foreign corporation T 
is a wholly-owned subsidiary of controlled foreign corporation S. S and 
T are incorporated in country M. S is not a financial services entity. 
In 1987, P sells tractors to T, which T sells to X, a foreign 
partnership that is organized in country M and is related to S and T. S 
makes a loan to X to finance the tractor sales. The interest earned by S 
from financing the sales is described in section 864(d)(7) and is export 
financing interest. Therefore, the income shall be general category 
income to S.

    (i) Interaction of section 907(c) and income described in this 
section. If a person receives or accrues income that is income described 
in section 907(c) (relating to oil and gas income), the rules of section 
907(c) and the regulations thereunder, as well as the rules of this 
section, shall apply to the income. The reduction in amount allowed as 
foreign tax provided by section 907(a) shall therefore be calculated 
separately for income in each separate category.
    (j) Special rule for DASTM gain or loss. Any DASTM gain or loss 
computed under Sec.  1.985-3(d) must be allocated among the categories 
of income under the rules of Sec.  1.985-3 (e)(2)(iv) or (e)(3). The 
rules of Sec.  1.985-3(e) apply before the rules of section 
904(d)(2)(B)(iii)(II) (the exception from passive income for high-taxed 
income).
    (k) Special rule for alternative minimum tax foreign tax credit. For 
purposes of computing the alternative minimum tax foreign tax credit 
under section 59(a), items included in alternative minimum taxable 
income by reason of section 56(g) (adjustments based on adjusted current 
earnings) shall be characterized as income described in a separate 
category under section 904(d) and this section based on the character of 
the underlying items of income.
    (l) Priority rule. Income that meets the definitions of a separate 
category described in paragraph (m) of this section and another category 
of income described in section 904(d)(2)(A)(i) and (ii) will be subject 
to the separate limitation described in paragraph (m) of this section 
and will not be treated as general category income described in section 
904(d)(2)(A)(ii).
    (m) Income treated as allocable to an additional separate category. 
If section 904(a), (b), and (c) are applied separately to any category 
of income under the Internal Revenue Code (for example, under section 
56(g)(4)(C)(iii)(IV), 245(a)(10), 865(h), 901(j), or 904(h)(10)), that 
category of income will be treated for all purposes of the Internal 
Revenue Code and regulations as if it were a separate category listed in 
section 904(d)(1).
    (n) Effective/applicability dates. Paragraphs (a), (b), (h)(3), and 
(l) of this section shall apply to taxable years of United States 
persons and, for purposes of section 906, foreign persons beginning 
after December 31, 2006 and ending on or after December 21, 2007, and to 
taxable years of a foreign corporation which end with or within taxable 
years of its domestic corporate shareholder beginning after December 31, 
2006 and ending on or after December 21, 2007. For purposes of 
determining whether passive income is high-taxed income, the grouping 
rules of paragraphs (c)(3) and (4) of this section apply in taxable 
years ending on or after April 20, 2009. See 26 CFR Sec.  1.904-4T(c)(3) 
and (4) (revised as of April 1, 2009) for grouping

[[Page 788]]

rules applicable to taxable years beginning after December 31, 2002, and 
ending before April 20, 2009. For corresponding rules applicable to 
taxable years beginning before January 1, 2003, see 26 CFR Sec.  1.904-
4(c)(2)(i) (revised as of April 1, 2006).

[T.D. 8214, 53 FR 27011, July 18, 1988]

    Editorial Note: For Federal Register citations affecting Sec.  
1.904-4, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.904-5  Look-through rules as applied to controlled 
foreign corporations and other entities.

    (a) Definitions. For purposes of section 904(d)(3) and (4) and the 
regulations under section 904, the following definitions apply:
    (1) The term separate category means, as the context requires, any 
category of income described in section 904(d)(1)(A) and (B) (or section 
904(d)(1)(A), (B), (C), (D), (F), (G), (H), or (I) for taxable years 
beginning before January 1, 2007) and in Sec.  1.904-4T(b) (or Sec.  
1.904-4(e) for taxable years beginning before January 1, 2007), any 
category of income described in Sec.  1.904-4(m), or any category of 
earnings and profits to which income described in such provisions is 
attributable.
    (2) The term controlled foreign corporation has the meaning given 
such term by section 957 (taking into account the special rule for 
certain captive insurance companies contained in section 953(c)).
    (3) The term United States shareholder has the meaning given such 
term by section 951(b) (taking into account the special rule for certain 
captive insurance companies contained in section 953(c)), except that 
for purposes of this section, a United States shareholder shall include 
any member of the controlled group of the United States shareholder. For 
this purpose the controlled group is any member of the affiliated group 
within the meaning of section 1504(a)(1) except that ``more than 50 
percent'' shall be substituted for ``at least 80 percent'' wherever it 
appears in section 1504(a)(2). For taxable years beginning before 
January 1, 2001, the preceding sentence shall be applied by substituting 
``50 percent'' for ``more than 50 percent''.
    (4) The term noncontrolled section 902 corporation means any foreign 
corporation with respect to which the taxpayer meets the stock ownership 
requirements of section 902(a), or, with respect to a lower-tier foreign 
corporation, the taxpayer meets the requirements of section 902(b). 
Except as provided in section 902 and the regulations under that section 
and paragraphs (i)(3) and (i)(4) of this section, a controlled foreign 
corporation shall not be treated as a noncontrolled section 902 
corporation with respect to any distributions out of its earnings and 
profits for periods during which it was a controlled foreign 
corporation. In the case of a partnership owning a foreign corporation, 
the determination of whether a taxpayer meets the ownership requirements 
of section 902(a) or (b) will be made with respect to the taxpayer's 
indirect ownership, and not the partnership's direct ownership, in the 
foreign corporation. See section 902(c)(7).
    (b) In general. Except as otherwise provided in section 904(d)(3) 
and (4) and this section, dividends, interest, rents, and royalties 
received or accrued by a taxpayer from a controlled foreign corporation 
in which the taxpayer is a United States shareholder shall be treated as 
general category income. See paragraph (c)(4)(iii) of this section for 
the treatment of dividends received by a domestic corporation from a 
noncontrolled section 902 corporation in which the domestic corporation 
meets the stock ownership requirements of section 902(a).
    (c) Rules for specific types of inclusions and payments--(1) Subpart 
F inclusions--(i) Rule. Any amount included in gross income under 
section 951(a)(1)(A) shall be treated as income in a separate category 
to the extent the amount so included is attributable to income received 
or accrued by the controlled foreign corporation that is described as 
income in such category. For purposes of this Sec.  1.904-5, income 
shall be characterized under the rules of Sec.  1.904-4 prior to the 
application of the rules of paragraph (c) of this section. For rules 
concerning inclusions under section 951(a)(1)(B), see paragraph 
(c)(4)(i) of this section.

[[Page 789]]

    (ii) Examples. The following examples illustrate the application of 
this paragraph (c)(1):

    Example 1. Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. S earns $200 of net income, $85 
of which is foreign base company shipping income, $15 of which is 
foreign personal holding company income, and $100 of which is non-
subpart F general limitation income. No foreign tax is imposed on the 
income. One hundred dollars ($100) of S's income is subpart F income 
taxed currently to P under section 951(a)(1)(A). Because $85 of the 
subpart F inclusion is attributable to shipping income of S, $85 of the 
subpart F inclusion is shipping income to P. Because $15 of the subpart 
F inclusion is attributable to passive income of S, $15 of the subpart F 
inclusion is passive income to P.
    Example 2. Controlled foreign corporation S is a wholly-owned 
subsidiary of domestic corporation P. S is a financial services entity. 
P manufactures cars and is not a financial services entity. In 1987, S 
earns $200 of interest income unrelated to its banking business and $900 
of interest income related to its banking business. Assume that S pays 
no foreign taxes and has no expenses. All of S's income is included in 
P's gross income as foreign personal holding company income. Because S 
is a financial services entity, income that would otherwise be passive 
income is considered to be financial services income. P, therefore, 
treats the entire subpart F inclusion as financial services income.
    Example 3. Controlled foreign corporation S is a wholly-owned 
subsidiary of domestic corporation P. P is a financial services entity. 
S manufactures cars and is not a financial services entity. In 1987, S 
earns $200 of passive income that is subpart F income and $900 of 
general limitation non-subpart F income. Assume that S pays no foreign 
taxes on its passive earnings and has no expenses. P includes the $200 
of subpart F income in gross income. Because P is a financial services 
entity, the inclusion will be financial services income to P.
    Example 4. Controlled foreign corporation S is a wholly-owned 
subsidiary of domestic corporation P. Neither P nor S is a financial 
services entity. Controlled foreign corporation T is a wholly-owned 
subsidiary of controlled foreign corporation S. T is a financial 
services entity. In 1991, T pays a dividend to S. For purposes of 
determining whether S is a financial services entity under Sec.  1.904-
4(e)(3)(i), the dividend from T is ignored. For purposes of 
characterizing the dividend in S's hands under the look-through rules of 
paragraph (c)(4) of this section, however, the dividend retains its 
character as financial services income. Similarly, any subpart F 
inclusion or dividend to P out of the earnings and profits attributable 
to the dividend from S is excluded in determining whether P is a 
financial services entity under Sec.  1.904-4(e)(3)(i), but retains its 
character in P's hands as financial services income under paragraph 
(c)(4) of this section.
    Example 5. Controlled foreign corporation S is a wholly-owned 
subsidiary of domestic corporation P. S owns 40 percent of foreign 
corporation A, 45 percent of foreign corporation B, 30 percent of 
foreign corporation C and 20 percent of foreign corporation D. A, B, C, 
and D are noncontrolled section 902 corporations. In 1987, S's only 
income is a $100 dividend from each foreign corporation. Assume that S 
pays no foreign taxes and has no expenses. All $400 of the income is 
foreign personal holding company income and is included in P's gross 
income. P must include $100 in its separate limitation for dividends 
from A, $100 in its separate limitation for dividends from B, $100 in 
its separate limitation for dividends from C, and $100 in its separate 
limitation for dividends from D.

    (2) Interest--(i) In general. For purposes of this paragraph, 
related person interest is any interest paid or accrued by a controlled 
foreign corporation to any United States shareholder in that corporation 
(or to any other related person) to which the look-through rules of 
section 904(d)(3) and this section apply. Unrelated person interest is 
all interest other than related person interest. Related person interest 
shall be treated as income in a separate category to the extent it is 
allocable to income of the controlled foreign corporation in that 
category. If related person interest is received or accrued from a 
controlled foreign corporation by two or more persons, the amount of 
interest received or accrued by each person that is allocable to any 
separate category of income shall be determined by multiplying the 
amount of related person interest allocable to that separate category of 
income by a fraction. The numerator of the fraction is the amount of 
related person interest received or accrued by that person and the 
denominator is the total amount of related person interest paid or 
accrued by the controlled foreign corporation.
    (ii) Allocating and apportioning expenses of a controlled foreign 
corporation including interest paid to a related person. Related person 
interest and other expenses of a controlled foreign corporation shall be 
allocated and apportioned in the following manner:

[[Page 790]]

    (A) Gross income in each separate category shall be determined;
    (B) Any expenses that are definitely related to less than all of 
gross income as a class, including unrelated person interest that is 
directly allocated to income from a specific property, shall be 
allocated and apportioned under the principles of Sec. Sec.  1.861-8 or 
1.861-10T, as applicable, to income in each separate category;
    (C) Related person interest shall be allocated to and shall reduce 
(but not below zero) the amount of passive foreign personal holding 
company income as determined after the application of paragraph 
(c)(2)(ii)(B) of this section;
    (D) To the extent that related person interest exceeds passive 
foreign personal holding company income as determined after the 
application of paragraphs (c)(2)(ii) (B) and (C) of this section, the 
related person interest shall be apportioned under the rules of this 
paragraph to separate categories other than passive income.
    (1) If under Sec.  1.861-9T, the modified gross income method of 
apportioning interest expense is elected, related person interest shall 
be apportioned as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.034

    (2) If under Sec.  1.861-9T, the asset method of apportioning 
interest expense is elected, related person interest shall be 
apportioned according to the following formula:
[GRAPHIC] [TIFF OMITTED] TC07OC91.035

    (E) Any other expenses (including unrelated person interest that is 
not directly allocated to income from a specific property) that are not 
definitely related expenses or that are definitely related to all of 
gross income as a class shall be apportioned under the rules of this 
paragraph to reduce income in each separate category.
    (1) If under Sec.  1.861-9T, the modified gross income method of 
apportioning interest expense is elected, the interest expense shall be 
apportioned as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.036


[[Page 791]]


    (2) If under Sec.  1.861-9T, the asset method of apportioning 
interest expense is elected, then the expense shall be apportioned as 
follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.037

    (3) Expenses other than interest shall be apportioned in a similar 
manner depending on the apportionment method used. See Sec.  1.861-
8T(c)(1) (i)-(vi).
    (iii) Allocating and apportioning expenses of a noncontrolled 
section 902 corporation. Expenses of a noncontrolled section 902 
corporation shall be allocated and apportioned in the same manner as 
expenses of a controlled foreign corporation under paragraph (c)(2)(ii) 
of this section, except that the related person interest rule of 
paragraphs (c)(2)(ii)(C) and (D) of this section shall not apply.
    (iv) Definitions--(A) Value of assets and reduction in value of 
assets and gross income. For purposes of paragraph (c)(2)(ii) (D) and 
(E) of this section, the value of total assets is the value of assets in 
all categories (determined under the principles of Sec.  1.861-9T(g)). 
See Sec.  1.861-10T(d)(2) to determine the reduction in value of assets 
and gross income for purposes of apportioning additional third person 
interest expense that is not directly allocated when some interest 
expense has been directly allocated. For purposes of this paragraph and 
paragraph (c)(2)(ii)(E) of this section, any reduction in the value of 
assets for indebtedness that relates to interest allocated under 
paragraph (c)(2)(ii)(C) of this section is made before determining the 
average of asset values. For rules relating to the averaging of reduced 
asset values see Sec.  1.861-9T(g)(2).
    (B) Related person debt allocated to passive assets. For purposes of 
paragraph (c)(2)(ii)(E) of this section, related person debt allocated 
to passive assets is determined as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.038


For this purpose, the term total related person debt means the sum of 
the principal amounts of obligations of a controlled foreign corporation 
owed to any United States shareholder of such corporation or to any 
related entity (within the meaning of paragraph (g) of this section) 
determined at the end of the taxable year.
    (v) Examples. The following examples illustrate the operation of 
this paragraph (c)(2).

    Example 1. (i) Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. In 1987, S earns $200 of 
foreign personal holding company income that is passive income. S also 
earns $100 of foreign base company sales income that is general 
limitation income. S has $2000 of passive assets and $2000 of general 
limitation assets. In 1987, S makes a $150 interest payment to P with 
respect to a $1500 loan from P. S also pays $100 of interest to an 
unrelated person on a $1000 loan from that person. S

[[Page 792]]

has no other expenses. S uses the asset method to apportion interest 
expense.
    (ii) Under paragraph (c)(2)(ii)(C) of this section, the $150 related 
person interest payment is allocable to S's passive foreign personal 
holding company income. Therefore, the $150 interest payment is passive 
income to P. Because the entire related person interest payment is 
allocated to passive income under paragraph (c)(2)(ii)(C) of this 
section, none of the related person interest payment is apportioned to 
general limitation income under paragraph (c)(2)(ii)(D) of this section. 
Under paragraph (c)(2)(iii)(B) of this section, the entire amount of the 
related person debt is allocable to passive assets ($1500 = $1500 x 
$150/$150). Under paragraph (c)(2)(ii)(E) of this section, $20 of 
interest expense paid to an unrelated person is apportioned to passive 
income ($20 = $100 x ($2000-$1500)/($4000-$1500)). Eighty dollars ($80) 
of the interest expense paid to an unrelated person is apportioned to 
general limitation income ($80 = $100 x $2000/($4000-$1500)).
    Example 2. The facts are the same as in Example 1, except that S 
uses the gross income method to apportion interest expense. Under 
paragraph (c)(2)(ii)(E) of this section, the unrelated person interest 
expense would be apportioned on a gross income method. Therefore, $33 of 
interest expense paid to unrelated persons would be apportioned to 
passive income ($33 = $100 x ($200-$150)/($300-$150) and $67 of interest 
expense paid to unrelated persons would be apportioned to general 
limitation income ($67 = $100 x $100/($300-$150).
    Example 3. (i) The facts are the same as in Example 1, except that S 
has an additional $50 of third person interest expense that is directly 
allocated to income from a specific property that produces only passive 
income. The principal amount of indebtedness to which the interest 
relates is $500. S also has $50 of additional non-interest expenses that 
are not definitely related expenses and that are apportioned on an asset 
basis.
    (ii) Under paragraph (c)(2)(ii)(B) of this section, the $50 of 
directly allocated third person interest is first allocated to reduce 
the passive income of S. Under paragraph (c)(2)(ii)(C) of this section, 
the $150 of related person interest is allocated to the remaining $150 
of passive income. Under paragraph (c)(2)(iii)(B) of this section, all 
of the related person debt is allocated to passive assets. ($1500 = 
$1500 x $150/$150).
    (iii) Under paragraph (c)(2)(ii)(E) of this section, the non-
interest expenses that are not definitely related are apportioned on the 
basis of the asset values reduced by the allocated related person debt. 
Therefore, $10 of these expenses are apportioned to the passive category 
($50 x ($2000-$1500)/($4000-$1500)) and $40 are apportioned to the 
general limitation category ($50 x $2000/($4000-$1500)).
    (iv) In order to apportion third person interest between the 
categories of assets, the value of assets in a separate category must 
also be reduced under the principles of Sec.  1.861-8 by the 
indebtedness relating to the specifically allocated interest. Therefore, 
under paragraph (c)(2)(iii)(B) of this section, the value of assets in 
the passive category for purposes of apportioning the additional third 
person interest = 0 ($2000 minus $500 (the principal amount of the debt, 
the interest payment on which is directly allocated to specific interest 
producing properties) minus $1500 (the related person debt allocated to 
passive assets)). Under paragraph (c)(2)(ii)(E) of this section, all 
$100 of the non-definitely related third person interest is apportioned 
to the general limitation category ($100 = $100 x $2000 / ($4000 - $500 
- $1500)).
    Example 4. (i) Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. In 1987, S earns $100 of 
foreign personal holding company income that is passive income. S also 
earns $100 of foreign base company sales income that is general 
limitation income. S has $1000 of general limitation assets and $1000 of 
passive assets. In 1987, S makes a $150 interest payment to P on a $1500 
loan from P and has $20 of general and administrative expenses (G & A) 
that under the principles of Sec. Sec.  1.861-8 through 1.861-14T is 
treated as directly allocable to all of P's gross income. S also makes a 
$25 interest payment to an unrelated person on a $250 loan from the 
unrelated person. S has no other expenses. S uses the asset method to 
apportion interest expense. S uses the gross income method to apportion 
G & A.
    (ii) Under paragraph (c)(2)(ii)(C) of this section, $100 of the 
interest payment to P is allocable to S's passive foreign personal 
holding company income. Under paragraph (c)(2)(ii)(D) of this section, 
the additional $50 of related person interest expense is apportioned to 
general limitation income ($50 = $50 x $1000/$1000). Under paragraph 
(c)(2)(iii)(B) of this section, related person debt allocated to passive 
assets equals $1000 ($1000 = $1500 x $100/$150).
    (iii) Under paragraph (c)(2)(ii)(E) of this section, none of the $25 
of interest expense paid to an unrelated person is apportioned to 
passive income ($0 = $25 x ($1000-$1000)/($2000-$1000). Twenty-five 
dollars ($25) of the interest expense paid to an unrelated person is 
apportioned to general limitation income ($25 = $25 x $1000/($2000-
$1000). Under paragraph (c)(2)(ii)(E) of this section, none of the G & A 
is allocable to S's passive foreign personal holding company income ($0 
= $20 x ($100-$100)/($200-$100). All $20 of the G & A is apportioned to 
S's general limitation income ($20 = $20 x $100/($200-$100).
    Example 5. The facts are the same as in Example 4, except that S 
uses the gross income method to apportion interest expense. As in 
Example 4, $100 of the interest payment to P

[[Page 793]]

is allocate to passive income under paragraph (c)(2)(ii)(C) of this 
section. Under paragraph (c)(2)(ii)(D) of this section, the additional 
$50 of related person interest expense is apportioned to general 
limitation income ($150-100 x $100/$100). Under paragraph (c)(2)(ii)(E) 
of this section, none of the unrelated person interest expense and none 
of the G & A is apportioned to passive income, because after the 
application of paragraph (c)(2)(ii)(C) of this section, no passive 
income remains in the passive income category.
    Example 6. Controlled foreign corporation T is a wholly-owned 
subsidiary of S, a controlled foreign corporation. S is a wholly-owned 
subsidiary of P, a domestic corporation. S is not a financial services 
entity. S and T are incorporated in the same country. In 1987, P sells 
tractors to T, which T sells to X, a foreign corporation that is related 
to both S and T and is organized in the same country as S and T. S makes 
a loan to X to finance the tractor sales. Assume that the interest 
earned by S from financing the sales is export financing interest that 
is neither related person factoring income nor foreign personal holding 
company income. The export financing interest earned by S is, therefore, 
general limitation income. S earns no other income. S makes a $100 
interest payment to P. The $100 of interest paid is allocable under the 
look-through rules of paragraph (c)(2)(ii) of this section to the 
general limitation income earned by S and is therefore general 
limitation income to P.

    (3) Rents and Royalties. Any rents or royalties received or accrued 
from a controlled foreign corporation in which the taxpayer is a United 
States shareholder shall be treated as income in a separate category to 
the extent they are allocable to income of the controlled foreign 
corporation in that category under the principles of Sec. Sec.  1.861-8 
through 1.861-14T.
    (4) Dividends--(i) Look-through rule for controlled foreign 
corporations. Any dividend paid or accrued out of the earnings and 
profits of any controlled foreign corporation, shall be treated as 
income in a separate category in proportion to the ratio of the portion 
of earnings and profits attributable to income in such category to the 
total amount of earnings and profits of the controlled foreign 
corporation. For purposes of this paragraph, the term ``dividend'' 
includes any amount included in gross income under section 951(a)(1)(B) 
as a pro rata share of a controlled foreign corporation's increase in 
earnings invested in United States property.
    (ii) Special rule for dividends attributable to certain loans. If a 
dividend is distributed to a taxpayer by a controlled foreign 
corporation, that controlled foreign corporation is the recipient of 
loan proceeds from a related look-through entity (within the meaning of 
Sec.  1.904-5(i)), and the purpose of such loan is to alter the 
characterization of the dividend for purposes of this section, then, to 
the extent of the principal amount of the loan, the dividend shall be 
characterized with respect to the earnings and profits of the related 
person lender rather than with respect to the earnings and profits of 
the dividend payor. A loan will not be considered made for the purpose 
of altering the characterization of a dividend if the loan would have 
been made or maintained on substantially the same terms irrespective of 
the dividend. The determination of whether a loan would have been made 
or maintained on substantially the same terms irrespective of the 
dividend will be made taking into account all the facts and 
circumstances of the relationship between the lender and the borrower. 
Thus, for example, a loan by a related party lender to a controlled 
foreign corporation that arises from the sale of inventory in the 
ordinary course of business will not be considered a loan made for the 
purpose of altering the character of any dividend paid by the borrower.
    (iii) Look-through rule for dividends from noncontrolled section 902 
corporations. Except as otherwise provided in this paragraph 
(c)(4)(iii), any dividend that is distributed by a noncontrolled section 
902 corporation and received or accrued by a domestic corporation that 
meets the stock ownership requirements of section 902(a) shall be 
treated as income in a separate category in proportion to the ratio of 
the portion of earnings and profits attributable to income in such 
category to the total amount of earnings and profits of the 
noncontrolled section 902 corporation. A dividend distributed by a 
noncontrolled section 902 corporation shall be treated as passive income 
if the Commissioner determines that the look-through characterization of 
such dividend cannot reasonably be determined based on the available 
information, or if such dividend is received or accrued

[[Page 794]]

by a shareholder that is neither a domestic corporation meeting the 
stock ownership requirements of section 902(a) nor a foreign corporation 
meeting the requirements of section 902(b). See paragraph (i)(4) of this 
section. See Sec.  1.904-7 for transition rules concerning the treatment 
of undistributed earnings (or a deficit) of a noncontrolled section 902 
corporation that were accumulated in taxable years beginning before 
January 1, 2003.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (c)(4).

    Example 1. Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. In 1987, S has earnings and 
profits of $1,000, $600 of which is attributable to general limitation 
income and $400 of which is attributable to dividends received by S from 
its wholly-owned subsidiary, T. T is a controlled foreign corporation 
and is incorporated and operates in the same country as S. All of T's 
income is financial services income. Neither S's general limitation 
income nor the dividend from T is subpart F income. In December 1987, S 
pays a dividend to P of $200, all of which is attributable to earnings 
and profits earned in 1987. Six-tenths of the dividend ($120) is treated 
as general limitation income because six-tenths of S's earnings and 
profits are attributable to general limitation income. Four-tenths of 
the dividend ($80) is treated as financial services income because four-
tenths of S's earnings and profits are attributable to dividends from T, 
and all of T's earnings are financial services income.
    Example 2. A, a United States person, has been the sole shareholder 
in controlled foreign corporation X since its organization on January 1, 
1963. Both X and A are calendar year taxpayers. X's earnings and profits 
for 1963 through the end of 1987 totaled $3,000. A sells his stock in X 
at the end of 1987 and realizes a gain of $4,000. Of the total $4,000 
gain, $3,000 (A's share of the post-1962 earnings and profits) is 
includible in A's gross income as a dividend and is subject to the look-
through rules including the transition rule of Sec.  1.904-7(a) with 
respect to the portion of the distribution out of pre-87 earnings and 
profits. The remaining $1,000 of the gain is includible as gain from the 
sale or exchange of the X stock and is passive income to A.

    (d) Effect of exclusions from subpart F income--(1) De minimis 
amount of subpart F income. If the sum of a controlled foreign 
corporation's gross foreign base company income (determined under 
section 954(a) without regard to section 954(b)(5)) and gross insurance 
income (determined under section 953(a)) for the taxable year is less 
than the lesser of 5 percent of gross income or $1,000,000, then all of 
that income (other than income that would be financial services income 
without regard to this paragraph (d)(1)) shall be treated as general 
limitation income. In addition, if the test in the preceding sentence is 
satisfied, for purposes of paragraphs (c)(2)(ii) (D) and (E) of this 
section (apportionment of interest expense to passive income using the 
asset method), any passive limitation assets shall be treated as general 
limitation assets. The determination in the first sentence shall be made 
prior to the application of the exception for certain income subject to 
a high rate of foreign tax described in paragraph (d)(2) of this 
section.
    (2) Exception for certain income subject to high foreign tax. Except 
as provided in Sec.  1.904-4(c)(7)(iii) (relating to reductions in tax 
upon distribution), for purposes of the dividend look-through rule of 
paragraph (c)(4)(i) of this section, an item of net income that would 
otherwise be passive income (after application of the priority rules of 
Sec.  1.904-4(l)) and that is received or accrued by a controlled 
foreign corporation shall be treated as general limitation income, and 
the earnings and profits attributable to such income shall be treated as 
general limitation earnings and profits, if the taxpayer establishes to 
the satisfaction of the Secretary that such income was subject to an 
effective rate of income tax imposed by a foreign country greater than 
90 percent of the maximum rate of tax specified in section 11 (with 
reference to section 15, if applicable). The preceding sentence has no 
effect on amounts (other than dividends) paid or accrued by a controlled 
foreign corporation to a United States shareholder of such controlled 
foreign corporation to the extent those amounts are allocable to passive 
income of the controlled foreign corporation.
    (3) Examples. The following examples illustrate the application of 
this paragraph.

    Example 1. Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. In 1987, S earns $100 of gross

[[Page 795]]

income, $4 of which is interest that is subpart F foreign personal 
holding company income and $96 of which is gross manufacturing income 
that is not subpart F income. S has no other earnings for 1987. S has no 
expenses and pays no foreign taxes. S pays P a $100 dividend. Under the 
de minimis rule of section 954(b)(3), none of S's income is treated as 
foreign base company income. All of S's income, therefore, is treated as 
general limitation income. The entire $100 dividend is general 
limitation income to P.
    Example 2. (i) Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. In 1987, S earns $50 of 
shipping income of a type that is foreign base company shipping income. 
S also earns $50 of dividends from T, a foreign corporation in which S 
owns 45 percent of the voting stock, and receives $50 of dividends from 
U, a foreign corporation in which S owns 5% of the voting stock. Foreign 
persons hold the remaining voting stock of both T and U. S, T, and U are 
all incorporated in different foreign countries. The dividends S 
receives from T and U are of a type that normally would be subpart F 
foreign personal holding company income that is passive income. Under 
Sec.  1.904-4(l)(1)(iv), however, the dividends from T are dividends 
from a noncontrolled section 902 corporation rather than passive income. 
S has no expenses. The earnings and profits of S are equal to the net 
income after taxes of S. The dividends and the shipping income are taxed 
abroad by S's country of incorporation at an effective rate of 40 
percent. P establishes to the satisfaction of the Secretary that the 
effective rate of tax on both the dividends and the shipping income 
exceeds 90 percent of the maximum United States tax rate. Thus, under 
section 954(b)(4), neither the shipping income nor the dividends are 
taxed currently to P under subpart F. S's earnings attributable to 
shipping income and dividends from a noncontrolled section 902 
corporation retain their character as such. Under paragraph (d)(2) of 
this section, S's earnings attributable to the dividends from U are 
treated as earnings attributable to general limitation income. See 
Sec. Sec.  1.905-3T and 1.905-4T, however, for rules concerning 
adjustments to the pools of earnings and profits and foreign taxes and 
redeterminations of United States tax liability when foreign taxes are 
refunded in a later year.
    (ii) In 1988, S has no earnings and pays a $150 dividend (including 
gross-up) to P. The dividend is paid out of S's post-1986 pool of 
earnings and profits. One-third of the dividend ($50) is attributable to 
S's shipping earnings, one-third ($50) is attributable to the dividend 
from T, and one-third ($50) is attributable to the dividend from U. 
Pursuant to section 904(d)(3)(E) and paragraph (c)(4) of this section, 
one-third of the dividend is shipping income, one-third is a dividend 
from a noncontrolled section 902 corporation, T, and one-third is 
general limitation income to P.

    (e) Treatment of subpart F income in excess of 70 percent of gross 
income--(1) Rule. If the sum of a controlled foreign corporation's gross 
foreign base company income (determined without regard to section 
954(b)(5)) and gross insurance income for the taxable year exceeds 70 
percent of the gross income, then all of the controlled foreign 
corporation's gross income shall be treated as foreign base company 
income (whichever is appropriate) and, thus, included in a United States 
shareholder's gross income. However, the inclusion in gross income of an 
amount that would not otherwise be subpart F income does not affect its 
character for purposes of determining whether the income is within a 
separate category. The determination of whether the controlled foreign 
corporation's gross foreign base company income and gross insurance 
income exceeds 70 percent of gross income is made before the exception 
for certain income subject to a high rate of foreign tax.
    (2) Example. The following example illustrates the application of 
this paragraph.

    Example. Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. S earns $100, $75 of which is 
foreign personal holding company income and $25 of which is non-subpart 
F services income. S is not a financial services entity. S's gross and 
net income are equal. Under the 70 percent full inclusion rule of 
section 954(b)(3)(B), the entire $100 is foreign base company income 
currently taxable to P under section 951. Because $75 of the $100 
section 951 inclusion is attributable to S's passive income, $75 of the 
inclusion is passive income to P. The remaining $25 of the inclusion is 
treated as general limitation income to P because $25 is attributable to 
S's general limitation income.

    (f) Modification of look-through rules for certain income--(1) High 
withholding tax interest. If a taxpayer receives or accrues interest 
from a controlled foreign corporation that is a financial services 
entity, and the interest would be described as high withholding tax 
interest if section 904(d)(3) and paragraph (c)(2) of this section (the 
look-through rules for interest) did not apply, then the interest shall 
be treated as high

[[Page 796]]

withholding tax interest to the extent that the interest is allocable 
under section 904(d)(3) and paragraph (c)(2)(i) of this section to 
financial services income of the controlled foreign corporation. See 
section 904(d)(3)(H). The amount treated as high-withholding tax 
interest under this paragraph (f)(1) shall not exceed the interest, or 
equivalent income, of the payor that would be taken into account in 
determining the financial services income of the payor if the look-
through rules applied.
    (2) Distributions from a FSC. Income received or accrued by a 
taxpayer that, under the rules of paragraph (c)(4) of this section 
(look-through rules for dividends), would be treated as foreign trade 
income or as passive income that is interest and carrying charges (as 
defined in section 927(d)(1)), and that is also a distribution from a 
FSC (or a former FSC), shall be treated as a distribution from a FSC (or 
a former FSC).
    (3) Example. The following example illustrates the operation of 
paragraph (f)(1) of this section.

    Example. Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. S is a financial services 
entity. In 1988, S earns $80 of interest that meets the definition of 
financial services income and $20 of high withholding tax interest. S 
makes a $100 interest payment to P. The interest payment to P is subject 
to a withholding tax of 15 percent. Twenty dollars ($20) of the interest 
payment to P is considered to be high withholding tax interest because, 
under section 904(d)(3), it is allocable to the high withholding tax 
interest earned by S. The remaining eighty dollars ($80) of the interest 
payment is also treated as high withholding tax interest to P because, 
under paragraph (f)(1) of this section, interest that is subject to a 
high withholding tax but would not be considered to be high withholding 
tax interest under the look-through rules of paragraph (c)(2) of this 
section, shall be treated as high withholding tax interest to the extent 
that the interest would have been treated as financial services interest 
income under the look-through rules of paragraph (c)(2)(i) of this 
section.

    (g) Application of look-through rules to certain domestic 
corporations. The principles of section 904(d)(3) and this section shall 
apply to any foreign source interest, rents and royalties paid by a 
United States corporation to a related corporation. For this purpose, a 
United States corporation and another corporation are considered to be 
related if one owns, directly or indirectly, stock possessing more than 
50 percent of the total voting power of all classes of stock of the 
other corporation or more than 50 percent of the total value of the 
other corporation. In addition, a United States corporation and another 
corporation shall be considered to be related if the same United States 
shareholders own, directly or indirectly, stock possessing more than 50 
percent of the total voting power of all classes of stock or more than 
50 percent of the total value of each corporation. For purposes of this 
paragraph, the constructive stock ownership rules of section 318 and the 
regulations under that section apply. For taxable years beginning before 
January 1, 2001, this paragraph (g) shall be applied by substituting 
``50 percent or more'' for ``more than 50 percent'' each place it 
appears.
    (h) Application of look-through rules to partnerships and other 
pass-through entities--(1) General rule. Except as provided in paragraph 
(h)(2) of this section, a partner's distributive share of partnership 
income shall be characterized as income in a separate category to the 
extent that the distributive share is a share of income earned or 
accrued by the partnership in such category. Payments to a partner 
described in section 707 (e.g., payments to a partner not acting in 
capacity as a partner) shall be characterized as income in a separate 
category to the extent that the payment is attributable under the 
principles of Sec.  1.861-8 and this section to income earned or accrued 
by the partnership in such category, if the payments are interest, 
rents, or royalties that would be characterized under the look-through 
rules of this section if the partnership were a foreign corporation, and 
the partner who receives the payment owns 10 percent or more of the 
value of the partnership. A payment by a partnership to a member of the 
controlled group (as defined in paragraph (a)(3) of this section) of the 
partner shall be characterized under the look-through rules of this 
section if the payment would be a section 707 payment entitled to look-
through

[[Page 797]]

treatment if it were made to the partner.
    (2) Exception for certain partnership interests--(i) Rule. Except as 
otherwise provided, if any limited partner or corporate general partner 
owns less than 10 percent of the value in a partnership, the partner's 
distributive share of partnership income from the partnership shall be 
passive income to the partner, and the partner's distributive share of 
partnership deductions from the partnership shall be allocated and 
apportioned under the principles of Sec.  1.861-8 only to the partner's 
passive income from that partnership.
    (ii) Exceptions. To the extent a partner's distributive share of 
income from a partnership is a share of high withholding tax interest 
received or accrued by the partnership, that partner's distributive 
share of partnership income will be high withholding tax interest 
regardless of the partner's level of ownership in the partnership. If a 
partnership interest described in paragraph (h)(2)(i) of this section is 
held in the ordinary course of a partner's active trade or business, the 
rules of paragraph (h)(1) of this section shall apply for purposes of 
characterizing the partner's distributive share of the partnership 
income. A partnership interest will be considered to be held in the 
ordinary course of a partner's active trade or business if the partner 
(or a member of the partner's affiliated group of corporations (within 
the meaning of section 1504(a) and without regard to section 
1504(b)(3))) engages (other than through a less than 10 percent interest 
in a partnership) in the same or related trade or business as the 
partnership.
    (3) Income from the sale of a partnership interest--(i) In general. 
To the extent a partner recognizes gain on the sale of a partnership 
interest, that income shall be treated as passive category income to the 
partner, unless the income is considered to be high-taxed under section 
904(d)(2)(B)(iii)(II) and Sec.  1.904-4(c).
    (ii) Exception for sale by 25-percent owner. In the case of a sale 
of an interest in a partnership by a partner that is a 25-percent owner 
of the partnership, determined by applying section 954(c)(4)(B) and 
substituting ``controlled foreign corporation'' with ``partner'' every 
place it appears, for purposes of determining the separate category to 
which the income recognized on the sale of the partnership interest is 
assigned such partner shall be treated as selling the proportionate 
share of the assets of the partnership attributable to such interest.
    (4) Value of a partnership interest. For purposes of paragraphs (i), 
(h)(1), and (h)(2) of this section, a partner will be considered as 
owning 10 percent of the value of a partnership for a particular year if 
the partner has 10 percent of the capital and profits interest of the 
partnership. Similarly, a partnership (first partnership) is considered 
as owning 50 percent of the value of another partnership (second 
partnership) if the first partnership owns 50 percent of the capital and 
profits interests of another partnership. For this purpose, value will 
be determined at the end of the partnership's taxable year. Similarly, a 
partnership (first partnership) is considered as owning more than 50 
percent of the value of another partnership (second partnership) if the 
first partnership owns more than 50 percent of the capital and profits 
interests of the second partnership. For this purpose, value will be 
determined at the end of the partnership's taxable year. For taxable 
years beginning before January 1, 2001, the second preceding sentence 
shall be applied by substituting ``50 percent'' for ``more than 50 
percent''.
    (i) Application of look-through rules to related entities--(1) In 
general. Except as provided in paragraphs (i)(2), (3), and (4) of this 
section, the principles of this section shall apply to distributions and 
payments that are subject to the look-through rules of section 904(d)(3) 
and this section from a controlled foreign corporation or other entity 
otherwise entitled to look-through treatment (a ``look-through entity'') 
under this section to a related look-through entity. A noncontrolled 
section 902 corporation shall be considered a look-through entity only 
to the extent provided in paragraph (i)(4) of this section. Two look-
through entities shall be considered to be related to each other if one 
owns, directly or indirectly, stock possessing more than 50 percent of 
the

[[Page 798]]

total voting power of all classes of voting stock of the other entity or 
more than 50 percent of the total value of such entity. In addition, two 
look-through entities are related if the same United States shareholders 
own, directly or indirectly, stock possessing more than 50 percent of 
the total voting power of all voting classes of stock (in the case of a 
corporation) or more than 50 percent of the total value of each look-
through entity. In the case of a corporation, value shall be determined 
by taking into account all classes of stock. In the case of a 
partnership, value shall be determined under the rules in paragraph 
(h)(4) of this section. For purposes of this section, indirect ownership 
shall be determined under section 318 and the regulations under that 
section.
    (2) Exception for distributive shares of partnership income. In the 
case of tiered partnership arrangements, a distributive share of 
partnership income will be characterized under the look-through rules of 
section 904(d)(3) and this section if the partner meets the requirements 
of paragraph (h)(1) of this section with respect to the partnership 
(first partnership), whether or not the income is received through 
another partnership or partnerships (second partnership) and whether or 
not the first partnership and the second partnership are considered to 
be related under the rules of paragraph (i)(1) of this section.
    (3) Special rule for dividends between controlled foreign 
corporations. Solely for purposes of dividend payments between 
controlled foreign corporations, two controlled foreign corporations 
shall be considered related look-through entities if the same United 
States shareholder owns, directly or indirectly, at least 10 percent of 
the total voting power of all classes of stock of each foreign 
corporation. If two controlled foreign corporations are not considered 
related look-through entities for purposes of this section because a 
United States shareholder does not satisfy the ownership requirement set 
forth in this paragraph (i)(3), the dividend payment will be 
characterized under the look-through rules of section 904(d)(4) and this 
section if the requirements set forth in paragraph (i)(4) of this 
section are satisfied.
    (4) Payor and recipient of dividend are members of the same 
qualified group. Solely for purposes of dividend payments in taxable 
years beginning after December 31, 2002, between controlled foreign 
corporations, noncontrolled section 902 corporations, or a controlled 
foreign corporation and a noncontrolled section 902 corporation, the 
payor and recipient corporations shall be considered related look-
through entities if the corporations are members of the same qualified 
group as defined in section 902(b)(2) and the recipient corporation is 
eligible to compute foreign taxes deemed paid with respect to the 
dividend under section 902(b)(1).
    (5) Examples. The following examples illustrate the provisions of 
this paragraph (i):

    Example 1. P, a domestic corporation, owns all of the stock of S, a 
controlled foreign corporation. S owns 40 percent of the stock of T, a 
Country X corporation that is a controlled foreign corporation. The 
remaining 60 percent of the stock of T is owned by V, a domestic 
corporation. The percentages of value and voting power of T owned by S 
and V correspond to their percentages of stock ownership. T owns 40 
percent (by vote and value) of the stock of U, a Country Z corporation 
that is a controlled foreign corporation. The remaining 60 percent of U 
is owned by unrelated U.S. persons. U earns exclusively general 
limitation non-subpart F income. In 2001, U makes an interest payment of 
$100 to T. Look-through principles do not apply because T and U are not 
related look-through entities under paragraph (i)(1) of this section 
(because T does not own more than 50 percent of the voting power or 
value of U). The interest is passive income to T, and is subpart F 
income to P and V. Under paragraph (c)(1) of this section, look-through 
principles determine P and V's characterization of the subpart F 
inclusion from T. P and V therefore must characterize the inclusion as 
passive income.
    Example 2. The facts are the same as in Example 1 except that 
instead of a $100 interest payment, U pays a $50 dividend to T in 2001. 
P and V each own, directly or indirectly, more than 10 percent of the 
voting power of all classes of stock of both T and U. Pursuant to 
paragraph (i)(3) of this section, for purposes of applying this section 
to the dividend from U to T, U and T are treated as related look-through 
entities. Therefore, look-through principles apply to characterize the 
dividend income as general limitation income to T. The dividend is 
subpart F income

[[Page 799]]

of T that is taxable to P and V. The subpart F inclusions of P and V are 
also subject to look-through principles, under paragraph (c)(1) of this 
section, and are characterized as general limitation income to P and V 
because the income is general limitation income of T.
    Example 3. The facts are the same as in Example 1, except that U 
pays both a $100 interest payment and a $50 dividend to T, and T owns 80 
percent (by vote and value) of U. Under paragraph (i)(1) of this 
section, T and U are related look-through entities, because T owns more 
than 50 percent (by vote and value) of U. Therefore, look-through 
principles apply to both the interest and dividend income paid or 
accrued by U to T, and T treats both types of income as general 
limitation income. Under paragraph (c)(1) of this section, P and V apply 
look-through principles to the resulting subpart F inclusions, which 
therefore are also general limitation income to P and V.
    Example 4. P, a domestic corporation, owns all of the voting stock 
of S, a controlled foreign corporation. S owns 5 percent of the voting 
stock of T, a controlled foreign corporation. The remaining 95 percent 
of the stock of T is owned by P. In 2006, T pays a $50 dividend to S and 
a $950 dividend to P. The dividend to S is not eligible for look-through 
treatment under paragraph (i)(4) of this section, and S is not eligible 
to compute an amount of foreign taxes deemed paid with respect to the 
dividend from T, because S and T are not members of the same qualified 
group (S owns less than 10 percent of the voting stock of T). See 
section 902(b) and Sec.  1.902-1(a)(3). However, the dividend is 
eligible for look-through treatment under paragraph (i)(3) of this 
section because P owns at least 10 percent of the voting power of all 
classes of stock of both S and T. The dividend is subpart F income of S 
that is taxable to P.
    Example 5. P, a domestic corporation, owns 50 percent of the voting 
stock of S, a controlled foreign corporation. S owns 10 percent of the 
voting stock of T, a controlled foreign corporation. The remaining 50 
percent of the stock of S and the remaining 90 percent of the stock of T 
are owned, respectively, by X and Y. X and Y are each United States 
shareholders of T but are not related to P, S, or each other. In 2006, T 
pays a $100 dividend to S. The dividend is not eligible for look-through 
treatment under paragraph (i)(3) of this section because no United 
States shareholder owns at least 10 percent of the voting power of all 
classes of stock of both S and T (P and X each own only 5 percent of T). 
However, the dividend is eligible for look-through treatment under 
paragraph (i)(4) of this section, and S is eligible to compute an amount 
of foreign taxes deemed paid with respect to the dividend from T, 
because S and T are members of the same qualified group. See section 
902(b) and Sec.  1.902-1(a)(3). The dividend is subpart F income of S 
that is taxable to P and X.

    (j) Look-through rules applied to passive foreign investment company 
inclusions. If a passive foreign investment company is a controlled 
foreign corporation and the taxpayer is a United States shareholder in 
that passive foreign investment company, any amount included in gross 
income under section 1293 shall be treated as income in a separate 
category to the extent the amount so included is attributable to income 
received or accrued by that controlled foreign corporation that is 
described as income in the separate category. For purposes of this 
paragraph (j), the priority rules of Sec.  1.904-4(l) shall apply prior 
to the application of the rules of this paragraph.
    (k) Ordering rules--(1) In general. Income received or accrued by a 
related person to which the look-through rules apply is characterized 
before amounts included from, or paid or distributed by that person and 
received or accrued by a related person. For purposes of determining the 
character of income received or accrued by a person from a related 
person if the payor or another related person also receives or accrues 
income from the recipient and the look-through rules apply to the income 
in all cases, the rules of paragraph (k)(2) of this section apply.
    (2) Specific rules. For purposes of characterizing income under this 
paragraph, the following types of income are characterized in the order 
stated:
    (i) Rents and royalties;
    (ii) Interest;
    (iii) Subpart F inclusions and distributive shares of partnership 
income;
    (iv) Dividend distributions.


If an entity is both a recipient and a payor of income described in any 
one of the categories described in (k)(2) (i) through (iv) of this 
section, the income received will be characterized before the income 
that is paid. In addition, the amount of interest paid or accrued, 
directly or indirectly, by a person to a related person shall be offset 
against and eliminate any interest received or accrued, directly or 
indirectly, by a person from that related person before application of 
the ordering rules of this paragraph. In a case in which a person pays 
or accrues interest to a related

[[Page 800]]

person, and also receives or accrues interest indirectly from the 
related person, the smallest interest payment is eliminated and the 
amount of all other interest payments are reduced by the amount of the 
smallest interest payment.
    (l) Examples. The following examples illustrate the application of 
paragraphs (g), (h), (i), and (k) of this section.

    Example 1. S and T, controlled foreign corporations, are wholly-
owned subsidiaries of P, a domestic corporation. S and T are 
incorporated in two different foreign countries and T is a financial 
services entity. In 1987, S earns $100 of income that is general 
limitation foreign base company sales income. After expenses, including 
a $50 interest payment to T, S's income is subject to foreign tax at an 
effective rate of 40 percent. P elects to exclude S's $50 of net income 
from subpart F under section 954(b)(4). T earns $350 of income that 
consists of $300 of subpart F financial services income and $50 of 
interest received from S. The $50 of interest is foreign personal 
holding company income in T's hands because section 954(c)(3)(A)(i) 
(same country exception for interest payments) does not apply. The $50 
of interest is also general limitation income to T because S and T are 
related look-through entities within the meaning of paragraph (i)(1) of 
this section and, therefore the look-through rules of paragraph 
(c)(2)(i) of this section apply to characterize the interest payment. 
Thus, with respect to T, P includes in its gross income $50 of general 
limitation foreign personal holding company income and $300 of financial 
services income.
    Example 2. The facts are the same as in Example (1) except that 
instead of earning $100 of general limitation foreign base company sales 
income, S earns $100 of foreign personal holding company income that is 
passive income. Although the interest payment to T would otherwise be 
passive income, T is a financial services entity and, under Sec.  1.904-
4(e)(1), the income is treated as financial services income in T's 
hands. Thus, P's entire $350 section 951 inclusion consists of financial 
services income.
    Example 3. P, a domestic corporation, wholly-owns S, a domestic 
corporation that is a 80/20 corporation. In 1987, S's earnings consist 
of $100 of foreign source shipping income and $100 of foreign source 
high withholding tax interest. S makes a $100 foreign source interest 
payment to P. The interest payment to P is subject to the look-through 
rules of paragraph (c)(2)(i) of this section, and is characterized as 
shipping income and high withholding tax interest to the extent that it 
is allocable to such income in S's hands.
    Example 4. PS is a domestic partnership that is the sole shareholder 
of controlled foreign corporation S. PS has two general partners, A and 
B. A and B each have a greater than 10 percent interest in PS. PS also 
has two limited partners, C and D. C has a 50 percent interest in the 
partnership and D has a 9 percent interest. A, B, C and D are all United 
States persons. In 1987, S has $100 of general limitation non-subpart F 
income on which it pays no foreign tax. S pays a $100 dividend to PS. 
The dividend is the only income of PS. Under the look-through rule of 
paragraph (c)(4) of this section, the dividend to PS is general 
limitation income. Under paragraph (h)(1) of this section, A's, B's, and 
C's distributive shares of PS's income are general limitation income. 
Under paragraph (h)(2) of this section, because D is a limited partner 
with a less than 10 percent interest in PS, D's distributive share of 
PS's income is passive income.
    Example 5. P has a 25 percent interest in partnership PS that he 
sells to X for $110. P's basis in his partnership interest is $35. P 
recognizes $75 of gain on the sale of its partnership interest and is 
subject to no foreign tax. Under paragraph (h)(3) of this section, the 
gain is treated as passive income.
    Example 6. P, a domestic corporation, owns 100 percent of the stock 
of S, a controlled foreign corporation, and S owns 100 percent of the 
stock of T, a controlled foreign corporation. S has $100 of passive 
foreign personal holding company income from unrelated persons and $100 
of general limitation income. S also has $50 of interest income from T. 
S pays T $100 of interest. Under paragraph (k)(2) of this section, the 
$100 interest payment from S to T is reduced for limitation purposes to 
the extent of the $50 interest payment from T to S before application of 
the rules in paragraph (c)(2)(ii) of this section. Therefore, the 
interest payment from T to S is disregarded. S is treated as if it paid 
$50 of interest to T, all of which is allocable to S's passive foreign 
personal holding company income. Therefore the $50 interest payment from 
S to T is passive income.
    Example 7. P, a domestic corporation, owns 100 percent of the stock 
of S, a controlled foreign corporation. S owns 100 percent of the stock 
of T, a controlled foreign corporation and 100 percent of the stock of 
U, a controlled foreign corporation. In 1988, T pays S $5 of interest, S 
pays U $10 of interest and U pays T $20 of interest. Under paragraph 
(k)(2) of this section, the interest payments from S to U must be offset 
by the amount of interest that S is considered as receiving indirectly 
from U and the interest payment from U to T is offset by the amount of 
the interest payment that U is considered as receiving indirectly from 
T. The $l0 payment by S to U is reduced by $5, the amount of the 
interest payment from T to S that is treated as being paid indirectly by 
U to S. Similarly, the $20 interest payment from U to T is reduced by 
$5, the amount of the interest payment from

[[Page 801]]

S to U that is treated as being paid indirectly by T to U. Therefore, 
under paragraph (k)(2) of this section, T is treated as having made no 
interest payment to S, S is treated as having paid $5 of interest to U, 
and U is treated as having paid $15 to T.
    Example 8. (i) P, a domestic corporation, owns 100 percent of the 
stock of S, a controlled foreign corporation, and S owns 100 percent of 
the stock of T, a controlled foreign corporation. In 1987, S earns $100 
of passive foreign personal holding company income and $100 of general 
limitation non-subpart F sales income from unrelated persons and $100 of 
general limitation non-subpart F interest income from a related person, 
W. S pays $150 of interest to T. T earns $200 of general limitation 
sales income from unrelated persons and the $150 interest payment from 
S. T pays S $100 of interest.
    (ii) Under paragraph (k)(2) of this section, the $100 interest 
payment from T to S reduces the $150 interest payment from S to T. S is 
treated as though it paid $50 of interest to T. T is treated as though 
it made no interest payment to S.
    (iii) Under paragraph (k)(2)(ii) of this section, the remaining $50 
interest payment from S to T is then characterized. The interest payment 
is first allocable under the rules of paragraph (c)(2)(ii)(C) of this 
section to S's passive income. Therefore, the $50 interest payment to T 
is passive income. The interest income is foreign personal holding 
company income in T's hands. T, therefore, has $50 of subpart F passive 
income and $200 of non-subpart F general limitation income.
    (iv) Under paragraph (k)(2)(iii) of this section, subpart F 
inclusions are characterized next. P has a subpart F inclusion with 
respect to S of $50 that is attributable to passive income of S and is 
treated as passive income to P. P has a subpart F inclusion with respect 
to T of $50 that is attributable to passive income of T and is treated 
as passive income to P.
    Example 9. (i) P, a domestic corporation, owns 100 percent of the 
stock of S, a controlled foreign corporation, and S owns 100 percent of 
the stock of T, a controlled foreign corporation. P also owns 100 
percent of the stock of U, a controlled foreign corporation. In 1987, S 
earns $100 of passive foreign personal holding company income and $200 
of non-subpart F general limitation income from unrelated persons. S 
also receives $150 of dividend income from T. S pays $100 of interest to 
T and $100 of interest to U. U earns $300 of non-subpart F general 
limitation income and the $100 of interest received from S. U pays a 
$100 royalty to T. T earns the $100 interest payment received from S and 
the $100 royalty received from U.
    (ii) Under paragraph (k)(2)(i) of this section, the royalty paid by 
U to T is characterized first. Assume that the royalty is directly 
allocable to U's general limitation income. Also assume that the royalty 
is not subpart F income to T. With respect to T, the royalty is general 
limitation income.
    (iii) Under paragraph (k)(2)(ii) of this section, the interest 
payments from S to T and U are characterized next. This characterization 
is done without regard to any dividend income received by S because, 
under paragraph (k)(2) of this section, dividends are characterized 
after interest payments from a related person. The interest payments are 
first allocable to S's passive income under paragraph (c)(2)(ii)(C) of 
this section. Therefore, $50 of the interest payment to T is passive and 
$50 of the interest payment to U is passive. The remaining $50 paid to T 
is general limitation income and the remaining $50 paid to U is general 
limitation income. All of the interest payments to T and U are subpart F 
foreign personal holding company income to both recipients.
    (iv) Under paragraph (k)(2)(iii) of this section, P has a $100 
subpart F inclusion with respect to T that is characterized next. Fifty 
dollars ($50) of the subpart F inclusion is passive income to P because 
it is attributable to the passive income portion of the interest income 
received by T from S, and $50 of the inclusion is treated as general 
limitation income to P because it is attributable to the general 
limitation portion of the interest income received by T from S. Under 
paragraph (k)(2)(iii) of this section, P also has a $100 subpart F 
inclusion with respect to U. Fifty dollars ($50) of the subpart F 
inclusion is passive income to P because it is attributable to the 
passive portion of the interest income received by U from S, and $50 of 
the inclusion is general limitation income to P because it is 
attributable to the general limitation portion of the interest income 
received by U from S.
    (v) Under paragraph (k)(2)(iv) of this section, the $150 
distribution from T to S is characterized next. One-hundred dollars 
($100) of the distribution is out of earnings and profits attributable 
to previously taxed income. Therefore, only $50 is a dividend that is 
subject to the look-through rules of paragraph (d) of this section. The 
$50 dividend is attributable to T's general limitation income and is 
general limitation income to S in its entirety.
    Example 10. (i) P, a domestic corporation, owns 100 percent of the 
stock of S, a controlled foreign corporation, and S owns 100 percent of 
the stock of T, a controlled foreign corporation. P also owns 100 
percent of the stock of U, a controlled foreign corporation. S, T and U 
are all incorporated in the same foreign country. In 1987, S earns $100 
of passive foreign personal holding income and $200 of general 
limitation non-subpart F income from unrelated persons. S pays $100 of 
interest to T and $100 of interest to U. U earns $300 of general 
limitation non-subpart F income and the $100 of interest received

[[Page 802]]

from S. T's only income is the $100 interest payment received from S.
    (ii) Under paragraph (k)(2)(ii) of this section, the interest 
payments from S to T and U are characterized first. The interest 
payments are first allocated under the rule of paragraph (c)(2)(ii)(C) 
of this section to S's passive income. Therefore, under that provision 
and paragraph (c)(2)(i) of this section, $50 of the interest payment to 
T is passive income to T and $50 of the interest payment to U is passive 
income to U. The remaining $50 paid to T is general limitation income 
and the remaining $50 paid to U is general limitation income.
    (iii) Under paragraph (k)(2)(iii) of this section, any subpart F 
inclusion of P is determined and characterized next. Under paragraph 
(c)(1)(i) of this section, paragraphs (c)(2)(i) and (c)(2)(ii) apply not 
only for purposes of determining the separate category of income of S to 
which the interest payments from S to T and U are allocable but also for 
purposes of determining the subpart F income of T and U. Although the 
interest payments from S to T and U are ``same country'' interest 
payments that would otherwise be excludible from T's and U's subpart F 
income under section 954(c)(3)(A)(i), section 954(c)(3)(B) provides that 
the exception for same country payments between related persons shall 
not apply to the extent such payments have reduced the subpart F income 
of the payor. In this case, $50 of the $100 interest payment from S to T 
reduced S's subpart F income and $50 of the $100 interest payment from S 
to U reduced the remaining $50 of S's subpart F income. Therefore, T has 
$50 of subpart F income that is passive income and U has $50 of subpart 
F income that is passive income. P includes $100 of subpart F income in 
gross income that is passive income to P.
    (iv) The remaining $50 of interest paid by S to T and the remaining 
$50 of interest paid by S to U is not subpart F income to T or U because 
it did not reduce S's subpart F income and is therefore eligible for the 
same country exception.
    Example 11. P, a domestic corporation, owns 100 percent of the stock 
of S, a controlled foreign corporation, and S owns 100 percent of the 
stock of T, a controlled foreign corporation. P also owns 100 percent of 
the stock of U, a controlled foreign corporation. In 1991, T earns $100 
of general limitation income that is not subpart F income and 
distributes the entire amount to S as a dividend. S earns $100 of 
passive foreign personal holding company income and the $100 dividend 
from T. S pays $100 of interest to U. U earns $200 of general limitation 
income that is foreign base company income and $100 of interest income 
from S. This transaction does not involve circular payments and, 
therefore, the ordering rules of paragraph (k)(2) of this section do not 
apply. Instead, pursuant to paragraph (k)(1) of this section, income 
received is characterized first. T's earnings and, thus, the dividend 
from T to S are characterized first. S includes the $100 dividend from T 
in gross income as general limitation income because all of T's earnings 
are general limitation income. S thus has $100 of passive foreign 
personal holding company income and $100 of general limitation income. 
The interest payment to U is then characterized as $100 passive income 
under paragraph (c)(2)(ii)(C) of this section (allocation of related 
person interest to passive foreign personal holding company income). For 
1991, U thus has $200 of general limitation income that is subpart F 
income, and $100 of passive foreign personal holding company income. For 
1991, P includes in its gross income $200 of general limitation subpart 
F income from U, $100 of passive subpart F income from U (relating to 
the interest payment from S to U), and $100 of general limitation 
subpart F income from S (relating to the dividend from T to S).

    (m) Application of section 904(h)--(1) In general. This paragraph 
(m) applies to certain amounts derived from controlled foreign 
corporations and noncontrolled section 902 corporations that are treated 
as United States-owned foreign corporations as defined in section 
904(h)(6). For purposes of determining the portion of an interest 
payment that is allocable to income earned or accrued by a controlled 
foreign corporation or noncontrolled section 902 corporation from 
sources within the United States under section 904(h)(3), the rules in 
paragraph (m)(2) of this section apply. For purposes of determining the 
portion of a dividend (or amount treated as a dividend, including 
amounts described in section 951(a)(1)(B)) paid or accrued by a 
controlled foreign corporation or noncontrolled section 902 corporation 
that is treated as from sources within the United States under section 
904(h)(4), the rules in paragraph (m)(4) of this section apply. For 
purposes of determining the portion of an amount included in gross 
income under section 951(a)(1)(A) or 1293 that is attributable to income 
of the controlled foreign corporation or noncontrolled section 902 
corporation from sources within the United States under section 
904(h)(2), the rules in paragraph (m)(5) of this section apply. In order 
to determine whether section 904(h) applies, section 904(h)(5) 
(exception if a United States-

[[Page 803]]

owned foreign corporation has a de minimis amount of United States 
source income) shall be applied to the total amount of earnings and 
profits of a controlled foreign corporation or noncontrolled section 902 
corporation for a taxable year without regard to the characterization of 
those earnings under section 904(d).
    (2) Treatment of interest payments--(i) Interest payments from 
controlled foreign corporations. If interest is received or accrued by a 
United States shareholder or a person related to a United States 
shareholder (within the meaning of paragraph (c)(2)(ii) of this section) 
from a controlled foreign corporation, the interest shall be considered 
to be allocable to income of the controlled foreign corporation from 
sources within the United States for purposes of section 904(d) to the 
extent that the interest is allocable under paragraph (c)(2)(ii)(C) of 
this section to passive income that is from sources within the United 
States. If related person interest is less than or equal to passive 
income, the related person interest will be allocable to United States 
source passive income based on the ratio of United States source passive 
income to total passive income. To the extent that related person 
interest exceeds passive income, and, therefore, is allocated under 
paragraph (c)(2)(ii)(D) of this section to income in a separate category 
other than passive, the following formulas apply in determining the 
portion of the interest payment that is from sources within the United 
States. If the taxpayer uses the gross income method to allocate 
interest, the portion of the interest payment from sources within the 
United States is determined as follows:
[GRAPHIC] [TIFF OMITTED] TC14NO91.118

    (ii) Interest payments from noncontrolled section 902 corporations. 
If interest is received or accrued by a shareholder from a noncontrolled 
section 902 corporation (where the shareholder is a domestic corporation 
that meets the stock ownership requirements of section 902(a)), the 
rules of paragraph (m)(2)(i) of this section apply in determining the 
portion of the interest payment that is from sources within the United 
States, except that the related party interest rules of paragraph 
(c)(2)(ii)(C) of this section shall not apply.
    If the taxpayer uses the asset method to allocate interest, then the 
portion of the interest payment from sources within the United States is 
determined as follows:
[GRAPHIC] [TIFF OMITTED] TC14NO91.119


For purposes of this paragraph, the value of assets in a separate 
category is the value of assets as determined under the principles of 
Sec.  1.861-9T(g). See Sec.  1.861-10T(d)(2) for purposes of determining 
the value of assets and gross income in a separate category as reduced 
for indebtedness the interest on which is directly allocated.
    (3) Examples. The following examples illustrate the application of 
this paragraph.


[[Page 804]]


    Example 1. Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. In 1988, S pays P $300 of 
interest. S has no other expenses. In 1988, S has $3000 of assets that 
generate $650 of foreign source general limitation sales income and a 
$1000 loan to an unrelated foreign person that generates $20 of foreign 
source passive interest income. S also has a $4000 loan to an unrelated 
United States person that generates $70 of United States source passive 
income and $4000 of inventory that generates $100 of United States 
source general limitation income. S uses the asset method to allocate 
interest expense. The following chart summarizes S's assets and income:

------------------------------------------------------------------------
                                          Foreign      U.S.      Totals
------------------------------------------------------------------------
Assets:
  Passive..............................       1000       4000       5000
  General..............................       3000       4000       7000
                                        --------------------------------
      TotaI............................       4000       8000      12000
Income:
  Passive..............................         20         70         90
  General..............................        650        100        750
                                        --------------------------------
      Total............................        670        170        840
------------------------------------------------------------------------


Under paragraph (c)(2)(ii)(C) of this section, $90 of the related person 
interest payment is allocable to S's passive income. Under paragraph 
(m)(2) of this section, $70 is from sources within the United States and 
$20 is from foreign sources. Under paragraph (c)(2)(ii)(D) of this 
section, the remaining $210 of the related person interest payment is 
allocated to general limitation income. Under paragraph (m)(2) of this 
section, $120 of the remaining $210 is treated as income from sources 
within the United States ($120 = $210 x $4000/$7000) and $90 is treated 
as income from foreign sources. ($90 = $210 x $3000/$7000).
    Example 2. The facts are the same as in Example 1 except that S uses 
the gross income method to allocate interest expense. The first $90 of 
related person interest expense is allocated to passive income in the 
same manner as in Example 1. Under paragraph (c)(2)(ii)(D) of this 
section, the remaining $210 of the related person interest expense is 
allocated to general limitation income. Under paragraph (m)(2) of this 
section, $28 of the remaining $210 is treated as income from United 
States sources ($28 = $210 x $100/$750) and $182 is treated as income 
from foreign sources ($182 = $210 x $650/$750).
    Example 3. Controlled foreign corporation S is a wholly-owned 
subsidiary of P, a domestic corporation. In 1988, S pays $300 of 
interest to P. S has no other expenses. S uses the asset method to 
allocate interest expense. In 1988, S has $4000 of assets that generate 
$650 of foreign source general limitation manufacturing income and a 
$1000 loan to an unrelated foreign person that generates $100 of foreign 
source passive interest income. S has $500 of shipping assets that 
generate $200 of foreign source shipping income and $500 of shipping 
assets that generate $200 of United States source shipping income. S 
also has a $1000 loan to an unrelated United States person that 
generates $100 of United States source passive income. S's passive 
income is not also described as shipping income. The following chart 
summarizes S's assets and income:

------------------------------------------------------------------------
                                          Foreign      U.S.      Totals
------------------------------------------------------------------------
Assets:
  Passive..............................       1000       1000       2000
  Shipping.............................        500        500       1000
  General..............................       4000          0       4000
                                        --------------------------------
      Total............................       5500       1500       7000
Income:
  Passive..............................        100        100        200
  Shipping.............................        200        200        400
  General..............................        650          0        650
                                        --------------------------------
      Total............................        950        300       1250
------------------------------------------------------------------------


Under paragraph (c)(2)(ii)(C) of this section, $200 of the related 
person interest payment is allocable to S's passive income. Under 
paragraph (m)(2) of this section, $100 of this amount is from foreign 
sources and $100 is from sources within the United States.
    Under paragraph (c)(2)(ii)(D) of this section, $80 of the remaining 
$100 of the related person interest payment is allocated to general 
limitation income ($80 = $100 x $4000/$5000) and $20 is allocated to 
shipping income ($20 = $100 x $1000/$5000).
    Under paragraph (m)(2) of this section, none of $80 of the interest 
payment allocated to general limitation income is treated as income from 
United States sources ($0 = $80 x $0/$4000). Therefore, the entire $80 
is treated as income from foreign sources.
    Under paragraph (m)(2) of this section, $10 of the $20 of the 
interest payment allocated to the shipping income is treated as income 
from United States sources ($10 = $20 x $500/$1000) and $10 of the $20 
is treated as income from foreign sources ($10 = $20 x $500/$1000).
    Example 4. The facts are the same as in Example 3 except that S uses 
the gross income method to allocate interest expense. The interest 
allocated to passive income under paragraph (c)(2)(ii)(C) of this 
section is the same, $200, $100 from United States sources and $100 from 
foreign sources.
    Under paragraph (c)(2)(ii)(D) of this section, the remaining $100 of 
related person interest is allocated between the shipping and general 
limitation categories based on the gross income in those categories. 
Therefore, $38 of the remaining $100 interest payment is allocated to 
shipping income ($38 = $100 x $400/($1250-$200)) and $62 is treated as 
allocated to general limitation income ($62 = $100 x $650/($1250-$200)).
    Under paragraph (m)(2) of this section, $19 of the $38 allocable to 
shipping income is

[[Page 805]]

treated as income from United States sources ($19 = $38 x $200/$400) and 
$19 is treated as income from foreign sources ($19 = $38 x $200/$400).
    Under paragraph (m)(2) of this section, all of the $62 allocated to 
general limitation income is treated as income from foreign sources ($62 
= $62 x $650/$650).

    (4) Treatment of dividend payments--(i) Rule. Any dividend or 
distribution treated as a dividend under this section (including an 
amount included in gross income under section 951(a)(1)(B)) that is 
received or accrued by a United States shareholder from a controlled 
foreign corporation, or any dividend that is received or accrued by a 
domestic corporate shareholder meeting the stock ownership requirements 
of section 902(a) from a noncontrolled section 902 corporation, shall be 
treated as income in a separate category derived from sources within the 
United States in proportion to the ratio of the portion of the earnings 
and profits of the controlled foreign corporation or noncontrolled 
section 902 corporation in the corresponding separate category from 
United States sources to the total amount of earnings and profits of the 
controlled foreign corporation or noncontrolled section 902 corporation 
in that separate category.
    (ii) Determination of earnings and profits from United States 
sources. In order to determine the portions of earnings and profits from 
United States sources and from foreign sources within each separate 
category, related person interest shall be allocated to the United 
States source portion of income in a separate category by applying the 
rules of paragraph (m)(2) of this section. Other expenses shall be 
allocated by applying the rules of paragraph (c)(2)(ii) of this section 
separately to the United States source income and the foreign source 
income in each category. For example, unrelated person interest expense 
that is allocated among categories of income based upon the relative 
amounts of assets in a category must be allocated between United States 
and foreign source income within each category by applying the rules of 
paragraph (c)(2)(ii)(E) of this section separately to United States 
source and foreign source assets in the separate category.
    (iii) Example. The following example illustrates the application of 
this paragraph.

    Example. Controlled foreign corporation, S, is a wholly owned 
subsidiary of P, a domestic corporation. S is a financial services 
entity. In 1987, S has $100 of non-subpart F general limitation earnings 
and profits and $100 of non-subpart F financial services income. None of 
the general limitation earnings and profits are from sources within the 
United States, and $50 of the financial services earnings and profits 
are from United States sources. In 1988, S earns $300 of non-subpart F 
general limitation earnings and profits and $500 of non-subpart F 
financial services earnings and profits. One hundred dollars ($100) of 
the general limitation earnings and profits are from sources within the 
United States. None of the financial services earnings and profits are 
from United States sources. In 1988, S pays P a $500 dividend. Under 
paragraph (c)(4) of this section, $200 of the dividend is attributable 
to general limitation earnings and profits ($200 = $500 x $400/$1000). 
Under this paragraph (m)(3), the portion of the dividend that is 
attributable to general limitation earnings and profits from sources 
within the United States is $50 ($200 x $100/$400). Under paragraph 
(c)(4) of this section, $300 of the dividend is attributable to 
financial services earnings and profits ($300 = $500 x $600/$1000). 
Under this paragraph (m)(3), the portion of the dividend that is 
attributable to financial services earnings and profits from sources 
within the United States is $25 ($300 x $50/$600).

    (5) Treatment of inclusions under sections 951(a)(1)(A) and 1293--
(i) Rule. Any amount included in the gross income of a United States 
shareholder of a controlled foreign corporation under section 
951(a)(1)(A) or in the gross income of domestic corporate shareholders 
that meet the stock ownership requirements of section 902(a) with 
respect to a noncontrolled section 902 corporation that is a qualified 
electing fund under section 1293 shall be treated as income subject to a 
separate limitation that is derived from sources within the United 
States to the extent such amount is attributable to income of the 
controlled foreign corporation or qualified electing fund, respectively, 
in the corresponding category of income from sources within the United 
States. In order to determine a controlled foreign corporation's taxable 
income and earnings and profits from sources within the United States in 
each separate category, the principles of paragraph

[[Page 806]]

(m)(4)(ii) of this section shall apply. In order to determine a 
qualified electing fund's earnings and profits from sources within the 
United States in each separate category, the principles of paragraph 
(m)(4)(ii) of this section shall apply, except that the related person 
interest rule of paragraph (m)(2) of this section shall not apply.
    (ii) Example. The following example illustrates the application of 
this paragraph (m)(5).

    Example. Controlled foreign corporation S is a wholly-owned 
subsidiary of domestic corporation, P. In 1987, S earns $100 of subpart 
F foreign personal holding company income that is passive income. Of 
this amount, $40 is derived from sources within the United States. S 
also earns $50 of subpart F general limitation income. None of this 
income is from sources within the United States. Assume that S pays no 
foreign taxes and has no expenses. P is required to include $150 in 
gross income under section 951(a). Of this amount, $60 will be foreign 
source passive income to P and $40 will be United States source passive 
income to P. Fifty dollars ($50) will be foreign source general 
limitation income to P.

    (6) Treatment of section 78 amount. For purposes of treating taxes 
deemed paid by a taxpayer under section 902(a) and section 960(a)(1) as 
a dividend under section 78, taxes that are paid or accrued with respect 
to United States source income in a separate category shall be treated 
as United States source income in that separate category.
    (7) Coordination with treaties--(i) Rule. If any amount of income 
derived from a United States-owned foreign corporation, as defined in 
section 904(g)(6), would be treated as derived from sources within the 
United States under section 904(g) and this paragraph (m) and, pursuant 
to an income tax convention with the United States, the taxpayer chooses 
to avail itself of benefits of the convention that treat that amount as 
arising from sources outside the United States under a rule explicitly 
treating the income as foreign source, then that amount will be treated 
as foreign source income. However, sections 904 (a), (b), (c), (d) and 
(f), 902, 907, and 960 shall be applied separately to amounts described 
in the preceding sentence with respect to each treaty under which the 
taxpayer has claimed benefits and, within each treaty, to each separate 
category of income.
    (ii) Example. The following example illustrates the application of 
this paragraph (m)(7).

    Example. Controlled foreign corporation S is incorporated in Country 
A and is a wholly-owned subsidiary of P, a domestic corporation. In 
1990, S earns $80 of foreign base company sales income in Country A 
which is general limitation income and $40 of U.S. source interest 
income. S incurs $20 of expenses attributable to its sales business. S 
pays P $40 of interest that is allocated to U.S. source passive income 
under paragraphs (c)(2)(ii)(C) and (m)(2) of this section. Assume that 
earnings and profits equal net income. All of S's net income of $60 is 
includible in P's gross income under subpart F (section 951(a)(1)). For 
1990, P also has $100 of passive income derived from investments in 
Country B. Pursuant to section 904(g)(3) and paragraph (m)(2) of this 
section, the $40 interest payment from S is United States source income 
to P because it is attributable to United States source interest income 
of S. The United States-Country A income tax treaty, however, treats all 
interest payments by residents of Country A as Country A sourced and P 
elects to apply the treaty. Pursuant to section 904(g)(10) and this 
paragraph (m)(7), the entire interest payment will be treated as foreign 
source income to P. P thus has $60 of foreign source general limitation 
income, $40 of foreign source passive income from S, and $100 of other 
foreign source passive income. In determining P's foreign tax credit 
limitation on passive income, the passive income from Country A shall be 
treated separately from any other passive income.

    (n) Order of application of section 904(d) and (h). In order to 
apply the rules of this section, section 904(d)(1) shall first be 
applied to the controlled foreign corporation or noncontrolled section 
902 corporation to determine the amount of income and earnings and 
profits derived by the controlled foreign corporation or noncontrolled 
section 902 corporation in each separate category. The income and 
earnings and profits in each separate category that are from United 
States sources shall then be determined. Section 904(d)(3), (d)(4), and 
(h), and this section shall then be applied for purposes of 
characterizing and sourcing income received, accrued, or included by a 
United States shareholder in the controlled foreign corporation or a 
domestic corporate

[[Page 807]]

shareholder that meets the stock ownership requirements of section 
902(a) with respect to a noncontrolled section 902 corporation that is 
attributable or allocable to income or earnings and profits of the 
foreign corporation.
    (o) Effective dates--(1) Rules for controlled foreign corporations 
and other look-through entities. Section 904(d)(3) and this section 
apply to distributions and section 951 inclusions of earnings and 
profits of a controlled foreign corporation (or other entity to which 
this section applies) derived during the first taxable year of the 
controlled foreign corporation (or other entity) beginning after 
December 31, 1986, and thereafter, and to payments made by a controlled 
foreign corporation (or other entity) during such taxable years, without 
regard to whether the corresponding taxable year of the recipient of the 
distribution or payment or of one or more of the United States 
shareholders of the controlled foreign corporation begins after December 
31, 1986.
    (2) Rules for noncontrolled section 902 corporations. Paragraphs 
(a), (a)(1), (a)(4), (b), (c)(2)(iii), (c)(4)(iii), (i)(1), (i)(3), 
(i)(4), (i)(5), Examples 4 and 5, (m)(1), (m)(2)(ii), (m)(4)(i), 
(m)(5)(i), and (n) of this section apply to distributions from a 
noncontrolled section 902 corporation that are paid in taxable years of 
the noncontrolled section 902 corporation ending on or after April 20, 
2009. See 26 CFR 1.904-5T(a), (a)(1), (a)(4), (b), (c)(2)(iii), 
(c)(4)(iii), (i)(1), (i)(3), (i)(4), (i)(5), Examples 4 and 5, and 26 
CFR 1.904-7T(f)(9) (revised as of April 1, 2009) for rules applicable to 
distributions from a noncontrolled section 902 corporation that are paid 
in taxable years of the noncontrolled section 902 corporation beginning 
after December 31, 2002, and ending before April 20, 2009. See 26 CFR 
1.904-5T(m)(1), (m)(2)(ii), (m)(4)(i), and (n) (revised as of April 1, 
2009) for rules applicable to distributions from a noncontrolled section 
902 corporation paid in taxable years of such corporation beginning 
after April 25, 2006, and ending before April 20, 2009. For 
corresponding rules applicable to taxable years beginning before January 
1, 2003, see 26 CFR 1.904-5 (revised as of April 1, 2006).
    (3) Rules for income from the sale of a partnership interest. 
Paragraph (h)(3) of this section shall apply to taxable years of United 
States persons and, for purposes of section 906, foreign persons 
beginning after December 31, 2006 and ending on or after December 21, 
2007, and to taxable years of a foreign corporation which end with or 
within taxable years of its domestic corporate shareholder beginning 
after December 31, 2006 and ending on or after December 21, 2007.

[T.D. 8214, 53 FR 27020, July 18, 1988]

    Editorial Note: For Federal Register citations affecting Sec.  
1.904-5, see the List of CFR Sections Affected, which appears in the 
Finding Aids section of the printed volume and at www.govinfo.gov.



Sec.  1.904-6  Allocation and apportionment of taxes.

    (a) Allocation and apportionment of taxes to a separate category or 
categories of income--(1) In general--(i) Taxes related to a separate 
category of income. The amount of foreign taxes paid or accrued with 
respect to a separate category of income (including United States source 
income) shall include only those taxes that are related to income in 
that separate category. Taxes are related to income if the income is 
included in the base upon which the tax is imposed. If, for example, 
foreign law exempts certain types of income from foreign taxes, or 
certain types of income are exempt from foreign tax under an income tax 
convention, then no taxes are considered to be related to such income 
for purposes of this paragraph. As another example, if foreign law 
provides for a specific rate of tax with respect to certain types of 
income (e.g., capital gains), or certain expenses, deductions, or 
credits are allowed under foreign law only with respect to a particular 
type of income, then such provisions shall be taken into account in 
determining the amount of foreign tax imposed on such income. A 
withholding tax (unless it is a withholding tax that is not the final 
tax payable on the income as described in Sec.  1.904-4(d)) is related 
to the income from which it is withheld. A tax that is imposed on a base 
that includes more than one separate category of income is considered to 
be imposed on income in all such categories, and, thus, the taxes are 
related to all such categories

[[Page 808]]

included within the foreign country or possession's taxable income base.
    (ii) Apportionment of taxes related to more than one separate 
category. If a tax is related to more than one separate category, then, 
in order to determine the amount of the tax paid or accrued with respect 
to each separate category, the tax shall be apportioned on an annual 
basis among the separate categories on the basis of the following 
formula:
[GRAPHIC] [TIFF OMITTED] TC07OC91.039


For purposes of apportioning foreign taxes among the separate 
categories, gross income is determined under the law of the foreign 
country or a possession of the United States to which the foreign income 
taxes have been paid or accrued. Gross income, as determined under 
foreign law, in the passive category shall first be reduced by any 
related person interest expense that is allocated to the income under 
the principles of section 954(b)(5) and Sec.  1.904-5(c)(2)(ii)(C) 
(adjusted gross passive income). Gross income in all separate categories 
(including adjusted gross passive income) is next reduced by deducting 
any expenses, losses, or other amounts that are deductible under foreign 
law that are specifically allocable to the gross amount of such income 
under the laws of that foreign country or possession. If expenses are 
not specifically allocated under foreign law then the expenses will be 
apportioned under the principles of foreign law but only after taking 
into account the reduction of passive income by the application of 
section 954(b)(5). Thus, for example, if foreign law provides that 
expenses will be apportioned on a gross income basis, the gross income 
amounts will be those amounts determined under foreign law except that, 
in the case of passive income, the amount will be adjusted gross passive 
income. If foreign law does not provide for the direct allocation or 
apportionment of expenses, losses, or other deductions to a particular 
category of income, then the principles of Sec. Sec.  1.861-8 through 
1.861-14T and section 954(b)(5) shall apply in allocating and 
apportioning such expenses, losses, or other deductions to gross income 
as determined under foreign law after reduction of passive income by the 
amount of related person interest allocated to passive income under 
section 954(b)(5) and Sec.  1.904-5(c)(2)(ii)(C). For example, the 
principles of Sec. Sec.  1.861-8 through 1.861-14T apply to require 
definitely related expenses to be directly allocated to particular 
categories of gross income and provide the methods of apportioning 
expenses that are definitely related to more than one category of gross 
income or that are not definitely related to any particular category of 
gross income. For this purpose, the apportionment of expenses required 
to be made under Sec. Sec.  1.861-8 through 1.861-14T need not be made 
on other than a separate company basis. The rules in this paragraph 
apply only for purposes of the apportionment of taxes among separate 
categories of income and do not affect the computation of a taxpayer's 
foreign tax credit limitation with respect to a specific category of 
income. If the taxpayer applies the principles of Sec. Sec.  1.861-8 
through 1.861-14T for purposes of allocating expenses at the level of 
the taxpayer (or at the level of the qualified business unit, foreign 
subsidiary, or other entity that paid or accrued the foreign taxes) 
under this paragraph (a)(1)(ii), such principles shall be applied (for 
such purposes) in the same manner as the taxpayer applies such 
principles in determining the income or earnings and profits for United 
States tax purposes of the taxpayer (or of the qualified business unit, 
foreign subsidiary, or other entity that paid or accrued the foreign 
taxes, as

[[Page 809]]

the case may be). For example, a taxpayer must use the modified gross 
income method under Sec.  1.861-9T when applying the principles of that 
section for purposes of this paragraph (a)(1)(ii) to determine the 
amount of a controlled foreign corporation's income, in each separate 
category, that is taxed by a foreign country, if the taxpayer applies 
the modified gross income method under Sec.  1.861-9T(f)(3) when 
applying Sec.  1.861-9T to determine the income and earnings and profits 
of the controlled foreign corporation for United States tax purposes.
    (iii) Apportionment of taxes for purposes of applying the high-tax 
income test. If taxes have been allocated and apportioned to passive 
income under the rules of paragraph (a)(1) (i) or (ii) of this section, 
the taxes must further be apportioned to the groups of income described 
in Sec.  1.904-4(c) (3), (4) and (5) for purposes of determining if the 
group is high-taxed income. Taxes will be related to income in a 
particular group under the same rules as those in paragraph (a)(1) (i) 
and (ii) of this section except that those rules shall be applied by 
substituting the term ``group'' for the term ``category.''
    (iv) Special rule for base and timing differences. If, under the law 
of a foreign country or possession of the United States, a tax is 
imposed on an item of income that does not constitute income under 
United States tax principles, that tax shall be treated as imposed with 
respect to general limitation income. If, under the law of a foreign 
country or possession of the United States, a tax is imposed on an item 
that would be income under United States tax principles in another year, 
that tax will be allocated to the appropriate separate category or 
categories as if the income were recognized under United States tax 
principles in the year in which the tax was imposed.
    (2) [Reserved]
    (b) Application of paragraph (a) to sections 902 and 960--(1) 
Determination of foreign taxes deemed paid. 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 
controlled foreign corporation for any taxable year and the amount 
included consists of income in more than one separate category of the 
controlled foreign corporation, then the domestic corporation shall be 
deemed to have paid only a portion of the taxes paid or accrued, or 
deemed paid or accrued, by the controlled foreign corporation that are 
allocated to each separate category to which the inclusion is 
attributable. The portion of the taxes allocated to a particular 
separate category that shall be deemed paid by the United States 
shareholder shall be equal to the taxes allocated to that separate 
category multiplied by the amount of the inclusion with respect to that 
category (as determined under Sec.  1.904-5(c)(1)) and divided by the 
earnings and profits of the controlled foreign corporation with respect 
to that separate category (in accordance with Sec.  1.904-5(c)(2)(ii)). 
The rules of this paragraph (b)(1) also apply for purposes of computing 
the foreign taxes deemed paid by United States shareholders of 
controlled foreign corporations under section 902.
    (2) Distributions received from foreign corporations that are 
excluded from gross income under section 959(b). The principles of this 
paragraph shall be applied to--
    (i) Any portion of a distribution received from a first-tier 
corporation by a domestic corporation or individual that is excluded 
from the domestic corporation's or individual's income under section 
959(a) and Sec.  1.959-1; and
    (ii) Any portion of a distribution received from an immediately 
lower-tier corporation by a second- or first-tier corporation that is 
excluded from such foreign corporation's gross income under section 
959(b) and Sec.  1.959-2, if such distribution is treated as a dividend 
pursuant to Sec.  1.960-2(a).
    (3) Application of section 78. For purposes of treating taxes deemed 
paid by a taxpayer under section 902(a) and section 960(a)(1) as a 
dividend under section 78, taxes that were allocated to income in a 
separate category shall be treated as income in that same separate 
category.
    (4) Increase in limitation. The amount of the increase in the 
foreign tax credit limitation allowed by section 960(b) and Sec.  1.960-
4 shall be determined with

[[Page 810]]

regard to the applicable category of income under section 904(d).
    (c) Examples. The following examples illustrate the application of 
this section.

    Example 1. M, a domestic corporation, conducts business in foreign 
country X. M earns $400 of shipping income, $200 of general limitation 
income and $200 of passive income as determined under foreign law. Under 
foreign law, none of M's expenses are directly allocated or apportioned 
to a particular category of income. Under the principles of Sec. Sec.  
1.861-8 through 1.861-14T, M apportions $75 of directly allocable 
expenses to shipping income, $10 of directly allocable expenses to 
general limitation income, and no such expenses to passive income. M 
also apportions expenses that are not directly allocable to a specific 
class of gross income--$40 to shipping income, $20 to general limitation 
income, and $20 to passive income. Therefore, for purposes of paragraph 
(a) of this section, M has $285 of net shipping income, $170 of net 
general limitation income, and $180 of net passive income. Country X 
imposes tax of $100 on a base that includes M's shipping income and 
general limitation income. Country X exempts passive income from tax. 
The tax paid by M is related to M's shipping and general limitation 
income. The $100 tax is apportioned between those limitations. Thus, M 
is considered to have paid $63 of X tax on its shipping income ($100 x 
$285/$455) and $37 of tax on its general limitation income ($100 x $170/
$455). None of the X tax is allocated to M's passive income.
    Example 2. The facts are the same as in example 1 except that X does 
not exempt all passive income from tax but only exempts interest income. 
M's passive income consists of $100 of gross dividend income, to which 
$10 of expenses that are not directly allocable are apportioned, and 
$100 of interest income, to which $10 of expenses that are not directly 
allocable are apportioned. The $90 of net dividend income is subject to 
X tax, and $90 of net interest income is exempt from X tax. M pays $130 
of tax to X. The $130 of tax is related to M's general, shipping, and 
passive income. The tax is apportioned among those limitations as 
follows: $68 to shipping income ($130 x $285/$545) $41 to general 
limitation income ($130 x $170/$545), and $21 to passive income ($130 x 
$90/$545).
    Example 3. P, a domestic corporation, owns 100 percent of S, a 
controlled foreign corporation organized in country X. S owns l00 
percent of T, a controlled foreign corporation that is also organized in 
country X. Country X grants group relief to S and T. In 1987, S earns 
$100 of income and T incurs an $80 loss. Under country X's group relief 
provisions, only $20 of S's income is subject to country X tax. Country 
X imposes a 30 percent tax on this income ($6). P includes $100 of S's 
income in gross income under section 951. Six dollars ($6) of foreign 
tax is related to that income for purposes of section 960.
    Example 4. P, a domestic corporation, owns 100 percent of S, a 
controlled foreign corporation organized in country X and 100 percent of 
T, a controlled foreign corporation organized in country Y. T has $200 
of gross manufacturing general limitation income and $50 of passive 
income. T also pays S $100 for shipping T's goods, a price that may be 
justified under section 482. T has no other expenses and S has no other 
income or expense. T's income and earnings and profits are the same. 
Foreign country X does not tax S on its shipping income. Foreign country 
Y taxes all of T's income at a rate of 20 percent. Under the law of 
foreign country Y, T is only allowed a $50 deduction for the payment to 
S. Therefore, for foreign law purposes, T has $150 of manufacturing 
income and earnings and profits and $50 of passive income and earnings 
and profits upon which it pays $40 of tax. Under the principles of 
foreign law, $30 of that tax is imposed on the general limitation 
manufacturing income and $10 of the tax is imposed on passive income. 
Therefore, the foreign effective rate on the general limitation income 
is 30 percent and the foreign effective rate on the passive income is 20 
percent. T has $100 of general limitation income and $50 of passive 
income and pays $30 of general limitation taxes and $10 of passive 
taxes. S has $100 of shipping income and pays no foreign tax.
    Example 5. R, a domestic corporation, owns 50 percent of T, a 
foreign corporation that is not a controlled foreign corporation and 
that is organized in foreign country X. R licenses certain property to 
T. T then relicenses this property to a third person. In 1987, T paid R 
a royalty of $100 all of which is treated as passive income to R because 
it was not an active royalty as defined in Sec.  1.904-4(b)(2). R has 
$10 of expenses associated with the royalty income and no foreign tax 
was imposed on the royalty so the high-tax kickout does not apply. In 
1988, the Commissioner determined that the correct arm's length royalty 
was $150 and under the authority of section 482 reallocated an 
additional $50 of income to R for 1987. Under a closing agreement with 
the Commissioner, R elected the benefits of Rev. Proc. 65-17 in relation 
to the income reallocated from R and established an account receivable 
from T. In 1988, T paid R an additional $50 to reflect the section 482 
adjustment and the account receivable that was established because of 
the adjustment. Foreign country X treats the $50 payment in 1988 as a 
dividend by T and imposes a $10 withholding tax on the payment. Under 
paragraph (a)(1) of this section, the $10 of withholding tax is treated 
as fully allocable to the $50 payment because under foreign law the tax 
is imposed only on that income. For

[[Page 811]]

U.S. purposes, the income is not characterized as a dividend but as a 
repayment of a bona fide debt and, therefore, the $50 of income is not 
required to be recognized by R in 1988. The $10 of tax is treated as a 
tax paid in 1988 on the $50 of passive income included by R in 1987 
pursuant to the section 482 adjustment rather than as a tax associated 
with a dividend from a noncontrolled section 902 corporation. The $10 
tax is a tax imposed on passive income under paragraph (a)(1)(iv) of 
this section.
    Example 6. P, a domestic corporation, owns all of the stock of S, a 
controlled foreign corporation that is incorporated in country X. In 
2004, S has $100 of passive income, $200 of shipping income and $200 of 
general limitation income. S also has $100 of related person interest 
expense and $100 of other expenses that under foreign law are directly 
allocable to the general limitation income of S. S has no other 
expenses. Country X imposes a tax of 25 percent on all of the net income 
of S and S, therefore, pays $75 in foreign tax. Under paragraph 
(a)(1)(ii) of this section, the passive income of S is first reduced by 
the amount of related person interest for purposes of determining the 
net amount for purposes of allocating the $75 of tax. Under paragraph 
(a)(1)(ii) of this section, the general limitation income of S is 
reduced by the $100 of other expenses. Therefore, $50 of the foreign tax 
is allocated to the shipping income of S ($50 = $75 x $200/$300), $25 is 
allocated to the general limitation income of S ($25 = $75 x $100/$300), 
and no taxes are allocated to S's passive income.
    Example 7. Domestic corporation P owns all of the stock of 
controlled foreign corporation S, which owns all of the stock of 
controlled foreign corporation T. All such corporations use the calendar 
year as the taxable year. Assume that earnings and profits are equal to 
net income and that the income amounts are identical under United States 
and foreign law principles. In 1987, T earns (before foreign taxes) 
$187.50 of net passive income and $62.50 of net general limitation 
income and pays $50 of foreign taxes. S earns no income in 1987 and pays 
no foreign taxes. For 1987, P is required under section 951 to include 
in gross income $175 attributable to the earnings and profits of T for 
that year. One hundred and fifty dollars ($150) of the subpart F 
inclusion is attributable to passive income earned by T, and $25 of the 
subpart F inclusion is attributable to general limitation income earned 
by T. In 1988, T earns no income and pays no foreign taxes. T pays a 
$200 dividend to S, consisting of $175 from its earnings and profits 
attributable to amounts required to be included in P's gross income with 
respect to T and $25 from its other earnings and profits. Assume that no 
withholding tax is imposed with respect to the distribution from T to S. 
In 1988, S earns $100 of net general limitation income and receives a 
$200 dividend from T. S pays $30 in foreign taxes. For 1988, P is 
required under section 951 to include in gross income $22.50 
attributable to the earnings and profits of S for such year. The entire 
subpart F inclusion is attributable to general limitation income earned 
by S. In 1988, S pays P a dividend of $247.50, consisting of $157.50 
from its earnings and profits attributable to the amount required under 
section 951 to be included in P's gross income with respect to T, $22.50 
from its earnings and profits attributable to the amount required under 
section 951 to be included in P's gross income with respect to S, and 
$67.50 from its other earnings and profits. Assume the de minimis rule 
of section 954(b)(3)(A) and the full inclusion rule of section 
954(b)(3)(B) do not apply to the gross amounts of income earned by S and 
T. The foreign income taxes deemed paid by P for 1987 and 1988 under 
section 960(a)(1) and section 902(a) are determined as follows on the 
basis of the following facts and computations.

  T corporation (second-tier corporation):
1. Pre-tax earnings and profits:
  (a) Passive income (p.i.)..................   187.50
    Plus:
  (b) General limitation income (g.l.i.).....    62.50
                                              ---------
  (c) Total..................................   250.00
    Less:
  (d) Foreign income taxes paid on or with     .......    50.00
   respect to T's earnings and profits (20%).
                                                       ---------
  (e) Earnings and profits...................  .......  .......   200.00
2. Allocation of taxes:
  (a) Foreign income taxes paid by T that are
   allocable to p.i. earned by T:
    Line 1(d) taxes..........................  .......    50.00
    Multiplied by: foreign law net p.i.......  .......   187.50
    Divided by: foreign law total net income.  .......   250.00
                                                       ---------
    Result...................................  .......  .......    37.50
  (b) Foreign income taxes paid by T that are
   allocable to g.l.i. earned by T:
    Line 1(d) taxes..........................  .......    50.00
    Multiplied by: foreign law net g.l.i.....  .......    62.50
    Divided by: foreign law total net income.  .......   250.00
                                                       ---------
    Result...................................  .......  .......    12.50
3. T's earnings and profits:
  (a) Earnings and profits attributable to
   T's p.i.:
    Line (1)(a) e & p........................  .......   187.50
    Less: line 2(a) taxes....................  .......    37.50
                                                       ---------
    Result...................................  .......  .......   150.00
  (b) Earnings and profits attributable to
   T's g.l.i.:
    Line (1)(b) e & p........................  .......    62.50

[[Page 812]]

 
    Less: line 2(b) taxes....................  .......    12.50
                                                       ---------
    Result...................................  .......  .......    50.00
4. Subpart F inclusion attributable to T:
  (a) Amount required to be included in P's    .......  .......   150.00
   gross income for 1987 under section 951
   with respect to T that is attributable to
   T's p.i...................................
  (b) Amount required to be included in P's    .......  .......    25.00
   gross income for 1987 under section 951
   with respect to T that is attributable to
   T's g.l.i.................................
5. Foreign income taxes deemed paid by P
 under section 960(a)(1) with respect to T:
  (a) Taxes deemed paid that are attributable
   to T's subpart F inclusion that are
   attributable to T's p.i.:
    Line 2(a) taxes..........................  .......    37.50
    Multiplied by: line 4(a) sec. 951 incl...  .......   150.00
    Divided by: line 3(a) e & p..............  .......   150.00
                                                       ---------
    Result:..................................  .......  .......    37.50
  (b) Taxes deemed paid that are attributable
   to T's subpart F inclusion that are
   attributable to T's g.l.i.:
    Line 2(b) taxes..........................  .......    12.50
    Multiplied by: line 4(b) sec. 951 incl...  .......    25.00
    Divided by: line 3(b) e & p..............  .......    50.00
                                                       ---------
    Result...................................  .......  .......     6.25
6. Dividends paid to S:
  (a) Dividends attributable to T's            .......   150.00
   previously taxed p.i......................
      Plus:
  (b) Dividends attributable to T's            .......    25.00
   previously taxed g.l.i....................
      Plus:
  (c) Dividends from T's non-previously taxed  .......     0
   earnings and profits attributable to p.i..
      Plus:
  (d) Dividends from T's non-previously taxed  .......  .......    25.00
   earnings and profits attributable to
   g.l.i.....................................
                                                       ---------
  (e) Total dividends paid to S..............  .......  .......   200.00
7. Taxes deemed paid by S:
  (a) Taxes of T deemed paid by S for 1987
   under section 902(b)(1) with regard to T's
   p.i.:
    Line 2(a) taxes..........................  .......    37.50
    Multiplied by: line 6(c) dividend........  .......     0
    Dividend by: line 3(a) e & p.............  .......  .......   150.00
                                                       ---------
    Result...................................  .......  .......     0
  (b) Taxes of T deemed paid by S for 1987
   under section 902(b)(1) with regard to T's
   g.l.i.:
    Line 2(b) taxes..........................  .......    12.50
    Multiplied by: line 6(d) dividend........  .......    25.00
    Dividend by: line 3(b) e & p.............  .......    50.00
                                                       ---------
    Result...................................  .......  .......     6.25
  S corporation (first-tier corporation):
8. Pre-tax earnings and profits:
  (a) Dividends from T attributable to T's        0
   non-previously taxed p.i..................
    Plus:
  (b) Dividends from T attributable to T's       25
   non-previously taxed g.l.i................
    Plus:
  (c) Dividends from T attributable to T's      150
   previously taxed p.i......................
    Plus:
  (d) Dividends from T attributable to T's       25
   previously taxed g.l.i....................
    Plus:
  (e) Passive income other than dividend from     0
   T.........................................
    Plus:
  (f) General limitation income other than      100.00
   dividend from T...........................
                                              ---------
  (g) Total pre-tax earnings and profits.....  .......   300.00
  (h) Foreign income taxes paid on or with     .......    30.00
   respect to S's earnings and profits (10%).
                                                       ---------
  (i) Earnings and profits...................  .......  .......   270.00
9. Allocation of taxes:
  (a) Foreign income taxes paid by S that are
   allocable to non-previously taxed p.i.
   earned by S:
    Line 8(h) taxes..........................  .......    30.00
    Multiplied by: foreign law line 8(a) &     .......     0
     8(e) p.i. amounts.......................
    Dividend by: foreign law total net income  .......   300.00
                                                       ---------
    Result...................................  .......  .......     0
  (b) Foreign income taxes paid by S that are
   allocable to S's previously taxed p.i.
   received from T:
    Line 8(h) taxes..........................  .......    30.00
    Multiplied by: foreign law line 8(c) p.i.  .......   150.00
     amount..................................
    Divided by: foreign law total net income.  .......   300.00
                                                       ---------
    Result...................................  .......  .......    15.00
  (c) Foreign income taxes paid by S that are
   allocable to non-previously taxed g.l.i.
   earned by S:
    Line 8(h) taxes..........................  .......    30.00

[[Page 813]]

 
    Multiplied by: foreign law line 8(b) &     .......   125.00
     line 8(f) g.l.i. amounts................
    Divided by: foreign law total net income.  .......   300.00
                                                       ---------
    Result...................................  .......  .......    12.50
  (d) Foreign income taxes paid by S that are
   allocable to S's previously taxed g.l.i.
   received from T:
    Line 8(h) taxes..........................  .......    30.00
    Multiplied by: foreign law line 8(d)       .......    25.00
     amount..................................
    Divided by: foreign law total net income.  .......   300.00
                                                       ---------
    Result...................................  .......  .......     2.50
10. (a) Non-previously taxed earnings and
 profits of S:
    Lines 8(a), 8(b), 8(e), & 8(f) e & p.....  .......   125.00
    Less: lines 9(a) & 9(c) taxes............  .......    12.50
                                                       ---------
    Result...................................  .......  .......   112.50
  (b) Portion of result in 10(a) attributable  .......  .......     0
   to S's p.i................................
  (c) Portion of result in 10(a) attributable  .......  .......   112.50
   to S's g.l.i..............................
11. (a) Previously taxed earnings and profits
 of S:
    Lines 8(c) and 8(d) e & p................  .......   175.00
    Less: lines 9(b) & 9(d) taxes............  .......    17.50
                                                       ---------
    Result...................................  .......  .......   157.50
  (b) Portion of result in 11(a) attributable
   to T's p.i.:
    Line 8(c)................................  .......   150.00
    Less: line 9(b) taxes....................  .......    15.00
                                                       ---------
    Result...................................  .......  .......   135.00
  (c) Portion of result in 11(a) attributable
   to T's g.l.i.:
    Line 8(d)................................  .......    25.00
    Less: line 9(d) taxes....................  .......     2.50
                                                       ---------
    Result...................................  .......  .......    22.50
12. Subpart F inclusion attributable to S:
  (a) Amount required to be included in P's    .......  .......     0
   gross income for 1988 under section 951
   with respect to S that is attributable to
   S's p.i...................................
  (b) Amount required to be included in P's    .......  .......    22.50
   gross income for 1988 under section 951
   with respect to S that is attributable to
   S's g.l.i.................................
13. Foreign income taxes deemed paid by P
 under section 960(a)(1) with respect to S:
  (a) Taxes deemed paid that are attributable
   to S's subpart F inclusion that are
   attributable to S's p.i.:
    Line 9(a) taxes..........................  .......     0
    Multiplied by: line 12(a) sec. 951 incl..  .......     0
    Divided by: line 10(b) e & p.............  .......     0
                                                       ---------
    Result...................................  .......  .......     0
  (b) Taxes deemed paid that are attributable
   to S's subpart F inclusion that are
   attributable to S's g.l.i.:
    Line 9(c) taxes..........................  .......    12.50
    Multiplied by: line 12(b) sec. 951 incl..  .......    22.50
    Divided by: line 10(c) e & p.............  .......   112.50
                                                       ---------
    Result...................................  .......  .......     2.50
  (c) Foreign income taxes deemed paid by S
   deemed paid by P that are allocable to S's
   p.i.:
    Line 7(a) taxes deemed paid by S.........  .......     0
    Multiplied by: line 12(a) sec. 951 incl..  .......     0
    Divided by: line 10(b) e & p.............  .......     0
                                                       ---------
    Result...................................  .......  .......     0
  (d) Foreign income taxes deemed paid by S
   deemed paid by P that are allocable to S's
   g.l.i.:
    Line 7(b) taxes deemed paid by S.........  .......     6.25
    Multiplied by: line 12(b) sec. 951 incl..  .......    22.50
    Divided by: line 10(c) e & p.............  .......   112.50
                                                       ---------
    Result...................................  .......  .......     1.25
14. Dividends paid to P:
  (a) Dividends from S attributable to S's     .......     0
   previously taxed p.i......................
      Plus:
  (b) Dividends from S attributable to S's     .......    22.50
   previously taxed g.l.i....................
      Plus:
  (c) Dividends to which section 902(a)
   applies:
    (i) Consisting of S's earnings and          135.00
     profits attributable to T's previously
     taxed p.i...............................
      Plus:
    (ii) Consisting of S's earnings and          22.50
     profits attributable to T's previously
     taxed g.l.i.............................
      Plus:
    (iii) Consisting of S's other p.i.            0
     earnings and profits....................
      Plus:
    (iv) Consisting of S's other g.l.i.          67.50
     earnings and profits....................
                                              ---------
    (v) Total section 902 dividend...........  .......   225.00
  (d) Total dividends paid to P..............  .......  .......   247.50

[[Page 814]]

 
15. Foreign income taxes deemed paid by P
 under section 902 and section 960(a)(3) with
 respect to S:
  (a) Taxes paid by S deemed paid by P under
   section 902(a) with regard to S's p.i.:
    Line 9(a) taxes..........................  .......     0
    Multiplied by: line 14(c)(iii) div.......  .......     0
    Divided by: line 10(b) e & p.............  .......     0
                                                       ---------
    Result...................................  .......  .......     0
  (b) Taxes paid by S deemed paid by P under
   section 902(a) with regard to S's g.l.i.:
    Line 9(c) taxes..........................  .......    12.50
    Multiplied by: line 14(c)(iv) div........  .......    67.50
    Divided by: line 10(c) e & p.............  .......   112.50
                                                       ---------
    Result...................................  .......  .......     7.50
  (c) Taxes deemed paid by S deemed paid by P
   under section 902(a) with regard to S's
   p.i.:
    Line 7(a) deemed paid taxes..............  .......     0
    Multiplied by: line 14(c)(iii) div.......  .......     0
    Divided by: line 10(b) e & p.............  .......     0
                                                       ---------
    Result...................................  .......  .......     0
  (d) Taxes deemed paid by S deemed paid by P
   under section 902(a) with regard to S's
   g.l.i.:
    Line 7(b) deemed paid taxes..............  .......     6.25
    Multiplied by: line 14(c)(iv) div........  .......    67.50
    Divided by: line 10(c) e & p.............  .......   112.50
                                                       ---------
    Result...................................  .......  .......     3.75
  (e) Foreign income taxes paid by S under
   section 960(a)(3) deemed paid by P with
   regard to S's previously taxed p.i.:
    Line 9(b) taxes..........................  .......    15.00
    Multiplied by: line 14(c)(i) div.........  .......   135.00
    Divided by: line 11(b) e & p.............  .......   135.00
                                                       ---------
    Result...................................  .......  .......    15.00
  (f) Foreign income taxes paid by S under
   section 960(a)(3) deemed paid by P with
   regard to S's previously taxed g.l.i.:
    Line 9(d) taxes..........................  .......     2.50
    Multiplied by: line 14(c)(ii) div........  .......    22.50
    Divided by: line 11(c) e & p.............  .......    22.50
                                                       ---------
    Result...................................  .......  .......     2.50
  Summary:
    Total taxes deemed paid by P under
     section 960(a)(1) with respect to--
    Passive income of S and T included under
     section 951 in income of P:
      Line 5(a)..............................  .......    37.50
        Plus:
      Line 13(a).............................  .......     0
        Plus:
      Line 13(c).............................  .......     0
                                                       ---------
      Result.................................  .......    37.50
    General limitation income of S and T
     included under section 951 in income of
     P:
      Line 5(b)..............................  .......     6.25
        Plus:
      Line 13(b).............................  .......     2.50
        Plus:
      Line 13(d).............................  .......     1.25
                                                       ---------
      Result.................................  .......    10.00
                                                       =========
    Total deemed paid taxes under section      .......    47.50
     960(a)(1)...............................
    Total taxes deemed paid by P under         .......  .......    15.00
     section 902 and section 960(a)(3)
     attributable to passive income of S and
     T (line 15(e))..........................
    Total taxes deemed paid by P under
     section 902 and section 960(a)(3)
     attributable to general limitation
     income of S and T:
      Line 15(b).............................  .......     7.50
        Plus:
      Line 15(d).............................  .......     3.75
        Plus:
      Line 15(f).............................  .......     2.50
                                                       ---------
      Result.................................  .......    13.75
 


[T.D. 8214, 53 FR 27029, July 18, 1988, as amended by T.D. 8412, 57 FR 
20652, May 14, 1992; T.D. 9141, 69 FR 43308, July 20, 2004; T.D. 9260, 
71 FR 24533, Apr. 25, 2006]



Sec.  1.904-7  Transition rules.

    (a) Characterization of distributions and section 951(a)(1) (A) (ii) 
and (iii) and (B) inclusions of earnings of a controlled foreign 
corporation accumulated in taxable years beginning before January 1, 
1987, during taxable years of both the payor controlled foreign 
corporation and the recipient which begin after December 31, 1986--(1) 
Distributions and section 951(a)(1) (A) (ii) and (iii) and (B) 
inclusions. Earnings accumulated in taxable years beginning before 
January 1, 1987, by a foreign corporation that was a controlled foreign 
corporation when

[[Page 815]]

such earnings were accumulated are characterized in that foreign 
corporation's hands under section 904(d)(1)(A) (separate limitation 
interest income) or section 904(d)(1)(E) (general limitation income) 
(prior to their amendment by the Tax Reform Act of 1986 (the Act)) after 
application of the de minimis rule of former section 904(d)(3)(C) (prior 
to its amendment by the Act). When, in a taxable year after the 
effective date of the Act, earnings and profits attributable to such 
income are distributed to, or included in the gross income of, a United 
States shareholder under section 951(a)(1) (A) (ii) or (iii) or (B) 
(hereinafter in this section ``inclusions''), the ordering rules of 
section 904(d)(3)(D) and Sec.  1.904-5(c)(4) shall be applied in 
determining initially the character of the income of the distributee or 
United States shareholder. Thus, a proportionate amount of a 
distribution described in this paragraph initially will be characterized 
as separate limitation interest income in the hands of the distributee 
based on the ratio of the separate limitation interest earnings and 
profits out of which the dividend was paid to the total earnings and 
profits out of which the dividend was paid. The distribution or 
inclusions must then be recharacterized in the hands of the distributee 
or United States shareholder on the basis of the following principles:
    (i) Distributions and inclusions that initially are characterized as 
separate limitation interest income shall be treated as passive income;
    (ii) Distributions and inclusions that initially are characterized 
as old general limitation income shall be treated as general limitation 
income, unless the taxpayer establishes to the satisfaction of the 
Commissioner that the distribution or inclusion is attributable to:
    (A) Earnings and profits accumulated with respect to shipping 
income, as defined in section 904(d)(2)(D) and Sec.  1.904-4(f); or
    (B) In the case of a financial services entity, earnings and profits 
accumulated with respect to financial services income, as defined in 
section 904(d)(2)(C)(ii) and Sec.  1.904-4(e)(1); or
    (C) Earnings and profits accumulated with respect to high 
withholding tax interest, as defined in section 904(d)(2)(B) and Sec.  
1.904-4(d).
    (2) Limitation on establishing the character of earnings and 
profits. In order for a taxpayer to establish that distributions or 
inclusions that are attributable to general limitation earnings and 
profits of a particular taxable year beginning before January 1, 1987, 
are attributable to shipping, financial services or high withholding tax 
interest earnings and profits, the taxpayer must establish the amounts 
of foreign taxes paid or accrued with respect to income attributable to 
those earnings and profits that are to be treated as taxes paid or 
accrued with respect to shipping, financial services or high withholding 
tax interest income, as the case may be, under section 904(d)(2)(I). 
Conversely, in order for a taxpayer to establish the amounts of general 
limitation taxes paid or accrued in a taxable year beginning before 
January 1, 1987, that are to be treated as taxes paid or accrued with 
respect to shipping, financial services or high withholding tax interest 
income, as the case may be, the taxpayer must establish the amount of 
any distributions or inclusions that are attributable to shipping, 
financial services or high withholding tax interest earnings and 
profits. For purposes of establishing the amounts of general limitation 
taxes that are to be treated as taxes paid or accrued with respect to 
shipping, financial services or high withholding tax interest income, 
the principles of Sec.  1.904-6 shall be applied.
    (b) Application of look-through rules to distributions (including 
deemed distributions) and payments by an entity to a recipient when 
one's taxable year begins before January 1, 1987 and the other's taxable 
year begins after December 31, 1986--(1) In general. This paragraph 
provides rules relating to the application of section 904(d)(3) to 
payments made by a controlled foreign corporation or other entity to 
which the look-through rules apply during its taxable year beginning 
after December 31, 1986, but received in a taxable year of the recipient 
beginning before January 1, 1987. The paragraph also provides rules 
relating to distributions (including deemed distributions) or payments 
made by a controlled foreign corporation to which

[[Page 816]]

section 904(d)(3) (as in effect before the Act) applies during its 
taxable year beginning before January 1, 1987, and received in a taxable 
year of the recipient beginning after December 31, 1986.
    (2) Payor of interest, rents, or royalties is subject to the Act and 
recipient is not subject to the Act. If interest, rents, or royalties 
are paid or accrued on or after the start of the payor's first taxable 
year beginning on or after January 1, 1987, but prior to the start of 
the recipient's first taxable year beginning on or after January 1, 
1987, such interest, rents, or royalties shall initially be 
characterized in accordance with section 904(d)(3) and Sec.  1.904-5. To 
the extent that interest payments in the hands of the recipient are 
initially characterized as passive income under these rules, they will 
be treated as separate limitation interest in the hands of the 
recipient. To the extent that rents or royalties in the hands of the 
recipient are initially characterized as passive income under these 
rules, they will be recharacterized as general limitation income in the 
hands of the recipient.
    (3) Recipient of interest, rents, or royalties is subject to the Act 
and payor is not subject to the Act. If interest, rents, or royalties 
are paid or accrued before the start of the payor's first taxable year 
beginning on or after January 1, 1987, but on or after the start of the 
recipient's first taxable year beginning after January 1, 1987, the 
income in the recipient's hands shall be initially characterized in 
accordance with former section 904(d)(3) (prior to its amendment by the 
Act). To the extent interest income is characterized as separate 
limitation interest income under these rules, that income shall be 
recharacterized as passive income in the hands of the recipient. Rents 
or royalties will be characterized as general limitation income.
    (4) Recipient of dividends and subpart F inclusions is subject to 
the Act and payor is not subject to the Act. If dividends are paid or 
accrued or section 951(a)(1) inclusions occur before the start of the 
first taxable year of a controlled foreign corporation beginning on or 
after January 1, 1987, but on or after the start of the first taxable 
year of the distributee or United States shareholder beginning on or 
after January 1, 1987, the dividends or section 951(a)(1) inclusions in 
the hands of the distributee or United States shareholder shall be 
initially characterized in accordance with former section 904(d)(3) 
(including the ordering rules of section 904(d)(3)(A). Therefore, under 
former section 904(d)(3)(A), dividends are considered to be paid or 
derived first from earnings attributable to separate limitation interest 
income. To the extent the dividend or section 951(a)(1) inclusion is 
initially characterized under these rules as separate limitation 
interest income in the hands of the distributee or United States 
shareholder, the dividend or section 951(a)(1) inclusion shall be 
recharacterized as passive income in the hands of the distributee or 
United States shareholder. The portion, if any, of the dividend or 
section 951(a)(1) inclusion that is not characterized as passive income 
shall be characterized according to the rules in paragraph (a) of this 
section. Therefore, a taxpayer may establish that income that would 
otherwise be characterized as general limitation income is shipping or 
financial services income. Rules comparable to the rules contained in 
section 904(d)(2)(I) shall be applied for purposes of characterizing 
foreign taxes deemed paid with respect to distributions and section 
951(a)(1) inclusions covered by this paragraph (b)(4).
    (5) Examples. The following examples illustrate the application of 
this paragraph (b).

    Example 1. P is a domestic corporation that is a fiscal year 
taxpayer (July 1-June 30). S, a controlled foreign corporation, is a 
wholly-owned subsidiary of P and has a calendar taxable year. On June l, 
1987, S makes a $100 interest payment to P. Because the payment is made 
after January 1, 1987 (the first day of S's first taxable year beginning 
after December 31, 1986), the look-through rules of section 904(d)(3) 
apply to characterize the payment made by S. To the extent, however, 
that the interest payment to P is allocable to passive income earned by 
S, the payment will be included in P's separate limitation for interest 
as provided in former section 904(d)(1)(A).
    Example 2. P is a domestic corporation that is a calendar year 
taxpayer. S, a controlled foreign corporation, is a wholly-owned 
subsidiary of P and has a July 1-June 30 taxable year. On June 1, 1987, 
S makes a $100 interest

[[Page 817]]

payment to P. Because the payment is made prior to July l, 1987 (the 
first day of S's first taxable year beginning after December 31, 1986), 
the look-through rules of section 904(d)(3) do not apply. Assume that, 
under former section 904(d)(3), the interest payment would be 
characterized as separate limitation interest income. For purposes of 
determining P's foreign tax credit limitation, the interest payment will 
be passive income as provided in section 904(d)(1)(A).
    Example 3. The facts are the same as in Example 2 except that on 
June 1, 1987, S makes a $100 dividend distribution to P. Because the 
dividend is paid prior to July l, 1987 (the first day of S's first 
taxable year beginning after December 31, 1986), the look-through rules 
of section 904(d)(3) do not apply. Assume that, under former section 
904(d)(3), S's earnings and profits for the taxable year ending June 30, 
1987, consist of $200 of earnings attributable to general limitation 
income and $75 of earnings attributable to separate limitation interest 
income. The portion of the dividend that is attributable to S's separate 
limitation interest and is treated as separate limitation interest 
income under former section 904(d)(3) is $75. The remaining $25 of the 
dividend is treated as general limitation income under former section 
904(d)(3). For purposes of determining P's foreign tax credit 
limitation, $75 of the dividend will be recharacterized as passive 
income. The remaining $25 of the dividend will be characterized as 
general limitation income, unless P can establish that the general 
limitation portion is attributable to shipping or financial services 
income.

    (c) Installment sales. If income is received or accrued by any 
person on or after the effective date of the Act (as applied to such 
person) that is attributable to a disposition of property by such person 
with regard to which section 453 or section 453A applies (installment 
sale treatment), and the disposition occurred prior to the effective 
date of the Act, that income shall be characterized according to the 
rules of Sec. Sec.  1.904-4 through 1.904-7.
    (d) Special effective date for high withholding tax interest earned 
by persons with respect to qualified loans described in section 
1201(e)(2) of the Act. For purposes of characterizing interest received 
or accrued by any person, the definition of high withholding tax 
interest in Sec.  1.904-4(d) shall apply to taxable years beginning 
after December 31, 1986, except as provided in section 1201(e)(2) of the 
Act.
    (e) Treatment of certain recapture income. Except as otherwise 
provided, if income is subject to recapture under section 585(c), the 
income shall be general limitation income. If the income is recaptured 
by a taxpayer that is a financial services entity, the entity may treat 
the income as financial services income if the taxpayer establishes to 
the satisfaction of the Secretary that the deduction to which the 
recapture amount is attributable is allocable to financial services 
income. If the taxpayer establishes to the satisfaction of the Secretary 
that the deduction to which the recapture amount is attributable is 
allocable to high-withholding tax interest income, the taxpayer may 
treat the income as high-withholding tax interest.
    (f) Treatment of non-look-through pools of a noncontrolled section 
902 corporation or a controlled foreign corporation in post-2002 taxable 
years--(1) Definition of non-look-through pools. The term non-look-
through pools means the pools of post-1986 undistributed earnings (as 
defined in Sec.  1.902-1(a)(9)) that were accumulated, and post-1986 
foreign income taxes (as defined in Sec.  1.902-1(a)(8)) paid, accrued, 
or deemed paid, in and after the first taxable year in which the foreign 
corporation had a domestic shareholder (as defined in Sec.  1.902-
1(a)(1)) but before any such shareholder was eligible for look-through 
treatment with respect to dividends from the foreign corporation.
    (2) Treatment of non-look-through pools of a noncontrolled section 
902 corporation. Any undistributed earnings in the non-look-through pool 
that were accumulated in taxable years beginning before January 1, 2003, 
by a noncontrolled section 902 corporation as of the last day of the 
corporation's last taxable year beginning before January 1, 2003, shall 
be treated in taxable years beginning after December 31, 2002, as if 
they were accumulated during a period when a dividend paid by the 
noncontrolled section 902 corporation to a domestic shareholder would 
have been eligible for look-through treatment under section 904(d)(4) 
and Sec.  1.904-5. Post-1986 foreign income taxes paid, accrued or 
deemed paid with respect to such earnings shall be treated as if they 
were paid, accrued or deemed paid during a period when the related 
earnings were eligible for look-through treatment.

[[Page 818]]

Any such earnings and taxes in the non-look-through pools shall 
constitute the opening balance of the noncontrolled section 902 
corporation's pools of post-1986 undistributed earnings and post-1986 
foreign income taxes on the first day of the foreign corporation's first 
taxable year beginning after December 31, 2002, in accordance with the 
rules of paragraph (f)(4) of this section.
    (3) Treatment of non-look-through pools of a controlled foreign 
corporation. A controlled foreign corporation may have non-look-through 
pools of post-1986 undistributed earnings and post-1986 foreign income 
taxes that were accumulated and paid in a taxable year beginning before 
January 1, 2003, in which it was a noncontrolled section 902 
corporation. Any such undistributed earnings in the non-look-through 
pool as of the last day of the controlled foreign corporation's last 
taxable year beginning before January 1, 2003, shall be treated in 
taxable years beginning on or after January 1, 2003, as if they were 
accumulated during a period when a dividend paid by the controlled 
foreign corporation out of such earnings, or an amount included in the 
gross income of a United States shareholder under section 951 that is 
attributable to such earnings, would have been eligible for look-through 
treatment. Any post-1986 foreign income taxes paid, accrued, or deemed 
paid with respect to such earnings shall be treated in taxable years 
beginning on or after January 1, 2003, as if they were paid, accrued, or 
deemed paid during a period when a dividend or inclusion out of such 
earnings would have been eligible for look-through treatment. Any such 
undistributed earnings and taxes in the non-look-through pools shall be 
added to the pools of post-1986 undistributed earnings and post-1986 
foreign income taxes of the controlled foreign corporation in the 
appropriate separate categories on the first day of the controlled 
foreign corporation's first taxable year beginning after December 31, 
2002, in accordance with the rules of paragraph (f)(4) of this section. 
Similar rules shall apply to characterize any previously-taxed earnings 
and profits described in section 959(c)(1)(A) that are attributable to 
earnings in the non-look-through pool.
    (4) Substantiation of look-through character of undistributed 
earnings and taxes in a non-look-through pool--(i) Reconstruction of 
earnings and taxes pools. In order to substantiate the look-through 
characterization of undistributed earnings and taxes in a non-look-
through pool under section 904(d)(4) and Sec.  1.904-5, the taxpayer 
shall make a reasonable, good-faith effort to reconstruct the non-look-
through pools of post-1986 undistributed earnings and post-1986 foreign 
income taxes (and previously-taxed earnings and profits, if any) on a 
look-through basis for each year in the non-look-through period, 
beginning with the first taxable year in which post-1986 undistributed 
earnings were accumulated in the non-look-through pool. Reconstruction 
shall be based on reasonably available books and records and other 
relevant information, and it must account for earnings distributed and 
taxes deemed paid in these years as if they were distributed and deemed 
paid pro rata from the amounts that were added to the non-look-through 
pools during the non-look-through period.
    (ii) Safe harbor method. A taxpayer that was eligible for look-
through treatment with respect to a distribution from the foreign 
corporation in the taxpayer's first taxable year ending after the first 
day of the foreign corporation's first taxable year beginning after 
December 31, 2002, may allocate the undistributed earnings and taxes in 
the non-look-through pools to the foreign corporation's look-through 
pools of post-1986 undistributed earnings and post-1986 foreign income 
taxes in other separate categories on the first day of the foreign 
corporation's first taxable year beginning after December 31, 2002, in 
the same percentages as the taxpayer properly characterizes the stock of 
the foreign corporation in the separate categories for purposes of 
apportioning the taxpayer's interest expense in its first taxable year 
ending after the first day of the foreign corporation's first taxable 
year beginning after December 31, 2002, under Sec.  1.861-12T(c)(3) or 
Sec.  1.861-12(c)(4), as the case may be. If the modified gross income 
method described in Sec.  1.861-9T(j) is used

[[Page 819]]

to apportion interest expense of the foreign corporation in its first 
taxable year beginning after December 31, 2002, the taxpayer must 
allocate the undistributed earnings and taxes in the non-look-through 
pools to the foreign corporation's look-through pools of post-1986 
undistributed earnings and post-1986 foreign income taxes based on an 
average of the foreign corporation's modified gross income ratios for 
the foreign corporation's taxable years beginning in 2003 and 2004. A 
taxpayer may also use the safe harbor method described in this paragraph 
(f)(4)(ii) to allocate to separate categories any previously-taxed 
earnings and profits described in section 959(c)(1)(A) that are 
attributable to the non-look-through pool. A taxpayer may choose to use 
the safe harbor method on either a timely filed or amended tax return or 
during an audit. However, a taxpayer that uses the safe harbor method on 
an amended return or in the course of an audit must make appropriate 
adjustments to eliminate any duplicate benefits arising from application 
of the safe harbor method to taxable years that are not open for 
assessment. A taxpayer's choice to use the safe harbor method is 
evidenced by employing the method. The taxpayer need not file any 
separate statement.
    (iii) Inadequate substantiation. If a taxpayer does not use, or is 
ineligible to use, the safe harbor method described in paragraph 
(f)(4)(ii) of this section and the Commissioner determines that the 
look-through characterization of earnings and taxes in the non-look-
through pools cannot reasonably be determined based on the available 
information, the Commissioner shall allocate the undistributed earnings 
and taxes in the non-look-through pools to the foreign corporation's 
passive category.
    (iv) Examples. The following examples illustrate the application of 
this paragraph (f)(4):

    Example 1. P, a domestic corporation, has owned 50 percent of the 
voting stock of S, a foreign corporation, at all times since January 1, 
1987, and S has been a noncontrolled section 902 corporation with 
respect to P since that date. P and S use the calendar year as their 
U.S. taxable year. The first year in which post-1986 undistributed 
earnings were accumulated in the non-look-through pool of S was 1987. As 
of December 31, 2002, S had 200u of post-1986 undistributed earnings and 
$100 of post-1986 foreign income taxes in its non-look-through pools. P 
does not use the safe harbor method under paragraph (f)(4)(ii) of this 
section to allocate the earnings and taxes in the non-look-through pools 
to S's other separate categories and does not attempt to substantiate 
the look-through characterization of S's non-look-through pools. The 
Commissioner, however, reasonably determines, based on information used 
to characterize S's stock for purposes of apportioning P's interest 
expense in P's 2003 and 2004 taxable years, that 100u of the earnings 
and all $100 of the taxes in the non-look-through pools are properly 
assigned on a look-through basis to the general limitation category, and 
100u of earnings and no taxes are properly assigned on a look-through 
basis to the passive category. Therefore, in accordance with the 
Commissioner's look-through characterization of the earnings and taxes 
in S's non-look-through pools, on January 1, 2003, S has 100u of post-
1986 undistributed earnings and $100 of post-1986 foreign income taxes 
in the general limitation category and 100u of post-1986 undistributed 
earnings and no post-1986 foreign income taxes in the passive category.
    Example 2. The facts are the same as in Example 1, except that the 
Commissioner cannot reasonably determine, based on the available 
information, the proper look-through characterization of the 200u of 
undistributed earnings and $100 of taxes in S's non-look-through pools. 
Accordingly, the Commissioner will assign such earnings and taxes to the 
passive category, so that as of January 1, 2003, S has 200u of post-1986 
undistributed earnings and $100 of post-1986 foreign income taxes in the 
passive category, and the Commissioner will treat S as a passive 
category asset for purposes of apportioning P's interest expense.

    (5) Treatment of a deficit accumulated in a non-look-through pool. 
Any deficit in the non-look-through pool of a noncontrolled section 902 
corporation or a controlled foreign corporation as of the end of its 
last taxable year beginning before January 1, 2003, shall be treated in 
taxable years beginning after December 31, 2002, as if the deficit had 
been accumulated during a period in which a dividend paid by the foreign 
corporation would have been eligible for look-through treatment. In the 
case of a noncontrolled section 902 corporation, the deficit and taxes, 
if any, in the non-look-through pools shall constitute the opening 
balance of the look-

[[Page 820]]

through pools of post-1986 undistributed earnings and post-1986 foreign 
income taxes of the noncontrolled section 902 corporation in the 
appropriate separate categories on the first day of its first taxable 
year beginning after December 31, 2002. In the case of a controlled 
foreign corporation, the deficit and taxes, if any, in the non-look-
through pools shall be added to the balance of the look-through pools of 
post-1986 undistributed earnings and post-1986 foreign income taxes of 
the controlled foreign corporation in the appropriate separate 
categories on the first day of its first taxable year beginning after 
December 31, 2002. The taxpayer must substantiate the look-through 
characterization of the deficit and taxes in accordance with the rules 
of paragraph (f)(4) of this section. If a taxpayer does not use the safe 
harbor method described in paragraph (f)(4)(ii) of this section and the 
Commissioner determines that the look-through characterization of the 
deficit and taxes cannot reasonably be determined based on the available 
information, the Commissioner shall allocate the deficit and taxes, if 
any, in the non-look-through pools to the foreign corporation's passive 
category. If, as of the end of a taxable year beginning after December 
31, 2002, in which it pays a dividend, the foreign corporation has zero 
or a deficit in post-1986 undistributed earnings (taking into account 
any earnings or a deficit accumulated in taxable years beginning before 
January 1, 2003), the deficit in post-1986 undistributed earnings shall 
be carried back to reduce pre-1987 accumulated profits, if any, on a 
last-in first-out basis. See Sec.  1.902-2(a)(1). If, as of the end of a 
taxable year beginning after December 31, 2002, in which the foreign 
corporation pays a dividend out of current earnings and profits, it has 
zero or a deficit in post-1986 undistributed earnings (taking into 
account any earnings or a deficit accumulated in taxable years beginning 
before January 1, 2003), and the sum of current plus accumulated 
earnings and profits is zero or less than zero, no foreign taxes shall 
be deemed paid with respect to the dividend. See Sec.  1.902-1(b)(4).
    (6) Treatment of pre-1987 accumulated profits. Any pre-1987 
accumulated profits (as defined in Sec.  1.902-1(a)(10)) of a controlled 
foreign corporation or noncontrolled section 902 corporation shall be 
treated in taxable years beginning after December 31, 2002, as if they 
were accumulated during a period in which a dividend paid by the foreign 
corporation would have been eligible for look-through treatment. Any 
pre-1987 foreign income taxes (as defined in Sec.  1.902-1(a)(10)(iii)) 
shall be treated as if they were paid, accrued or deemed paid during a 
year when a dividend out of the related pre-1987 accumulated profits 
would have been eligible for look-through treatment. The taxpayer must 
substantiate the look-through characterization of the pre-1987 
accumulated profits and pre-1987 foreign income taxes in accordance with 
the rules of paragraph (f)(4) of this section. If a taxpayer does not 
use, or is ineligible to use, the safe harbor method described in 
paragraph (f)(4)(ii) of this section and the Commissioner determines 
that the look-through characterization of the pre-1987 accumulated 
profits and pre-1987 foreign income taxes cannot reasonably be 
determined based on the available information, the pre-1987 accumulated 
profits and pre-1987 foreign income taxes shall be allocated to the 
foreign corporation's passive category.
    (7) Treatment of post-1986 undistributed earnings or a deficit of a 
controlled foreign corporation attributable to dividends from a 
noncontrolled section 902 corporation paid in taxable years beginning 
before January 1, 2003--(i) Look-through treatment of post-1986 
undistributed earnings at controlled foreign corporation level. 
Dividends paid by a noncontrolled section 902 corporation to a 
controlled foreign corporation in post-1986 taxable years of the 
noncontrolled section 902 corporation beginning before January 1, 2003, 
were assigned to a separate category for dividends from that 
noncontrolled section 902 corporation. Beginning on the first day of the 
controlled foreign corporation's first taxable year beginning on or 
after the first day of the lower-tier corporation's first taxable year 
beginning after December 31, 2002, any post-1986 undistributed earnings, 
or previously-taxed earnings and profits described in section 959(c)(1) 
or (2), of the controlled foreign corporation in such a separate 
category shall

[[Page 821]]

be treated as if they were accumulated during a period when a dividend 
paid by the noncontrolled section 902 corporation would have been 
eligible for look-through treatment. Any post-1986 foreign income taxes 
in such a separate category shall also be treated as if they were paid, 
accrued or deemed paid during a period when such a dividend would have 
been eligible for look-through treatment. Any such post-1986 
undistributed earnings and post-1986 foreign income taxes in a separate 
category for dividends from a noncontrolled section 902 corporation 
shall be added to the opening balance of the controlled foreign 
corporation's look-through pools of post-1986 undistributed earnings and 
post-1986 foreign income taxes in the appropriate separate categories on 
the first day of the controlled foreign corporation's first taxable year 
beginning on or after the first day of the lower-tier corporation's 
first taxable year beginning after December 31, 2002. Any section 
952(c)(2) recapture account with respect to such a separate category 
shall be allocated in the same manner as the associated post-1986 
undistributed earnings. The taxpayer must substantiate the look-through 
characterization of such earnings and taxes in accordance with the rules 
of paragraph (f)(7)(iii) of this section.
    (ii) Look-through treatment of deficit in post-1986 undistributed 
earnings at controlled foreign corporation level. If a controlled 
foreign corporation has a deficit in a separate category for dividends 
from a lower-tier noncontrolled section 902 corporation that is a member 
of the controlled foreign corporation's qualified group as defined in 
section 902(b)(2), such deficit shall be treated in taxable years of the 
upper-tier corporation beginning on or after the first day of the lower-
tier corporation's first taxable year beginning after December 31, 2002, 
as if the deficit had been accumulated during a period in which a 
dividend from the lower-tier corporation would have been eligible for 
look-through treatment. Any post-1986 foreign income taxes in the 
separate category for dividends from the noncontrolled section 902 
corporation shall also be treated as if they were paid, accrued or 
deemed paid during a period when the dividends were eligible for look-
through treatment. The deficit and related post-1986 foreign income 
taxes, if any, shall be added to the opening balance of the controlled 
foreign corporation's look-through pools of post-1986 undistributed 
earnings and post-1986 foreign income taxes in the appropriate separate 
categories on the first day of the controlled foreign corporation's 
first taxable year beginning on or after the first day of the lower-tier 
corporation's first taxable year beginning after December 31, 2002. The 
taxpayer must substantiate the look-through characterization of the 
deficit and taxes in accordance with the rules of paragraph (f)(7)(iii) 
of this section.
    (iii) Substantiation required for look-through treatment. The 
taxpayer must substantiate the look-through characterization of post-
1986 undistributed earnings, previously-taxed earnings and profits, or a 
deficit in post-1986 undistributed earnings in a separate category for 
dividends paid by a noncontrolled section 902 corporation in taxable 
years beginning before January 1, 2003, by making a reasonable, good-
faith effort to reconstruct the earnings (or deficit) and taxes in the 
separate category at the level of the controlled foreign corporation on 
a look-through basis, in accordance with the principles of paragraph 
(f)(4)(i) of this section. Alternatively, the taxpayer may allocate the 
earnings (or deficit) and taxes to the controlled foreign corporation's 
look-through pools under the safe harbor method described in paragraph 
(f)(4)(ii) of this section at the level of the controlled foreign 
corporation. If the taxpayer uses the safe harbor method, the earnings 
(or deficit) and taxes shall be allocated to the controlled foreign 
corporation's look-through pools in the appropriate separate categories 
on the first day of the controlled foreign corporation's first taxable 
year beginning on or after the first day of the lower-tier corporation's 
first taxable year beginning after December 31, 2002. The allocation 
shall be made in the same percentages as the controlled foreign 
corporation would properly characterize the stock of the lower-tier 
noncontrolled section 902 corporation in the separate categories

[[Page 822]]

for purposes of apportioning the controlled foreign corporation's 
interest expense in its first taxable year ending after the first day of 
the noncontrolled section 902 corporation's first taxable year beginning 
after December 31, 2002. Under Sec.  1.861-12T(c)(3), the apportionment 
ratios properly used by the controlled foreign corporation are in turn 
based on the apportionment ratios properly used by the noncontrolled 
section 902 corporation to apportion its interest expense in its first 
taxable year beginning after December 31, 2002. In the case of a 
taxpayer that uses the safe harbor method where the lower-tier 
noncontrolled section 902 corporation uses the modified gross income 
method described in Sec.  1.861-9T(j) to apportion interest expense for 
its first taxable year beginning after December 31, 2002, earnings (or a 
deficit) and taxes in the separate category for dividends from the 
noncontrolled section 902 corporation shall be allocated to the look-
through pools based on the average of the noncontrolled section 902 
corporation's modified gross income ratios for its taxable years 
beginning in 2003 and 2004. In the case of a controlled foreign 
corporation that has in its qualified group a chain of lower-tier 
noncontrolled section 902 corporations, the safe harbor applies first to 
characterize the stock of the third-tier corporation and then to 
characterize the stock of the second-tier corporation. Where a taxpayer 
uses the safe harbor method with respect to a lower-tier noncontrolled 
section 902 corporation with respect to which the taxpayer did not meet 
the requirements of section 902(a) as of the end of the upper-tier 
controlled foreign corporation's last taxable year beginning before 
January 1, 2003, the earnings (or deficit) and taxes in the separate 
category for dividends from the lower-tier corporation shall be 
allocated to the upper-tier corporation's look-through pools in the 
separate categories in the same percentages as the stock of the lower-
tier corporation would have been characterized for purposes of 
apportioning the upper-tier corporation's interest expense in the last 
year the taxpayer met the ownership requirements of section 902(a) with 
respect to the lower-tier corporation if the look-through rules had 
applied in that year. If a taxpayer does not use the safe harbor method 
described in this paragraph (f)(7)(iii), and the Commissioner determines 
that the look-through characterization of the earnings (or deficit) and 
taxes cannot reasonably be determined based on the available 
information, the Commissioner shall allocate the earnings (or deficit) 
and associated foreign income taxes to the controlled foreign 
corporation's passive category.
    (8) Treatment of distributions received by an upper-tier corporation 
from a lower-tier noncontrolled section 902 corporation, including when 
the corporations do not have the same taxable years--(i) Rule. In the 
case of dividends paid by a lower-tier noncontrolled section 902 
corporation to an upper-tier corporation where both are members of the 
same qualified group as defined in section 902(b)(2), the following 
rules apply. Dividends paid by the lower-tier corporation in taxable 
years beginning before January 1, 2003, are assigned to a separate 
category for dividends from that corporation, regardless of whether the 
corresponding taxable year of the recipient corporation began after 
December 31, 2002. Post-1986 undistributed earnings, previously-taxed 
earnings and profits, and post-1986 foreign income taxes in such a 
separate category shall be treated, beginning on the first day of the 
upper-tier corporation's first taxable year beginning on or after the 
first day of the lower-tier corporation's first taxable year beginning 
after December 31, 2002, as if they were accumulated during a period 
when a dividend paid by the lower-tier corporation would have been 
eligible for look-through treatment under section 904(d)(4) and Sec.  
1.904-5. Dividends paid by a lower-tier corporation in taxable years 
beginning after December 31, 2002, are eligible for look-through 
treatment when paid, without regard to whether the corresponding taxable 
year of the recipient upper-tier corporation began after December 31, 
2002.
    (ii) Example. The following example illustrates the application of 
paragraph (f) of this section:

    Example. M, a domestic corporation, has directly owned 50 percent of 
the stock of foreign corporation X, and X has directly owned 50 percent 
of the stock of foreign corporation

[[Page 823]]

Y, at all times since X and Y were organized on January 1, 1990. 
Accordingly, X and Y are noncontrolled section 902 corporations with 
respect to M, and X and Y are members of the same qualified group. M and 
Y use the calendar year as their U.S. taxable year, and X uses a taxable 
year beginning on July 1. Under Sec.  1.904-4(g) and paragraph (f)(10) 
of this section, a dividend paid to M by X on January 15, 2003 (during 
X's last pre-2003 taxable year) is not eligible for look-through 
treatment in 2003. However, under Sec.  1.861-12(c)(4), M will 
characterize the stock of X on a look-through basis for purposes of 
interest expense apportionment in its 2003 taxable year. Under Sec.  
1.904-2(h)(1), any unused foreign taxes in M's separate category for 
dividends from X will be carried over to M's other separate categories 
on a look-through basis for M's taxable years beginning on and after 
January 1, 2004. Under paragraph (f)(2) of this section, any 
undistributed earnings and taxes in X's non-look-through pools will be 
allocated to X's other separate categories on July 1, 2003. Under Sec.  
1.904-5(i)(4) and paragraphs (f)(8)(i) and (f)(10) of this section, a 
dividend paid to X by Y on January 15, 2003 (during Y's first post-2002 
taxable year) is eligible for look-through treatment when paid, 
notwithstanding that it is received in a pre-2003 taxable year of X.

    (9) Election to apply pre-AJCA rules to 2003 and 2004 taxable 
years--(i) Definition. The term single category for dividends from all 
noncontrolled section 902 corporations means the separate category 
described in section 904(d)(1)(E) as in effect for taxable years 
beginning after December 31, 2002, and prior to its repeal by the 
American Jobs Creation Act (AJCA), Public Law 108-357, 118 Stat. 1418 
(October 22, 2004).
    (ii) Time, manner, and form of election. A taxpayer may elect not to 
apply the provisions of section 403 of the AJCA and to apply the rules 
of this paragraph (f)(9) to taxable years of noncontrolled section 902 
corporations beginning after December 31, 2002, and before January 1, 
2005, without regard to whether the corresponding taxable years of the 
taxpayer or any upper-tier corporation begin before or after such dates. 
A taxpayer shall be eligible to make such an election provided that--
    (A) The taxpayer's tax liability as shown on an original or amended 
tax return for each of its affected taxable years is consistent with the 
rules of this paragraph (f)(9), the guidance set forth in Notice 2003-5 
(2003-1 CB 294) (see Sec.  601.601(d)(2) of this chapter), and the 
principles of Sec.  1.861-12(c)(4) for each such year for which the 
statute of limitations does not preclude the filing of an amended 
return;
    (B) The taxpayer makes appropriate adjustments to eliminate any 
duplicate benefits arising from the application of this paragraph (f)(9) 
to taxable years that are not open for assessment; and
    (C) The taxpayer attaches a statement to its next tax return for 
which the due date (with extensions) is more than 90 days after April 
25, 2006, indicating that the taxpayer elects not to apply the 
provisions of section 403 of the AJCA to taxable years of its 
noncontrolled section 902 corporations beginning in 2003 and 2004, and 
that the taxpayer has filed original returns or will file amended 
returns reflecting tax liabilities for each affected year that satisfy 
the requirements described in this paragraph (f)(9)(ii).
    (iii) Treatment of non-look-through pools in taxable years beginning 
after December 31, 2004. Undistributed earnings (or a deficit) and taxes 
in the non-look-through pools of a controlled foreign corporation or a 
noncontrolled section 902 corporation as of the end of its last taxable 
year beginning before January 1, 2005, shall be treated in taxable years 
beginning after December 31, 2004, as if they were accumulated and paid 
during a period in which a distribution out of earnings in the non-look-
through pool would have been eligible for look-through treatment. Such 
earnings (or deficit) and taxes shall be added to the foreign 
corporation's pools of post-1986 undistributed earnings and post-1986 
foreign income taxes in the appropriate separate categories on the first 
day of the foreign corporation's first taxable year beginning after 
December 31, 2004. In accordance with the principles of paragraph (f)(4) 
of this section, the taxpayer must reconstruct the non-look-through 
pools or, if the taxpayer chooses to use the safe harbor method, 
allocate the earnings and taxes in the non-look-through pools to the 
foreign corporation's look-through pools in the appropriate separate 
categories on the first day of the foreign corporation's first taxable 
year beginning after December 31, 2004. Under the safe harbor method, 
this allocation is made in the

[[Page 824]]

same percentages as the taxpayer properly characterized the stock of the 
foreign corporation for purposes of apportioning the taxpayer's interest 
expense in the taxpayer's first taxable year ending after the first day 
of the foreign corporation's first taxable year beginning after December 
31, 2002. See Sec.  1.861-12T(c)(3) and Sec.  1.861-12(c)(4). If a 
taxpayer does not use the safe harbor method described in paragraph 
(f)(4)(ii) of this section and the Commissioner determines that the 
look-through characterization of the earnings (or deficit) and taxes 
cannot reasonably be determined based on the available information, the 
earnings (or deficit) and taxes shall be allocated to the foreign 
corporation's passive category.
    (iv) Carryover of unused foreign tax. To the extent that a taxpayer 
has unused foreign taxes in the single category for dividends from all 
noncontrolled section 902 corporations, such taxes shall be carried 
forward to the appropriate separate categories in the taxpayer's taxable 
years beginning on or after the first day of the relevant noncontrolled 
section 902 corporation's first taxable year beginning after December 
31, 2004. Such unused taxes shall be carried forward in the same manner 
as Sec.  1.904-2(h)(1) provides that unused foreign taxes in the 
separate categories for dividends from each noncontrolled section 902 
corporation are carried over to taxable years beginning on or after the 
first day of the noncontrolled section 902 corporation's first taxable 
year beginning after December 31, 2002, in the case of a taxpayer that 
does not make the election under this paragraph (f)(9). The electing 
taxpayer shall determine which noncontrolled section 902 corporations 
paid the dividends to which the unused foreign taxes are attributable 
and assign the taxes to the appropriate separate categories as if such 
dividends had been eligible for look-through treatment when paid. 
Accordingly, the taxpayer must substantiate the look-through 
characterization of the unused foreign taxes in accordance with 
paragraph (f)(4) of this section by reconstructing the non-look-through 
pools or, if the taxpayer uses the safe harbor method, by allocating the 
unused foreign taxes to other separate categories in the same 
percentages as the taxpayer properly characterized the stock of the 
noncontrolled section 902 corporation for purposes of apportioning the 
taxpayer's interest expense for its first taxable year ending after the 
first day of the noncontrolled section 902 corporation's first taxable 
year beginning after December 31, 2002. The rule described in this 
paragraph (f)(9)(iv) shall apply only to unused foreign taxes 
attributable to dividends out of earnings that were accumulated by 
noncontrolled section 902 corporations in taxable years of such 
corporations beginning before January 1, 2003, because only unused 
foreign taxes attributable to distributions out of pre-2003 earnings are 
included in the single category for dividends from all noncontrolled 
section 902 corporations. To the extent that unused foreign taxes 
carried forward to the single category for dividends from all 
noncontrolled section 902 corporations under the rules of Notice 2003-5 
were either absorbed by low-taxed dividends paid by noncontrolled 
section 902 corporations out of the non-look-through pool in taxable 
years of such corporations beginning in 2003 or 2004, or expired unused, 
the amount of taxes carried forward to the separate categories on a 
look-through basis will be smaller than the aggregate amount of taxes 
initially carried forward to the single category for dividends from all 
noncontrolled section 902 corporations. In this case, the unused foreign 
taxes arising in each taxable year shall be deemed attributable to each 
noncontrolled section 902 corporation in the same ratio as the dividends 
included in the separate category that were paid by such corporation in 
such year bears to all such dividends paid by all noncontrolled section 
902 corporations in such year. Unused foreign taxes carried forward from 
the separate categories for dividends from each noncontrolled section 
902 corporation to the single category for dividends from all 
noncontrolled section 902 corporations will similarly be deemed to have 
been utilized on a pro rata basis. The remaining unused foreign taxes 
are then assigned to the appropriate separate categories under the rules 
of paragraph (f)(4) of this section. Unused foreign taxes shall be 
treated

[[Page 825]]

as allocable to general category income to the extent that such taxes 
would otherwise have been allocable to passive income (based on 
reconstructed pools or the safe harbor method), or to the extent that, 
under paragraph (f)(4)(iii) of this section, the Commissioner determines 
that the look-through characterization cannot reasonably be determined 
based on the available information.
    (v) Carryback of unused foreign tax. To the extent that a taxpayer 
has unused foreign taxes attributable to a dividend paid by a 
noncontrolled section 902 corporation that was eligible for look-through 
treatment under section 904(d)(4) and Sec.  1.904-5, any such unused 
foreign taxes shall be carried back to prior taxable years within the 
same separate category and not to the single category for dividends from 
all noncontrolled section 902 corporations or any separate category for 
dividends from a noncontrolled section 902 corporation. See Notice 2003-
5 for rules relating to the carryback of unused foreign taxes in the 
single category for dividends from all noncontrolled section 902 
corporations.
    (vi) Recapture of overall foreign loss or separate limitation loss 
in the single category for dividends from all noncontrolled section 902 
corporations. To the extent that a taxpayer has a balance in a separate 
limitation loss or overall foreign loss account in the single category 
for dividends from all noncontrolled section 902 corporations under 
section 904(d)(1)(E) (prior to its repeal by the AJCA), at the end of 
the taxpayer's last taxable year beginning before January 1, 2005 (or a 
later taxable year in which the taxpayer received a dividend subject to 
the separate limitation for dividends from all noncontrolled section 902 
corporations), the amount of such balance shall be allocated on the 
first day of the taxpayer's next taxable year to the taxpayer's other 
separate categories. The amount of such balance that is attributable to 
each noncontrolled section 902 corporation shall be allocated in the 
same percentages as the taxpayer properly characterized the stock of 
such corporation for purposes of apportioning the taxpayer's interest 
expense for its first taxable year ending after the first day of such 
corporation's first taxable year beginning after December 31, 2002, 
under Sec.  1.861-12T(c)(3) or Sec.  1.861-12(c)(4), as the case may be. 
To the extent that a taxpayer has a balance in a separate limitation 
loss account for the single category for dividends from all 
noncontrolled section 902 corporations with respect to another separate 
category, and the separate limitation loss account would otherwise be 
assigned to that other category under this paragraph (f)(9)(vi), such 
balance shall be eliminated.
    (vii) Recapture of separate limitation losses in other separate 
categories. To the extent that a taxpayer has a balance in any separate 
limitation loss account in a separate category with respect to the 
single category for dividends from all noncontrolled section 902 
corporations at the end of the taxpayer's last taxable year with or 
within which ends the last taxable year of the relevant noncontrolled 
section 902 corporation beginning before January 1, 2005, such loss 
shall be recaptured in subsequent taxable years as income in the 
appropriate separate category. The separate limitation loss account 
shall be deemed attributable on a pro rata basis to those noncontrolled 
section 902 corporations that paid dividends out of earnings accumulated 
in taxable years beginning before January 1, 2003, in the years in which 
the separate limitation loss in the other separate category arose. The 
ratable portions of the separate limitation loss account shall be 
recaptured as income in the taxpayer's separate categories in the same 
percentages as the taxpayer properly characterized the stock of the 
relevant noncontrolled section 902 corporation for purposes of 
apportioning the taxpayer's interest expense in its first taxable year 
ending after the first day of such corporation's first taxable year 
beginning after December 31, 2002, under Sec.  1.861-12T(c)(3) or Sec.  
1.861-12(c)(4), as the case may be. To the extent that a taxpayer has a 
balance in any separate limitation loss account in any separate category 
that would have been recaptured as income in that same category under 
this paragraph (f)(9)(vii), such balance shall be eliminated.
    (viii) Treatment of undistributed earnings in an upper-tier 
corporation-level single category for dividends from lower-

[[Page 826]]

tier noncontrolled section 902 corporations. Where a controlled foreign 
corporation or noncontrolled section 902 corporation has a single 
category for dividends from all noncontrolled section 902 corporations 
containing earnings attributable to dividends paid by one or more lower-
tier corporations, the following rules apply. The post-1986 
undistributed earnings, previously-taxed earnings and profits described 
in section 959(c)(1) or (2), if any, and associated post-1986 foreign 
income taxes shall be allocated to the upper-tier corporation's other 
separate categories in the same manner as earnings and taxes in a 
separate category for dividends from each noncontrolled section 902 
corporation maintained by the upper-tier corporation are allocated under 
paragraph (f)(7) of this section. Accordingly, post-1986 undistributed 
earnings, previously-taxed earnings and profits, if any, and post-1986 
foreign income taxes in the single category for dividends from all 
noncontrolled section 902 corporations shall be treated as if they were 
accumulated and paid, accrued or deemed paid during a period when a 
dividend paid by each lower-tier corporation that paid dividends 
included in the single category would have been eligible for look-
through treatment. If the taxpayer uses the safe harbor method described 
in paragraph (f)(7)(iii) of this section, the earnings and taxes shall 
be allocated based on the apportionment ratios properly used by the 
lower-tier corporation to apportion its interest expense for its first 
taxable year beginning after December 31, 2002. Any section 952(c)(2) 
recapture account with respect to the single category shall be allocated 
in the same manner as the associated post-1986 undistributed earnings. 
The taxpayer must substantiate the look-through characterization of the 
earnings and taxes in accordance with the rules of paragraph (f)(7)(iii) 
of this section. If the taxpayer does not use the safe harbor method and 
the Commissioner determines that the look-through characterization of 
the earnings cannot reasonably be determined based on the available 
information, the earnings and taxes shall be assigned to the upper-tier 
corporation's passive category.
    (ix) Treatment of a deficit in the single category for dividends 
from lower-tier noncontrolled section 902 corporations. Where a 
controlled foreign corporation or noncontrolled section 902 corporation 
had an aggregate deficit in the single category for dividends from all 
noncontrolled section 902 corporations as of the end of the upper-tier 
corporation's last taxable year beginning before January 1, 2005, such 
deficit and the associated post-1986 foreign income taxes, if any, shall 
be allocated to the upper-tier corporation's other separate categories 
in the same percentages in which the non-look-through pools of each 
lower-tier corporation to which the deficit is attributable were 
assigned to such corporation's other separate categories in its first 
taxable year beginning after December 31, 2002. If the taxpayer uses the 
safe harbor method described in paragraph (f)(7)(iii) of this section, 
the deficit and taxes shall be allocated based on how the taxpayer 
properly characterized the stock of the lower-tier noncontrolled section 
902 corporation for purposes of apportioning the upper-tier 
corporation's interest expense for the upper-tier corporation's first 
taxable year ending after the first day of the lower-tier corporation's 
first taxable year beginning after December 31, 2002. The taxpayer must 
substantiate the look-through characterization of the deficit and taxes 
in accordance with the rules of paragraph (f)(7)(iii) of this section. 
If the taxpayer does not use the safe harbor method and the Commissioner 
determines that the look-through characterization of the deficit cannot 
reasonably be determined based on the available information, the deficit 
and taxes shall be assigned to the upper-tier corporation's passive 
category.
    (10) Effective/applicability date. This paragraph (f) shall apply to 
dividends from a noncontrolled section 902 corporation that are paid in 
taxable years of the noncontrolled section 902 corporation ending on or 
after April 20, 2009. See 26 CFR Sec.  1.904-7T(f) (revised as of April 
1, 2009) for rules applicable, except in the case of a taxpayer that 
makes the election under paragraph (f)(9) of that section, to dividends 
from a noncontrolled section 902 corporation

[[Page 827]]

that are paid in taxable years of the noncontrolled section 902 
corporation beginning after December 31, 2002, and ending before April 
20, 2009. See 26 CFR 1.904-7T(f) (revised as of April 1, 2009) for rules 
applicable, in the case of a taxpayer that makes the election under 
paragraph (f)(9) of that section, to dividends from a noncontrolled 
section 902 corporation that are paid in taxable years of the 
noncontrolled section 902 corporation beginning after December 31, 2004, 
and ending before April 20, 2009. However, taxpayers may choose to apply 
paragraph (f) of this section in its entirety in lieu of 26 CFR 1.904-
7T(f) to all dividends paid in periods covered by the temporary 
regulations, provided that appropriate adjustments are made to eliminate 
duplicate benefits arising from application of paragraph (f) to taxable 
years that are not open for assessment.
    (g) Treatment of earnings and foreign taxes of a controlled foreign 
corporation or a noncontrolled section 902 corporation accumulated in 
taxable years beginning before January 1, 2007--(1) Definitions--(i) 
Pre-2007 pools means the pools in each separate category of post-1986 
undistributed earnings (as defined in Sec.  1.902-1(a)(9)) that were 
accumulated, and post-1986 foreign income taxes (as defined in Sec.  
1.902-1(a)(8)) paid, accrued, or deemed paid, in taxable years beginning 
before January 1, 2007.
    (ii) Pre-2007 separate categories means the separate categories of 
income described in section 904(d) as applicable to taxable years 
beginning before January 1, 2007, and any other separate category of 
income described in Sec.  1.904-4(m).
    (iii) Post-2006 separate categories means the separate categories of 
income described in section 904(d) as applicable to taxable years 
beginning after December 31, 2006, and any other separate category of 
income described in Sec.  1.904-4(m).
    (2) Treatment of pre-2007 pools of a controlled foreign corporation 
or a noncontrolled section 902 corporation. Any post-1986 undistributed 
earnings in a pre-2007 pool of a controlled foreign corporation or a 
noncontrolled section 902 corporation shall be treated in taxable years 
beginning after December 31, 2006, as if they were accumulated during a 
period in which the rules governing the determination of post-2006 
separate categories applied. Post-1986 foreign income taxes paid, 
accrued, or deemed paid with respect to such earnings shall be treated 
as if they were paid, accrued, or deemed paid during a period in which 
the rules governing the determination of post-2006 separate categories 
(including the rules of section 904(d)(3)(E)) applied as well. Any such 
earnings and taxes in pre-2007 pools shall constitute the opening 
balance of the foreign corporation's post-1986 undistributed earnings 
and post-1986 foreign income taxes on the first day of the foreign 
corporation's first taxable year beginning after December 31, 2006, in 
accordance with the rules of paragraph (g)(3) of this section. Similar 
rules shall apply to characterize any deficits in the pre-2007 pools and 
previously-taxed earnings and profits described in section 959(c)(1) and 
(2) that are attributable to earnings in the pre-2007 pools. Any section 
952(c)(2) recapture account with respect to a separate category shall be 
allocated in the same manner as the post-1986 undistributed earnings in 
the associated pre-2007 pool.
    (3) Substantiation of post-2006 character of earnings and taxes in a 
pre-2007 pool--(i) Reconstruction of earnings and taxes pools. In order 
to substantiate the post-2006 characterization of post-1986 
undistributed earnings (as well as deficits and previously-taxed 
earnings, if any) and post-1986 foreign income taxes in pre-2007 pools 
of a controlled foreign corporation or a noncontrolled section 902 
corporation, the taxpayer shall make a reasonable, good-faith effort to 
reconstruct the pre-2007 pools of post-1986 undistributed earnings (as 
well as deficits and previously-taxed earnings, if any) and post-1986 
foreign income taxes following the rules governing the determination of 
post-2006 separate categories for each taxable year beginning before 
January 1, 2007, beginning with the first year in which post-1986 
undistributed earnings were accumulated in the pre-2007 pool. 
Reconstruction shall be based on reasonably available books and records 
and other relevant information. To the extent any pre-2007 separate 
category includes earnings that would be allocated to

[[Page 828]]

more than one post-2006 separate category, the taxpayer must account for 
earnings distributed and taxes deemed paid in these years for such 
category as if they were distributed and deemed paid pro rata from the 
amounts that were added to that category during each taxable year 
beginning before January 1, 2007.
    (ii) Safe harbor method--(A) In general. Subject to the rules of 
paragraph (g)(3)(iii) of this section, a taxpayer may allocate the post-
1986 undistributed earnings and post-1986 foreign income taxes in pre-
2007 pools of a controlled foreign corporation or a noncontrolled 
section 902 corporation (as well as deficits and previously-taxed 
earnings, if any) under one of the safe harbor methods described in 
paragraphs (g)(3)(ii)(B) and (g)(3)(ii)(C) of this section. A taxpayer 
may choose to use the safe harbor method on a timely filed (original or 
amended) tax return or during an audit. A taxpayer that uses the safe 
harbor method on an amended return or in the course of an audit must 
make appropriate adjustments to eliminate any double benefit arising 
from application of the safe harbor method to years that are not open 
for assessment. A taxpayer's choice to use the safe harbor method is 
evidenced by employing the method. The taxpayer need not file any 
separate statement.
    (B) General safe harbor method--(1) Any post-1986 undistributed 
earnings (as well as deficits and previously-taxed earnings, if any) and 
post-1986 foreign income taxes of a noncontrolled section 902 
corporation or a controlled foreign corporation in a pre-2007 separate 
category for passive income, certain dividends from a DISC or former 
DISC, taxable income attributable to certain foreign trade income, or 
certain distributions from a FSC or former FSC shall be allocated to the 
post-2006 separate category for passive category income.
    (2) Any post-1986 undistributed earnings (as well as deficits and 
previously-taxed earnings, if any) and post-1986 foreign income taxes of 
a noncontrolled section 902 corporation or a controlled foreign 
corporation in a pre-2007 separate category for financial services 
income, shipping income or general limitation income shall be allocated 
to the post-2006 separate category for general category income.
    (3) Except as provided in paragraph (g)(3)(ii)(B)(4) of this 
section, any post-1986 undistributed earnings (as well as deficits and 
previously-taxed earnings, if any) and post-1986 foreign income taxes of 
a noncontrolled section 902 corporation or a controlled foreign 
corporation in a pre-2007 separate category for high withholding tax 
interest shall be allocated to the post-2006 separate category for 
passive category income.
    (4) If a controlled foreign corporation has positive post-1986 
undistributed earnings and post-1986 foreign income taxes in a pre-2007 
separate category for high withholding tax interest, such earnings and 
taxes shall be allocated to the post-2006 separate category for general 
category income if the earnings would qualify as income subject to high 
foreign taxes under section 954(b)(4) if the entire amount of post-1986 
undistributed earnings were treated as a net item of income subject to 
the rules of Sec.  1.954-1(d). If the high withholding tax interest 
earnings would not qualify as income subject to high foreign taxes under 
section 954(b)(4), then the earnings and taxes shall be allocated to the 
post-2006 separate category for passive category income.
    (C) Interest apportionment safe harbor. A taxpayer may allocate the 
post-1986 undistributed earnings (as well as deficits and previously-
taxed earnings, if any) and post-1986 foreign income taxes in pre-2007 
pools of a controlled foreign corporation or a noncontrolled section 902 
corporation following the principles of paragraph (f)(4)(ii) of this 
section.
    (iii) Consistency rule. The election to apply a safe harbor method 
under paragraph (g)(3)(ii) of this section in lieu of the rules 
described in paragraph (g)(3)(i) of this section may be made on a 
separate category by separate category basis. However, if a taxpayer 
elects to apply a safe harbor to allocate pre-2007 pools of more than 
one pre-2007 separate category of a controlled foreign corporation or a 
noncontrolled section 902 corporation, such safe harbor (the general 
safe harbor described in paragraph (g)(3)(ii)(B) of this section

[[Page 829]]

or the interest apportionment safe harbor described in paragraph 
(g)(3)(ii)(C) of this section) shall apply to allocate post-1986 
undistributed earnings (as well as deficits and previously-taxed 
earnings, if any) and post-1986 foreign income taxes for the pre-2007 
pools in each pre-2007 separate category of the foreign corporation for 
which the taxpayer elected to apply a safe harbor method in lieu of 
reconstructing the pre-2007 pools.
    (4) Treatment of pre-1987 accumulated profits. Any pre-1987 
accumulated profits (as defined in Sec.  1.902-1(a)(10)) of a 
noncontrolled section 902 corporation or a controlled foreign 
corporation shall be treated in taxable years beginning after December 
31, 2006, as if they had been accumulated during a period in which the 
rules governing the determination of post-2006 separate categories 
applied. Foreign income taxes paid, accrued, or deemed paid with respect 
to such earnings shall be treated as if they were paid, accrued, or 
deemed paid during a period in which the rules governing the 
determination of post-2006 separate categories applied as well. The 
taxpayer must substantiate the post-2006 characterization of the pre-
1987 accumulated profits and pre-1987 foreign income taxes in accordance 
with the rules of paragraph (g)(3) of this section, including the safe 
harbor provisions. Similar rules shall apply to characterize any 
deficits or previously-taxed earnings and profits described in section 
959(c)(1) and (2) that are attributable to pre-1987 accumulated profits.
    (5) Treatment of earnings and foreign taxes in pre-2007 pools of a 
lower-tier controlled foreign corporation or noncontrolled section 902 
corporation. The rules of paragraphs (g)(1) through (4) of this section 
apply to post-1986 undistributed earnings (as well as deficits and 
previously-taxed earnings, if any) and post-1986 foreign income taxes in 
pre-2007 pools, and pre-1987 accumulated profits and pre-1987 foreign 
income taxes, of a lower-tier controlled foreign corporation or 
noncontrolled section 902 corporation.
    (6) Effective/applicability date. This paragraph (g) shall apply to 
taxable years of United States persons and, for purposes of section 906, 
foreign persons beginning after December 31, 2006 and ending on or after 
December 21, 2007, and to taxable years of a foreign corporation which 
end with or within taxable years of its domestic corporate shareholder 
beginning after December 31, 2006 and ending on or after December 21, 
2007.

[T.D. 8214, 53 FR 27034, July 18, 1988, as amended by T.D. 8412, 57 FR 
20653, May 14, 1992; T.D. 9260, 71 FR 24533, Apr. 25, 2006; T.D. 9368, 
72 FR 72590, Dec. 21, 2007; T.D. 9452, 74 FR 27881, June 11, 2009; T.D. 
9521, 76 FR 19272, Apr. 7, 2011]



Sec.  1.904(b)-0  Outline of regulation provisions.

    This section lists the headings for Sec. Sec.  1.904(b)-1 and 
1.904(b)-2.

      Sec.  1.904(b)-1 Special rules for capital gains and losses.

    (a) Capital gains and losses included in taxable income from sources 
outside the United States.
    (1) Limitation on capital gain from sources outside the United 
States when the taxpayer has net capital losses from sources within the 
United States.
    (i) In general.
    (ii) Allocation of reduction to separate categories or rate groups.
    (A) In general.
    (B) Taxpayer with capital gain rate differential.
    (2) Exclusivity of rules; no reduction by reason of net capital loss 
from sources outside the United States in a different separate category.
    (3) Capital losses from sources outside the United States in the 
same separate category.
    (4) Examples.
    (b) Capital gain rate differential.
    (1) Application of adjustments only if capital gain rate 
differential exists.
    (2) Determination of whether capital gain rate differential exists.
    (3) Special rule for certain noncorporate taxpayers.
    (c) Rate differential adjustment of capital gains.
    (1) Rate differential adjustment of capital gains in foreign source 
taxable income.
    (i) In general.
    (ii) Special rule for taxpayers with a net long-term capital loss 
from sources within the United States.

[[Page 830]]

    (iii) Examples.
    (2) Rate differential adjustment of capital gains in entire taxable 
income.
    (d) Rate differential adjustment of capital losses from sources 
outside the United States.
    (1) In general.
    (2) Determination of which capital gains are offset by net capital 
losses from sources outside the United States.
    (e) Qualified dividend income.
    (1) In general.
    (2) Exception.
    (f) Definitions.
    (1) Alternative tax rate.
    (2) Net capital gain.
    (3) Rate differential portion.
    (4) Rate group.
    (i) Short-term capital gains or losses.
    (ii) Long-term capital gains.
    (iii) Long-term capital losses.
    (5) Terms used in sections 1(h), 904(b) or 1222.
    (g) Examples.
    (h) Coordination with section 904(f).
    (1) In general.
    (2) Examples.
    (i) Effective date.

  Sec.  1.904(b)-2 Special rules for application of section 904(b) to 
               alternative minimum tax foreign tax credit.

    (a) Application of section 904(b)(2)(B) adjustments.
    (b) Use of alternative minimum tax rates.
    (1) Taxpayers other than corporations.
    (2) Corporate taxpayers.
    (c) Effective date.

[T.D. 9371, 72 FR 72596, Dec. 21, 2007]



Sec.  1.904(b)-1  Special rules for capital gains and losses.

    (a) Capital gains and losses included in taxable income from sources 
outside the United States--(1) Limitation on capital gain from sources 
outside the United States when the taxpayer has net capital losses from 
sources within the United States--(i) In general. Except as otherwise 
provided in this section, for purposes of section 904 and this section, 
taxable income from sources outside the United States (in all of the 
taxpayer's separate categories in the aggregate) shall include capital 
gain net income from sources outside the United States (determined by 
considering all of the capital gain and loss items in all of the 
taxpayer's separate categories in the aggregate) only to the extent of 
capital gain net income from all sources. Thus, capital gain net income 
from sources outside the United States (determined by considering all of 
the capital gain and loss items in all of the taxpayer's separate 
categories in the aggregate) shall be reduced to the extent such amount 
exceeds capital gain net income from all sources.
    (ii) Allocation of reduction to separate categories or rate groups--
(A) In general. If capital gain net income from sources outside the 
United States exceeds capital gain net income from all sources, and the 
taxpayer has capital gain net income from sources outside the United 
States in only one separate category, such excess is allocated as a 
reduction to that separate category. If a taxpayer has capital gain net 
income from foreign sources in two or more separate categories, such 
excess must be apportioned on a pro rata basis as a reduction to each 
such separate category. For purposes of the preceding sentence, pro rata 
means based on the relative amounts of the capital gain net income from 
sources outside the United States in each separate category.
    (B) Taxpayer with capital gain rate differential. If a taxpayer with 
a capital gain rate differential for the year (within the meaning of 
paragraph (b) of this section) has capital gain net income from foreign 
sources in only one rate group within a separate category, any reduction 
to such separate category pursuant to paragraph (a)(1)(ii)(A) of this 
section must be allocated to such rate group. If a taxpayer with a 
capital gain rate differential for the year (within the meaning of 
paragraph (b) of this section) has capital gain net income from foreign 
sources in two or more rate groups within a separate category, any 
reduction to such separate category pursuant to paragraph (a)(1)(ii)(A) 
of this section must be apportioned on a pro rata basis among such rate 
groups. For purposes of the preceding sentence, pro rata means based on 
the relative amounts of the capital gain net income from sources outside 
the United States

[[Page 831]]

in each rate group within the applicable separate category.
    (2) Exclusivity of rules; no reduction by reason of net capital 
losses from sources outside the United States in a different separate 
category. Capital gains from sources outside the United States in any 
separate category shall be limited by reason of section 904(b)(2)(A) and 
the comparable limitation of section 904(b)(2)(B)(i) only to the extent 
provided in paragraph (a)(1) of this section (relating to limitation on 
capital gain from sources outside the United States when taxpayer has 
net capital losses from sources within the United States).
    (3) Capital losses from sources outside the United States in the 
same separate category. Except as otherwise provided in paragraph (d) of 
this section, taxable income from sources outside the United States in 
each separate category shall be reduced by any capital loss that is 
allocable or apportionable to income from sources outside the United 
States in such separate category to the extent such loss is allowable in 
determining taxable income for the taxable year.
    (4) Examples. The following examples illustrate the application of 
this paragraph (a) to taxpayers that do not have a capital gain rate 
differential for the taxable year. See paragraph (g) of this section for 
examples that illustrate the application of this paragraph (a) to 
taxpayers that have a capital gain rate differential for the year. The 
examples are as follows:

    Example 1. Taxpayer A, a corporation, has a $3,000 capital loss from 
sources outside the United States in the general limitation category, a 
$6,000 capital gain from sources outside the United States in the 
passive category, and a $2,000 capital loss from sources within the 
United States. A's capital gain net income from sources outside the 
United States in the aggregate, from all separate categories, is $3,000 
($6,000 - $3,000). A's capital gain net income from all sources is 
$1,000 ($6,000 - $3,000 - $2,000). Thus, for purposes of section 904, 
A's taxable income from sources outside the United States in all of A's 
separate categories in the aggregate includes only $1,000 of capital 
gain net income from sources outside the United States. See paragraph 
(a)(1)(i) of this section. Pursuant to paragraphs (a)(1)(i) and 
(a)(1)(ii)(A) of this section, A must reduce the $6,000 of capital gain 
net income from sources outside the United States in the passive 
category by $2,000 ($3,000 of capital gain net income from sources 
outside the United States - $1,000 of capital gain net income from all 
sources). After the adjustment, A has $4,000 of capital gain from 
sources outside the United States in the passive category and $3,000 of 
capital loss from sources outside the United States in the general 
limitation category.
    Example 2. Taxpayer B, a corporation, has a $300 capital gain from 
sources outside the United States in the general limitation category and 
a $200 capital gain from sources outside the United States in the 
passive category. B's capital gain net income from sources outside the 
United States is $500 ($300 + $200). B also has a $150 capital loss from 
sources within the United States and a $50 capital gain from sources 
within the United States. Thus, B's capital gain net income from all 
sources is $400 ($300 + $200 - $150 + $50). Pursuant to paragraph 
(a)(1)(ii)(A) of this section, the $100 excess of capital gain net 
income from sources outside the United States over capital gain net 
income from all sources ($500 - $400) must be apportioned, as a 
reduction, three-fifths ($300/$500 of $100, or $60) to the general 
limitation category and two-fifths ($200/$500 of $100, or $40) to the 
passive category. Therefore, for purposes of section 904, the general 
limitation category includes $240 ($300 - $60) of capital gain net 
income from sources outside the United States and the passive category 
includes $160 ($200 - $40) of capital gain net income from sources 
outside the United States.
    Example 3. Taxpayer C, a corporation, has a $10,000 capital loss 
from sources outside the United States in the general limitation 
category, a $4,000 capital gain from sources outside the United States 
in the passive category, and a $2,000 capital gain from sources within 
the United States. C's capital gain net income from sources outside the 
United States is zero, since losses exceed gains. C's capital gain net 
income from all sources is also zero. C's capital gain net income from 
sources outside the United States does not exceed its capital gain net 
income from all sources, and therefore paragraph (a)(1) of this section 
does not require any reduction of C's passive category capital gain. For 
purposes of section 904, C's passive category includes $4,000 of capital 
gain net income. C's general limitation category includes a capital loss 
of $6,000 because only $6,000 of capital loss is allowable as a 
deduction in the current year. The entire $4,000 of capital loss in 
excess of the $6,000 of capital loss that offsets capital gain in the 
taxable year is carried back or forward under section 1212(a), and none 
of such $4,000 is taken into account under section 904(a) or (b) for the 
current taxable year.

    (b) Capital gain rate differential--(1) Application of adjustments 
only if capital

[[Page 832]]

gain rate differential exists. Section 904(b)(2)(B) and paragraphs (c) 
and (d) of this section apply only for taxable years in which the 
taxpayer has a capital gain rate differential.
    (2) Determination of whether capital gain rate differential exists. 
For purposes of section 904(b) and this section, a capital gain rate 
differential is considered to exist for the taxable year only if the 
taxpayer has taxable income (excluding net capital gain and qualified 
dividend income) for the taxable year, a net capital gain for the 
taxable year and--
    (i) In the case of a taxpayer other than a corporation, tax is 
imposed on the net capital gain at a reduced rate under section 1(h) for 
the taxable year; or
    (ii) In the case of a corporation, tax is imposed under section 
1201(a) on the taxpayer at a rate less than any rate of tax imposed on 
the taxpayer by section 11, 511, or 831(a) or (b), whichever applies 
(determined without regard to the last sentence of section 11(b)(1)), 
for the taxable year.
    (3) Special rule for certain noncorporate taxpayers. A taxpayer that 
has a capital gain rate differential for the taxable year under 
paragraph (b)(2)(i) of this section and is not subject to alternative 
minimum tax under section 55 for the taxable year may elect not to apply 
the rate differential adjustments contained in section 904(b)(2)(B) and 
paragraphs (c) and (d) of this section if the highest rate of tax 
imposed on such taxpayer's taxable income (excluding net capital gain 
and any qualified dividend income) for the taxable year under section 1 
does not exceed the highest rate of tax in effect under section 1(h) for 
the taxable year and the amount of the taxpayer's net capital gain from 
sources outside the United States, plus the amount of the taxpayer's 
qualified dividend income from sources outside the United States, is 
less than $20,000. A taxpayer that has a capital gain rate differential 
for the taxable year under paragraph (b)(2)(i) of this section and is 
subject to alternative minimum tax under section 55 for the taxable year 
may make such election if the rate of tax imposed on such taxpayer's 
alternative minimum taxable income (excluding net capital gain and any 
qualified dividend income) under section 55 does not exceed 26 percent, 
the highest rate of tax imposed on such taxpayer's taxable income 
(excluding net capital gain and any qualified dividend income) for the 
taxable year under section 1 does not exceed the highest rate of tax in 
effect under section 1(h) for the taxable year and the amount of the 
taxpayer's net capital gain from sources outside the United States, plus 
the amount of the taxpayer's qualified dividend income from sources 
outside the United States, is less than $20,000. A taxpayer who makes 
this election shall apply paragraph (a) of this section as if such 
taxpayer does not have a capital gain rate differential for the taxable 
year. An eligible taxpayer shall be presumed to have elected not to 
apply the rate differential adjustments, unless such taxpayer applies 
the rate differential adjustments contained in section 904(b)(2)(B) and 
paragraphs (c) and (d) of this section in determining its foreign tax 
credit limitation for the taxable year.
    (c) Rate differential adjustment of capital gains--(1) Rate 
differential adjustment of capital gains in foreign source taxable 
income--(i) In general. Subject to paragraph (c)(1)(ii) of this section, 
in determining taxable income from sources outside the United States for 
purposes of section 904 and this section, capital gain net income from 
sources outside the United States in each long-term rate group in each 
separate category (separate category long-term rate group), shall be 
reduced by the rate differential portion of such capital gain net 
income. For purposes of paragraph (c)(1) of this section, references to 
capital gain net income are references to capital gain net income 
remaining after any reduction to such income pursuant to paragraph 
(a)(1) of this section (i.e., paragraph (a)(1) of this section applies 
before paragraphs (c) and (d) of this section).
    (ii) Special rule for taxpayers with a net long-term capital loss 
from sources within the United States. If a taxpayer has a net long-term 
capital loss from sources within the United States (i.e., the taxpayer's 
long-term capital losses from sources within the United States exceed 
the taxpayer's long-term capital

[[Page 833]]

gains from sources within the United States) and also has any short-term 
capital gains from sources within or without the United States, then 
capital gain net income from sources outside the United States in each 
separate category long-term rate group shall be reduced by the rate 
differential portion of the applicable rate differential amount. The 
applicable rate differential amount is determined as follows:
    (A) Step 1: Determine the U.S. long-term capital loss adjustment 
amount. The U.S. long-term capital loss adjustment amount is the excess, 
if any, of the net long-term capital loss from sources within the United 
States over the amount, if any, by which the taxpayer reduced long-term 
capital gains from sources without the United States pursuant to 
paragraph (a)(1) of this section.
    (B) Step 2: Determine the applicable rate differential amount. If a 
taxpayer has capital gain net income from sources outside the United 
States in only one separate category long-term rate group, the 
applicable rate differential amount is the excess of such capital gain 
net income over the U.S. long-term capital loss adjustment amount. If a 
taxpayer has capital gain net income from sources outside the United 
States in more than one separate category long-term rate group, the U.S. 
long-term capital loss adjustment amount shall be apportioned on a pro 
rata basis to each separate category long-term rate group with capital 
gain net income. For purposes of the preceding sentence, pro rata means 
based on the relative amounts of capital gain net income from sources 
outside the United States in each separate category long-term rate 
group. The applicable rate differential amount for each separate 
category long-term rate group with capital gain net income is the excess 
of such capital gain net income over the portion of the U.S. long-term 
capital loss adjustment amount apportioned to the separate category 
long-term rate group pursuant to this Step 2.
    (iii) Examples. The following examples illustrate the provisions of 
paragraph (c)(1)(ii) of this section. The taxpayers in the examples are 
assumed to have taxable income (excluding net capital gain and qualified 
dividend income) subject to a rate of tax under section 1 greater than 
the highest rate of tax in effect under section 1(h) for the applicable 
taxable year. The examples are as follows:

    Example 1. (i) M, an individual, has $300 of long-term capital gain 
from foreign sources in the passive category, $200 of which is subject 
to tax at a rate of 15 percent under section 1(h) and $100 of which is 
subject to tax at a rate of 28% under section 1(h). M has $150 of short-
term capital gain from sources within the United States. M has a $100 
long-term capital loss from sources within the United States.
    (ii) M's capital gain net income from sources outside the United 
States ($300) does not exceed M's capital gain net income from all 
sources ($350). Therefore, paragraph (a)(1) of this section does not 
require any reduction of M's capital gain net income in the passive 
category.
    (iii) Because M has a net long-term capital loss from sources within 
the United States ($100) and also has a short-term capital gain from 
U.S. sources ($150), M must apply the provisions of paragraph (c)(1)(ii) 
of this section to determine the amount of the $300 of capital gain net 
income in the passive category that is subject to a rate differential 
adjustment. Under Step 1, the U.S. long-term capital loss adjustment 
amount is $100 ($100 - $0). Under Step 2, M must apportion this amount 
to each rate group in the passive category pro rata based on the amount 
of capital gain net income in each rate group. Thus, $66.67 ($200/$300 
of $100) is apportioned to the 15 percent rate group and $33.33 ($100/
$300 of $100) is apportioned to the 28 percent rate group. The 
applicable rate differential amount for the 15 percent rate group is 
$133.33 ($200 - $66.67). Thus, $133.33 of the $200 of capital gain net 
income in the 15 percent rate group is subject to a rate differential 
adjustment pursuant to paragraph (c)(1) of this section. The remaining 
$66.67 is not subject to a rate differential adjustment. The applicable 
rate differential amount for the 28 percent rate group is $66.67 ($100 - 
$33.33). Thus, $66.67 of the $100 of capital gain net income in the 28 
percent rate group is subject to a rate differential adjustment pursuant 
to paragraph (c)(1) of this section. The remaining $33.33 is not subject 
to a rate differential adjustment.
    Example 2. (i) N, an individual, has $300 of long-term capital gain 
from foreign sources in the passive category, all of which is subject to 
tax at a rate of 15 percent under section 1(h). N has $50 of short-term 
capital gain from sources within the United States. N has a $100 long-
term capital loss from sources within the United States.

[[Page 834]]

    (ii) N's capital gain net income from sources outside the United 
States ($300) exceeds N's capital gain net income from all sources 
($250). Pursuant to paragraph (a)(1) of this section, N must reduce the 
$300 capital gain in the passive category by $50. N has $250 of capital 
gain remaining in the passive category.
    (iii) Because N has a net long-term capital loss from sources within 
the United States ($100) and also has a short-term capital gain from 
U.S. sources ($50), N must apply the provisions of paragraph (c)(1)(ii) 
of this section to determine the amount of the $250 of capital gain in 
the passive category that is subject to a rate differential adjustment. 
Under Step 1, the U.S. long-term capital loss adjustment amount is $50 
($100 - $50). Under Step 2, the applicable rate differential amount is 
$200 ($250 - $50). Thus, $200 of the capital gain in the passive 
category is subject to a rate differential adjustment under paragraph 
(c)(1) of this section. The remaining $50 is not subject to a rate 
differential adjustment.
    Example 3. (i) O, an individual, has a $100 short-term capital gain 
from foreign sources in the passive category. O has $300 of long-term 
capital gain from foreign sources in the passive category, all of which 
is subject to tax at a rate of 15 percent under section 1(h). O has a 
$100 long-term capital loss from sources within the United States.
    (ii) O's capital gain net income from sources outside the United 
States ($400) exceeds O's capital gain net income from all sources 
($300). Pursuant to paragraph (a)(1) of this section, O must reduce the 
$400 capital gain net income in the passive category by $100. Because C 
has capital gain net income in two or more rate groups in the passive 
category, O must apportion such amount, as a reduction, to each rate 
group on a pro rata basis pursuant to paragraph (a)(1)(ii)(B) of this 
section. Thus, $25 ($100/$400 of $100) is apportioned to the short-term 
capital gain and $75 ($300/$400 of $100) is apportioned to the long-term 
capital gain in the 15 percent rate group. After application of 
paragraph (a)(1) of this section, O has $75 of short-term capital gain 
in the passive category and $225 of long-term capital gain in the 15 
percent rate group in the passive category.
    (iii) Because O has a net long-term capital loss from sources within 
the United States ($100) and also has a short-term capital gain from 
foreign sources ($100), O must apply the provisions of paragraph 
(c)(1)(ii) of this section to determine the amount of the $225 of long-
term capital gain in the 15 percent rate group that is subject to a rate 
differential adjustment. Under Step 1, the U.S. long-term capital loss 
adjustment amount is $25 ($100 - $75). Under Step 2, the applicable rate 
differential amount is $200 ($225 - $25). Thus, $200 of the long-term 
capital gain is subject to a rate differential adjustment under 
paragraph (c)(1) of this section. The remaining $25 of long-term capital 
gain is not subject to a rate differential adjustment.

    (2) Rate differential adjustment of capital gains in entire taxable 
income. For purposes of section 904 and this section, entire taxable 
income shall include gains from the sale or exchange of capital assets 
only to the extent of capital gain net income reduced by the sum of the 
rate differential portions of each rate group of net capital gain.
    (d) Rate differential adjustment of capital losses from sources 
outside the United States--(1) In general. In determining taxable income 
from sources outside the United States for purposes of section 904 and 
this section, a taxpayer with a net capital loss in a separate category 
rate group shall reduce such net capital loss by the sum of the rate 
differential portions of the capital gain net income in each long-term 
rate group offset by such net capital loss. A net capital loss in a 
separate category rate group is the amount, if any, by which capital 
losses in a rate group from sources outside the United States included 
in a separate category exceed capital gains from sources outside the 
United States in the same rate group and the same separate category.
    (2) Determination of which capital gains are offset by net capital 
losses from sources outside the United States. For purposes of paragraph 
(d)(1) of this section, in order to determine the capital gain net 
income offset by net capital losses from sources outside the United 
States, the following rules shall apply in the following order:
    (i) Net capital losses from sources outside the United States in 
each separate category rate group shall be netted against capital gain 
net income from sources outside the United States from the same rate 
group in other separate categories.
    (ii) Capital losses from sources within the United States shall be 
netted against capital gains from sources within the United States in 
the same rate group.
    (iii) Net capital losses from sources outside the United States in 
excess of the amounts netted against capital gains under paragraph 
(d)(2)(i) of this

[[Page 835]]

section shall be netted against the taxpayer's remaining capital gains 
from sources within and outside the United States in the following 
order, and without regard to any net capital losses, from any rate 
group, from sources within the United States--
    (A) First against capital gain net income from sources within the 
United States in the same rate group;
    (B) Next, against capital gain net income in other rate groups, in 
the order in which capital losses offset capital gains for purposes of 
determining the taxpayer's taxable income and without regard to whether 
such capital gain net income derives from sources within or outside the 
United States, as follows:
    (1) A net capital loss in the short-term rate group is used first to 
offset any capital gain net income in the 28 percent rate group, then to 
offset capital gain net income in the 25 percent rate group, then to 
offset capital gain net income in the 15 percent rate group, and finally 
to offset capital gain net income in the 5 percent rate group.
    (2) A net capital loss in the 28 percent rate group is used first to 
offset capital gain net income in the 25 percent rate group, then to 
offset capital gain net income in the 15 percent rate group, and finally 
to offset capital gain net income in the 5 percent rate group.
    (3) A net capital loss in the 15 percent rate group is used first to 
offset capital gain net income in the 5 percent rate group, and then to 
offset capital gain net income in the 28 percent rate group, and finally 
to offset capital gain net income in the 25 percent rate group.
    (iv) Net capital losses from sources outside the United States in 
any rate group, to the extent netted against capital gains in any other 
separate category under paragraph (d)(2)(i) of this section or against 
capital gains in the same or any other rate group under paragraph 
(d)(2)(iii) of this section, shall be treated as coming pro rata from 
each separate category that contains a net capital loss from sources 
outside the United States in that rate group. For example, assume that 
the taxpayer has $20 of net capital losses in the 15 percent rate group 
in the passive category and $40 of net capital losses in the 15 percent 
rate group in the general limitation category, both from sources outside 
the United States. Further assume that $50 of the total $60 net capital 
losses from sources outside the United States are netted against capital 
gain net income in the 28 percent rate group (from other separate 
categories or from sources within the United States). One-third of the 
$50 of such capital losses would be treated as coming from the passive 
category, and two-thirds of such $50 would be treated as coming from the 
general limitation category.
    (v) In determining the capital gain net income offset by a net 
capital loss from sources outside the United States pursuant to this 
paragraph (d)(2), a taxpayer shall take into account any reduction to 
capital gain net income from sources outside the United States pursuant 
to paragraph (a) of this section and shall disregard any adjustments to 
such capital gain net income pursuant to paragraph (c)(1) of this 
section.
    (vi) If at any time during a taxable year, tax is imposed under 
section 1(h) at a rate other than a rate of tax specified in this 
paragraph (d)(2), the principles of this paragraph (d)(2) shall apply to 
determine the capital gain net income offset by any net capital loss in 
a separate category rate group.
    (vii) The determination of which capital gains are offset by capital 
losses from sources outside the United States under this paragraph 
(d)(2) is made solely in order to determine the appropriate rate-
differential-based adjustments to such capital losses under this section 
and section 904(b), and does not change the source, allocation, or 
separate category of any such capital gain or loss for purposes of 
computing taxable income from sources within or outside the United 
States or for any other purpose.
    (e) Qualified dividend income--(1) In general. A taxpayer that has 
taxable income (excluding net capital gain and qualified dividend 
income) for the taxable year and that qualifies for a reduced rate of 
tax under section 1(h) on its qualified dividend income (as defined in 
section 1(h)(11)) for the taxable year shall adjust the amount of such 
qualified dividend income in a manner consistent with the rules of 
paragraphs

[[Page 836]]

(c)(1)(i) (first sentence) and (c)(2) of this section irrespective of 
whether such taxpayer has a net capital gain for the taxable year. For 
purposes of making adjustments pursuant to this paragraph (e), the 
special rule in paragraph (c)(1)(ii) of this section for taxpayers with 
a net long-term capital loss from sources within the United States shall 
be disregarded.
    (2) Exception. A taxpayer that makes the election provided for in 
paragraph (b)(3) of this section shall not make adjustments pursuant to 
paragraph (e)(1) of this section. Additionally, a taxpayer other than a 
corporation that does not have a capital gain rate differential for the 
taxable year within the meaning of paragraph (b)(2) of this section may 
elect not to apply paragraph (e)(1) of this section if such taxpayer 
would have qualified for the election provided for in paragraph (b)(3) 
of this section had such taxpayer had a capital gain rate differential 
for the taxable year. Such a taxpayer shall be presumed to make the 
election provided for in the preceding sentence unless such taxpayer 
applies the rate differential adjustments provided for in paragraph 
(e)(1) of this section to the qualified dividend income in determining 
its foreign tax credit limitation for the taxable year.
    (f) Definitions. For purposes of section 904(b) and this section, 
the following definitions apply:
    (1) Alternative tax rate. The term alternative tax rate means, with 
respect to any rate group, the rate applicable to that rate group under 
section 1(h) (for taxpayers other than corporations) or section 1201(a) 
(for corporations). For example, the alternative tax rate for 
unrecaptured section 1250 gain is 25 percent.
    (2) Net capital gain. For purposes of this section, net capital gain 
shall not include any qualified dividend income (as defined in section 
1(h)(11)). See paragraph (e) of this section for rules relating to 
qualified dividend income.
    (3) Rate differential portion. The term rate differential portion 
with respect to capital gain net income from sources outside the United 
States in a separate category long-term rate group (or the applicable 
portion of such amount), net capital gain in a rate group, or capital 
gain net income in a long-term rate group, as the case may be, means the 
same proportion of such amount as--
    (i) The excess of the highest applicable tax rate (as defined in 
section 904(b)(3)(E)(ii)) over the alternative tax rate; bears to
    (ii) The highest applicable tax rate (as defined in section 
904(b)(3)(E)(ii)).
    (4) Rate group. For purposes of this section, the term rate group 
means:
    (i) Short-term capital gains or losses. With respect to a short-term 
capital gain or loss, the rate group is the short-term rate group.
    (ii) Long-term capital gains. With respect to a long-term capital 
gain, the rate group is the particular rate of tax to which such gain is 
subject under section 1(h). Such a rate group is a long-term rate group. 
For example, the 28 percent rate group of capital gain net income from 
sources outside the United States consists of the capital gain net 
income from sources outside the United States that is subject to tax at 
a rate of 28 percent under section 1(h). Such 28 percent rate group is a 
long-term rate group. If a taxpayer has long-term capital gains that may 
be subject to tax at more than one rate under section 1(h) and the 
taxpayer's net capital gain attributable to such long-term capital gains 
and any qualified dividend income are taxed at one rate of tax under 
section 1(h), then all of such long-term capital gains shall be treated 
as long-term capital gains in that one rate group. If a taxpayer has 
long-term capital gains that may be subject to tax at more than one rate 
of tax under section 1(h) and the taxpayer's net capital gain 
attributable to such long-term capital gains and any qualified dividend 
income are taxed at more than one rate pursuant to section 1(h), the 
taxpayer shall determine the rate group for such long-term capital gains 
from sources within or outside the United States (and, to the extent 
from sources outside the United States, from each separate category) 
ratably based on the proportions of net capital gain and any qualified 
dividend income taxed at each applicable rate. For example, under the 
section 1(h) rates in effect for tax years beginning in 2004, a long-
term capital gain (other than a

[[Page 837]]

long-term capital gain described in section 1(h)(4)(A) or (h)(6)) may be 
subject to tax at 5 percent or 15 percent.
    (iii) Long-term capital losses. With respect to a long-term capital 
loss, a loss described in section 1(h)(4)(B)(i) (collectibles loss) or 
(iii) (long-term capital loss carryover) is a loss in the 28 percent 
rate group. All other long-term capital losses shall be treated as 
losses in the highest rate group in effect under section 1(h) for the 
tax year with respect to long-term capital gains other than long-term 
capital gains described in section 1(h)(4)(A) or (h)(6). For example, 
under the section 1(h) rates in effect for tax years beginning in 2004, 
a long-term capital loss not described in section 1(h)(4)(B)(i) or (iii) 
shall be treated as a loss in the 15 percent rate group.
    (5) Terms used in sections 1(h), 904(b) or 1222. For purposes of 
this section, any term used in this section and also used in section 
1(h), section 904(b) or section 1222 shall have the same meaning given 
such term by section 1(h), 904(b) or 1222, respectively, except as 
otherwise provided in this section.
    (g) Examples. The following examples illustrate the provisions of 
this section. In these examples, the rate differential adjustment is 
shown as a fraction, the numerator of which is the alternative tax rate 
percentage and the denominator of which is 35 percent (assumed to be the 
highest applicable tax rate for individuals under section 1). Finally, 
all dollar amounts in the examples are abbreviated from amounts in the 
thousands (for example, $50 represents $50,000). The examples are as 
follows:

    Example 1. (i) AA, an individual, has items from sources outside the 
United States only in the passive category for the taxable year. AA has 
$1000 of long-term capital gains from sources outside the United States 
that are subject to tax at a rate of 15 percent under section 1(h). AA 
has $700 of long-term capital losses from sources outside the United 
States, which are not described in section 1(h)(4)(B)(i) or (iii). For 
the same taxable year, AA has $800 of long-term capital gains from 
sources within the United States that are taxed at a rate of 28 percent 
under section 1(h). AA also has $100 of long-term capital losses from 
sources within the United States, which are not described in section 
1(h)(4)(B)(i) or (iii). AA also has $500 of ordinary income from sources 
within the United States. The highest tax rate in effect under section 
1(h) for the taxable year with respect to long-term capital gains other 
than long-term capital gains described in section 1(h)(4)(A) or (h)(6) 
is 15 percent. Accordingly, AA's long-term capital losses are in the 15 
percent rate group.
    (ii) AA's items of ordinary income, capital gain and capital loss 
for the taxable year are summarized in the following table:

------------------------------------------------------------------------
                                                                Foreign
                                                      U.S.      source:
                                                     source     passive
------------------------------------------------------------------------
15% rate group...................................     ($100)     $1,000
                                                                   (700)
28% rate group...................................        800
Ordinary income..................................        500
------------------------------------------------------------------------

    (iii) AA's capital gain net income from sources outside the United 
States ($300) does not exceed AA's capital gain net income from all 
sources ($1,000). Therefore, paragraph (a)(1) of this section does not 
require any reduction of AA's capital gain net income in the passive 
category.
    (iv) In computing AA's taxable income from sources outside the 
United States in the numerator of the section 904(a) foreign tax credit 
limitation fraction for the passive category, AA's $300 of capital gain 
net income in the 15 rate group in the passive category must be adjusted 
as required under paragraph (c)(1) of this section. AA adjusts the $300 
of capital gain net income using 15 percent as the alternative tax rate, 
as follows: $300 (15%/35%).
    (v) In computing AA's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fraction, AA combines 
the $300 of capital gain net income from sources outside the United 
States and the $100 net capital loss from sources within the United 
States in the same rate group (15 percent). AA must adjust the resulting 
$200 ($300 - $100) of net capital gain in the 15 percent rate group as 
required under paragraph (c)(2) of this section, using 15 percent as the 
alternative tax rate, as follows: $200 (15%/35%). AA must also adjust 
the $800 of net capital gain in the 28 percent rate group, using 28 
percent as the alternative tax rate, as follows: $800 (28%/35%). AA must 
also include ordinary income from sources outside the United States in 
the numerator, and ordinary income from all sources in the denominator, 
of the foreign tax credit limitation fraction.
    (vi) AA's passive category foreign tax credit limitation fraction is 
$128.58/$1225.72, computed as follows:

[[Page 838]]

[GRAPHIC] [TIFF OMITTED] TR20JY04.001

    Example 2. (i) BB, an individual, has the following items of 
ordinary income, capital gain, and capital loss for the taxable year:

------------------------------------------------------------------------
                                                     Foreign source
                                  U.S. source --------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group..................         $300        ($500)         $100
25% rate group..................          200  ............  ...........
28% rate group..................          500         (300)  ...........
Ordinary income.................        1,000          500           500
------------------------------------------------------------------------

    (ii) BB's capital gain net income from sources outside the United 
States in the aggregate (zero, since losses exceed gains) does not 
exceed BB's capital gain net income from all sources ($300). Therefore, 
paragraph (a)(1) of this section does not require any reduction of BB's 
capital gain net income in the passive category.
    (iii) In computing BB's taxable income from sources outside the 
United States in the numerators of the section 904(a) foreign tax credit 
limitation fractions for the passive and general limitation categories, 
BB must adjust capital gain net income from sources outside the United 
States in each separate category long-tem rate group and net capital 
losses from sources outside the United States in each separate category 
rate group as provided in paragraphs (c)(1) and (d) of this section.
    (A) The $100 of capital gain net income in the 15 percent rate group 
in the passive category is adjusted under paragraph (c)(1) of this 
section as follows: $100 (15%/35%).
    (B) BB must adjust the net capital losses in the 15 percent and 28 
percent rate groups in the general limitation category in accordance 
with the ordering rules contained in paragraph (d)(2) of this section. 
Under paragraph (d)(2)(i) of this section, BB's net capital loss in the 
15 percent rate group is netted against capital gain net income from 
sources outside the United States in other separate categories in the 
same rate group. Thus, $100 of the $500 net capital loss in the 15 
percent rate group in the general limitation category offsets $100 of 
capital gain net income in the 15 percent rate group in the passive 
category. Accordingly, $100 of the $500 net capital loss is adjusted 
under paragraph (d)(1) of this section as follows: $100 (15%/35%).
    (C) Next, under paragraph (d)(2)(iii)(A) of this section, BB's net 
capital losses from sources outside the United States in any separate 
category rate group are netted against capital gain net income in the 
same rate group from sources within the United States. Thus, $300 of the 
$500 net capital loss in the 15 percent rate group in the general 
limitation category offsets $300 of capital gain net income in the 15 
percent rate group from sources within the United States. Accordingly, 
$300 of the $500 net capital loss is adjusted under paragraph (d)(1) of 
this section as follows: $300 (15%/35%). Similarly, the $300 of net 
capital loss in the 28 percent rate group in the general limitation 
category offsets $300 of capital gain net income in the 28 percent rate 
group from sources within the United States. The $300 net capital loss 
is adjusted under paragraph (d)(1) of this section as follows: $300 
(28%/35%).
    (D) Finally, under paragraph (d)(2)(iii)(B) of this section, the 
remaining net capital losses in a separate category rate group are 
netted against capital gain net income from other rate groups from 
sources within and outside the United States. Thus, the remaining $100 
of the $500 net capital loss in the 15 percent rate group in the general 
limitation category offsets $100 of the remaining capital gain net 
income in the 28 percent rate group from sources within the United 
States. Accordingly, the remaining $100 of net capital loss is adjusted 
under paragraph (d)(1) of this section as follows: $100 (28%/35%).
    (iv) In computing BB's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fractions, BB must 
adjust net capital gain by netting all of BB's capital gains and losses, 
from sources within and outside the United States, and adjusting any 
remaining net capital gains, based on rate group, under paragraph (c)(2) 
of this section. BB must also include foreign source ordinary income in 
the numerators, and ordinary income from all sources in the denominator, 
of the foreign tax credit limitation fractions. The denominator of BB's 
foreign tax credit limitation fractions reflects $2,000 of ordinary 
income from all sources, $100 of net capital gain

[[Page 839]]

taxed at the 28% rate and adjusted as follows: $100 (28%/35%), and $200 
of net capital gain taxed at the 25% rate and adjusted as follows: $200 
(25%/35%).
    (v) BB's foreign tax credit limitation fraction for the general 
limitation category is $8.56/$2222.86, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.002

    (vi) BB's foreign tax credit limitation fraction for the passive 
category is $542.86/$2222.86, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.003

    Example 3. (i) CC, an individual, has the following items of 
ordinary income, capital gain, and capital loss for the taxable year:

------------------------------------------------------------------------
                                                    Foreign source
                                 U.S. source ---------------------------
                                                 General       Passive
------------------------------------------------------------------------
15% rate group.................         $300        ($720)         ($80)
25% rate group.................          200  ............  ............
28% rate group.................          500         (150)           50
Ordinary income................        1,000        1,000           500
------------------------------------------------------------------------

    (ii) CC's capital gain net income from sources outside the United 
States (zero, since losses exceed gains) does not exceed CC's capital 
gain net income from all sources ($100). Therefore, paragraph (a)(1) of 
this section does not require any adjustment.
    (iii) In computing CC's taxable income from sources outside the 
United States in the numerators of the section 904(a) foreign tax credit 
limitation fractions for the passive and general limitation categories, 
CC must adjust capital gain net income from sources outside the United 
States in each separate category long-tem rate group and net capital 
losses from sources outside the United States in each separate category 
rate group as provided in paragraphs (c)(1) and (d) of this section.
    (A) CC must adjust the $50 of capital gain net income in the 28 
percent rate group in the passive category pursuant to paragraph (c)(1) 
of this section as follows: $50 (28%/35%).
    (B) Under paragraph (d)(2)(i) of this section, $50 of CC's $150 net 
capital loss in the 28 percent rate group in the general limitation 
category offsets $50 of capital gain net income in the 28 percent rate 
group in the passive category. Thus, $50 of the $150 net capital loss is 
adjusted as follows: $50 (28%/35%). Next, under paragraph (d)(2)(iii)(A) 
of this section, the remaining $100 of net capital loss in the 28 
percent rate group in the general limitation category offsets $100 of 
capital gain net income in the 28 percent rate group from sources within 
the United States. Thus, the remaining $100 of net capital loss is 
adjusted as follows: $100 (28%/35%).
    (C) Under paragraphs (d)(2)(iii)(A) and (d)(2)(iv) of this section, 
the net capital losses in the 15 percent rate group in the passive and 
general limitation categories offset on a pro rata basis the $300 of 
capital gain net income in the 15 percent rate group from sources within 
the United States. The proportionate amount of the $720 net capital loss 
($720/$800 of $300, or $270) is adjusted as follows: $270 (15%/35%). The 
proportionate amount of the $80 net capital loss ($80/$800 of $300, or 
$30) is adjusted as follows $30 (15%/35%).
    (D) Of the remaining $500 of net capital loss in the 15 percent rate 
group in the general limitation and passive categories, $400 offsets the 
remaining $400 of capital gain net income in the 28 percent rate group 
from sources within the United States under paragraph (d)(2)(iii)(B)(3) 
of this section. The proportionate amount of the $720 net capital

[[Page 840]]

loss ($720/$800 of $400, or $360) is adjusted as follows: $360 (28%/
35%). The proportionate amount of the $80 net capital loss ($80/$800 of 
$400, or $40) is adjusted as follows: $40 (28%/35%).
    (E) Under paragraph (d)(2)(iii)(B)(3) of this section, the remaining 
$100 of net capital loss in the 15 percent rate group in the general 
limitation and passive limitation categories offsets $100 of capital 
gain net income in the 25 percent rate group from sources within the 
United States. The proportionate amount of the $720 net capital loss 
($720/$800 of $100, or $90) is adjusted as follows: $90 (25%/35%). The 
proportionate amount of the $80 net capital loss ($80/$800 of $100 of 
$10) is adjusted as follows: $10 (25%/35%).
    (iv) In computing CC's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fractions, CC must 
adjust capital gain net income by netting all of CC's capital gains and 
losses, from sources within and outside the United States, and adjusting 
any remaining net capital gains, based on rate group, under paragraph 
(c)(2) of this section. The denominator of CC's foreign tax credit 
limitation fractions reflects $2,500 of ordinary income from all sources 
and $100 of net capital gain taxed at the 25% rate and adjusted as 
follows: $100 (25%/35%).
    (v) CC's foreign tax credit limitation fraction for the general 
limitation category is $412/$2571.42, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.004

    (vi) CC's foreign tax credit limitation fraction for the passive 
category is $488.00/$2571.42, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.005

    Example 4. (i) DD, an individual, has the following items of 
ordinary income, capital gain and capital loss for the taxable year:

------------------------------------------------------------------------
                                                     Foreign source
                                  U.S. source --------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group.................         ($80)        ($100)         $300
Short-term.....................  ............          500           100
Ordinary income................          500   ............  ...........
------------------------------------------------------------------------

    (ii) DD's capital gain net income from outside the United States 
($800) exceeds DD's capital gain net income from all sources ($720). 
Pursuant to paragraph (a)(1)(ii)(A) of this section, DD must apportion 
the $80 of excess of capital gain net income from sources outside the 
United States between the general limitation and passive categories 
based on the amount of capital gain net income in each separate 
category. Thus, one-half ($400/$800 of $100, or $40) is apportioned to 
the general limitation category and one-half ($400/$800 of $80, or $40) 
is apportioned to the passive category. The $40 apportioned to the 
general limitation category reduces DD's $500 short-term capital gain in 
the general limitation category to $460. Pursuant to paragraph 
(a)(1)(ii)(B) of this section, the $40 apportioned to the passive 
category must be apportioned further between the capital gain net income 
in the short-term rate group and the 15 percent rate group based on the 
relative amounts of capital gain net income in each rate group. Thus, 
one-fourth ($100/$400 of $40 or $10) is apportioned to the short-term 
rate group and three-fourths ($300/$400 of $40 or $30) is apportioned to 
the 15 percent rate group. DD's passive category includes $90 of short-
term capital gain and $270 of capital gain net income in the 15% rate 
group.
    (iii) Because DD has a net long-term capital loss from sources 
within the United States ($80) and also has short-term capital

[[Page 841]]

gains, DD must apply the provisions of paragraph (c)(1)(ii) of this 
section to determine the amount of DD's $270 of capital gain net income 
in the 15% rate group that is subject to a rate differential adjustment 
under paragraph (c)(1) of this section. Under Step 1, the U.S. long-term 
capital loss adjustment amount is $50 ($80-$30). Under Step 2, the 
applicable rate differential amount is the excess of the remaining 
capital gain net income over the U.S. long-term adjustment amount. Thus, 
the applicable rate differential amount is $220 ($270 - $50). In 
computing DD's taxable income from sources outside the United States in 
the numerator of the section 904(a) foreign tax credit limitation 
fraction for the passive category, DD must adjust this amount as 
follows: $220 (15%/35%). DD does not adjust the remaining $50 of capital 
gain net income in the 15% rate group.
    (iv) The amount of capital gain net income in the 15% rate group in 
the passive category, taking into account the adjustment pursuant to 
paragraph (a)(1) of this section and disregarding the adjustment 
pursuant to paragraph (c)(1) of this section, is $270. Under paragraphs 
(d)(2)(i) and (d)(2)(v) of this section, DD's $100 net capital loss in 
the 15% rate group in the general limitation category offsets capital 
gain net income in the 15% rate group in the passive category. 
Accordingly, the $100 of net capital loss is adjusted as follows: $100 
(15%/35%).
    (v) In computing DD's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fractions, DD must 
adjust capital gain net income by netting all of DD's capital gains and 
losses from sources within and outside the United States, and adjusting 
the remaining net capital gain in each rate group pursuant to paragraph 
(c)(2) of this section. The denominator of DD's foreign tax credit 
limitation fraction reflects $500 of ordinary income from all sources, 
$600 of short-term capital gain and $120 of net capital gain in the 15 
percent rate group adjusted as follows: $120 (15%/35%).
    (vi) DD's foreign tax credit limitation fraction for the general 
limitation category is $417.14/$1151.43, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.006

    (vii) DD's foreign tax credit limitation fraction for the passive 
category is $234.29/$1151.43, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.007

    Example 5. (i) EE, an individual, has the following items of 
ordinary income, capital gain and capital loss for the taxable year:

------------------------------------------------------------------------
                                                                Foreign
                                                      U.S.       source
                                                     source   ----------
                                                                Passive
------------------------------------------------------------------------
15% rate group...................................      ($150)       $300
28% rate group...................................  ..........        200
Short-term.......................................         30         100
Ordinary income..................................        500   .........
------------------------------------------------------------------------

    (ii) EE's capital gain net income from sources outside the United 
States ($600) exceeds EE's capital gain net income from all sources 
($480). Pursuant to paragraph (a)(1)(ii) of this section, the $120 of 
excess capital gain net income from sources outside the United States is 
allocated as a reduction to the passive category and must be apportioned 
pro rata to each rate group within the passive category with capital 
gain net income. Thus, $20 ($100/$600 of $120) is apportioned to the 
short-term rate group, $60 ($300/$600 of $120) is apportioned to the 15 
percent rate group and $40 ($200/$600 of $120) is apportioned to the 28 
percent rate group. After application of paragraph (a)(1) of this 
section, EE has $80 of capital gain net income in the short-term rate 
group, $240 of capital gain net income in the 15 percent rate group and 
$160 of capital gain net income in the 28 percent rate group.
    (iii) Because EE has a net long-term capital loss from sources 
within the United States ($150) and also has short-term capital gains, 
EE must apply the provisions of paragraph (c)(1)(ii) of this section to 
determine the amount of EE's remaining $400 ($240 + $160) of capital 
gain net income in long-term rate groups in the passive category that is 
subject to a rate differential adjustment to a rate differential 
adjustment. Under Step 1, the U.S. long-term capital loss adjustment 
amount is $50 ($150-$100). Under Step 2, EE must apportion this amount 
pro rata to each long-term rate group within the passive category with 
capital gain net income. Thus, $30 ($240/$400 of $50) is apportioned to 
the 15 percent rate group and $20 ($160/$400 of $50) is apportioned to 
the 28 percent rate group. The applicable rate differential amount for 
the 15 percent rate group is $210 ($240 - $30). The applicable rate 
differential amount for the 28 percent rate group is $140 ($160 - $20).
    (iv) Pursuant to paragraph (c)(1)(ii) of this section, EE must 
adjust $210 of the $240 capital gain in the 15 percent rate group as 
follows: $210 (15%/35%). EE does not adjust the remaining $30. Pursuant 
to paragraph (c)(1)(ii) of this section, EE must adjust $140 of the $160 
capital gain in the 28 percent rate group as follows: $140 (28%/35%). EE 
does not adjust the remaining $20.
    (v) In computing EE's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fractions, EE must 
adjust capital gain net income by netting all of EE's capital gains and 
losses from sources within and outside the United

[[Page 842]]

States, and adjusting the remaining net capital gain in each rate group 
pursuant to paragraph (c)(2) of this section. The denominator of EE's 
foreign tax credit limitation fraction reflects $500 of ordinary income 
from all sources, $130 of short-term capital gain, $150 of net capital 
gain in the 15 percent rate group adjusted as follows: $150 (15%/35%), 
and $200 of net capital gain in the 28 percent rate group adjusted as 
follows: $200 (28%/35%).
    (vi) EE's foreign tax credit limitation fraction for the passive 
category is $332/$854.29, computed as follows:
[GRAPHIC] [TIFF OMITTED] TR20JY04.008

    (h) Coordination with section 904(f)--(1) In general. Section 904(b) 
and this section shall apply before the provisions of section 904(f) as 
follows:
    (i) The amount of a taxpayer's separate limitation income or loss in 
each separate category, the amount of overall foreign loss, and the 
amount of any additions to or recapture of separate limitation loss or 
overall foreign loss accounts pursuant to section 904(f) shall be 
determined after applying paragraphs (a), (c)(1), (d) and (e) of this 
section to adjust capital gains and losses and qualified dividend income 
from sources outside the United States in each separate category.
    (ii) To the extent a capital loss from sources within the United 
States reduces a taxpayer's foreign source taxable income under 
paragraph (a)(1) of this section, such capital loss shall be disregarded 
in determining the amount of a taxpayer's taxable income from sources 
within the United States for purposes of computing the amount of any 
additions to the taxpayer's overall foreign loss accounts.
    (iii) In determining the amount of a taxpayer's loss from sources in 
the United States under section 904(f)(5)(D) (section 904(f)(5)(D) 
amount), the taxpayer shall make appropriate adjustments to capital 
gains and losses from sources within the United States to reflect 
adjustments pursuant to section 904(b)(2) and this section. Therefore, 
for purposes of section 904, a taxpayer's section 904(f)(5)(D) amount 
shall be equal to the excess of the taxpayer's foreign source taxable 
income in all separate categories in the aggregate for the taxable year 
(taking into account any adjustments pursuant to paragraphs (a)(1), 
(c)(1), (d) and (e) of this section) over the taxpayer's entire taxable 
income for the taxable year (taking into account any adjustments 
pursuant to paragraphs (c)(2) and (e) of this section).
    (2) Examples. The following examples illustrate the application of 
paragraph (h) of this section:

    Example 1. (i) W, an individual, has the following items of ordinary 
income, capital gain, and capital loss for the taxable year:

------------------------------------------------------------------------
                                                     Foreign source
                                   U.S. source -------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group...................         $500         $100       ($400)
Ordinary income..................          900          100  ...........
------------------------------------------------------------------------

    (ii) In computing W's taxable income from sources outside the United 
States for purposes of section 904 and this section, W must adjust the 
capital gain net income and net capital loss in each separate category 
as provided in paragraphs (c)(1) and (d) of this section. Thus, W must 
adjust the $100 of capital gain net income in the general limitation 
category and the $400 of net capital loss in the passive category as 
follows: $100 (15%/35%) and $400 (15%/35%).
    (iii) After the adjustment to W's net capital loss in the passive 
category, W has a $171.43 separate limitation loss in the passive 
category. After the adjustment to W's capital gain in the general 
limitation category, W has $142.86 of foreign source taxable income in 
the general limitation category. Thus, $142.86 of the separate 
limitation loss

[[Page 843]]

reduces foreign source taxable income in the general limitation 
category. See section 904(f)(5)(B). W adds $142.86 to the separate 
limitation loss account for the passive category. The remaining $28.57 
of the separate limitation loss reduces income from sources within the 
United States. See section 904(f)(5)(A). Thus, W adds $28.57 to the 
overall foreign loss account for the passive category.
    Example 2. (i) X, a corporation, has the following items of ordinary 
income, ordinary loss, capital gain and capital loss for the taxable 
year: foreign source:

------------------------------------------------------------------------
                                                                Foreign
                                                     U.S.       source:
                                                    source      general
------------------------------------------------------------------------
Capital gain....................................      ($500)       $700
Ordinary income.................................       1100       (1000)
------------------------------------------------------------------------

    (ii) X's capital gain net income from sources outside the United 
States ($700) exceeds X's capital gain net income from all sources 
($200). Pursuant to paragraph (a)(1) of this section, X must reduce the 
$700 capital gain in the general limitation category by $500. After the 
adjustment, X has $200 of capital gain net income remaining in the 
general limitation category. Thus, X has an overall foreign loss 
attributable to the general limitation category of $800.
    (iii) For purposes of computing the amount of the addition to X's 
overall foreign loss account for the general limitation category, the 
$500 capital loss from sources within the United States is disregarded 
and X's taxable income from sources within the United States is $1100. 
Accordingly, X must increase its overall foreign loss account for the 
general limitation category by $800.
    Example 3. (i) Y, a corporation, has the following items of ordinary 
income, ordinary loss, capital gain and capital loss for the taxable 
year:

------------------------------------------------------------------------
                                                                Foreign
                                                       U.S.     source:
                                                      source    passive
------------------------------------------------------------------------
Capital gain......................................     ($100)       $200
Ordinary income...................................      (200)        500
------------------------------------------------------------------------

    (ii) Y's capital gain net income from sources outside the United 
States ($200) exceeds Y's capital gain net income from all sources 
($100). Pursuant to paragraph (a)(1) of this section, Y must reduce the 
$200 capital gain in the passive category by $100. Y has $100 of capital 
gain net income remaining in the passive category.
    (iii) Y is not required to make adjustments pursuant to paragraph 
(c), (d) or (e) of this section. See paragraphs (b) and (e) of this 
section. Y's foreign source taxable income in the passive category after 
the adjustment pursuant to paragraph (a)(1) of this section is $600. Y's 
entire taxable income for the taxable year is $400.
    (iv) Y's section 904(f)(5)(D) amount is the excess of Y's foreign 
source taxable income in all separate categories in the aggregate for 
the taxable year after taking into account the adjustment pursuant to 
paragraph (a)(1) of this section ($600) over Y's entire taxable income 
for the taxable year ($400). Therefore, Y's section 904(f)(5)(D) amount 
is $200 and Y's foreign source taxable income in the passive category is 
reduced to $400. See section 904(f)(5)(D).
    Example 4. (i) Z, an individual, has the following items of ordinary 
income, ordinary loss and capital gain for the taxable year:

------------------------------------------------------------------------
                                                     Foreign source:
                                   U.S. source -------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group..................         $100   ...........  ...........
Ordinary income.................         (200)         $300         $300
------------------------------------------------------------------------

    (ii) Z's foreign source taxable income in all of Z's separate 
categories in the aggregate for the taxable year is $600. (There are no 
adjustments to Z's foreign source taxable income pursuant to paragraph 
(a)(1), (c)(1), (d) or (e) of this section.)
    (iii) In computing Z's entire taxable income in the denominator of 
the section 904(d) foreign tax credit limitation fractions, Z must 
adjust the $100 of net capital gain in the 15 percent rate group 
pursuant to paragraph (c)(2) of this section as follows: $100 (15%/35%). 
Thus, Z's entire taxable income for the taxable year, taking into 
account the adjustment pursuant to paragraph (c)(2) of this section, is 
$442.86.
    (iv) Z's section 904(f)(5)(D) amount is the excess of Z's foreign 
source taxable income in all separate categories in the aggregate for 
the taxable year ($600) over Z's entire taxable income for the taxable 
year after the adjustment pursuant to paragraph (c)(2) of this section 
($442.86). Therefore, Z's section 904(f)(5)(D) amount is $157.32. This 
amount must be allocated pro rata to the passive and general limitation 
categories in accordance with section 904(f)(5)(D).
    Example 5. (i) O, an individual, has the following items of ordinary 
income, ordinary loss and capital gain for the taxable year:

[[Page 844]]



------------------------------------------------------------------------
                                                     Foreign source
                                  U.S. source --------------------------
                                                  General      Passive
------------------------------------------------------------------------
15% rate group.................        $1100         ($500)  ...........
Ordinary income................        (1000)         1000          $500
------------------------------------------------------------------------

    (ii) In determining O's taxable income from sources outside the 
United States, O must reduce the $500 capital loss in the general 
limitation category to $214.29 ($500 x 15%/35%) pursuant to paragraph 
(d) of this section. Taking this adjustment into account, O's foreign 
source taxable income in all of O's separate categories in the aggregate 
is $1285.71 ($1000 - $214.29 + $500).
    (iii) In computing O's entire taxable income in the denominator of 
the section 904(a) foreign tax credit limitation fraction, O must reduce 
the $600 of net capital gain for the year to $257.14 ($600 x 15%/35%) 
pursuant to paragraph (c)(2) of this section. Taking this adjustment 
into account, O's entire taxable income for the year is $757.14 ($500 + 
$257.14).
    (iv) Therefore, O's section 904(f)(5)(D) amount is $528.57 ($1285.71 
- $757.14). This amount must be allocated pro rata to O's $500 of income 
in the passive category and O's $785.71 of adjusted income in the 
general limitation category in accordance with section 904(f)(5)(D).

    (i) Effective date. This section shall apply to taxable years 
beginning after July 20, 2004. Taxpayers may choose to apply this 
section and Sec.  1.904(b)-2 to taxable years ending after July 20, 
2004.

[T.D. 9141, 69 FR 43308, July 20, 2004; 69 FR 61761, Oct. 21, 2004]



Sec.  1.904(b)-2  Special rules for application of section 904(b) 
to alternative minimum tax foreign tax credit.

    (a) Application of section 904(b)(2)(B) adjustments. Section 
904(b)(2)(B) shall apply for purposes of determining the alternative 
minimum tax foreign tax credit under section 59 (regardless of whether 
or not the taxpayer has made an election under section 59(a)(4)).
    (b) Use of alternative minimum tax rates--(1) Taxpayers other than 
corporations. In the case of a taxpayer other than a corporation, for 
purposes of determining the alternative minimum tax foreign tax credit 
under section 59--
    (i) Section 904(b)(3)(D)(i) shall be applied by using the language 
``section 55(b)(3)'' instead of ``subsection (h) of section 1'';
    (ii) Section 904(b)(3)(E)(ii)(I) shall be applied by using the 
language ``section 55(b)(1)(A)(i)'' instead of ``subsection (a), (b), 
(c), (d), or (e) of section 1 (whichever applies)''; and
    (iii) Section 904(b)(3)(E)(iii)(I) shall be applied by using the 
language ``the alternative rate of tax determined under section 
55(b)(3)'' instead of ``the alternative rate of tax determined under 
section 1(h)''.
    (2) Corporate taxpayers. In the case of a corporation, for purposes 
of determining the alternative minimum tax foreign tax credit under 
section 59, section 904(b)(3)(E)(ii)(II) shall be applied by using the 
language ``section 55(b)(1)(B)'' instead of ``section 11(b)''.
    (c) Effective date. This section shall apply to taxable years 
beginning after July 20, 2004. See Sec.  1.904(b)-1(i) for a rule 
permitting taxpayers to choose to apply Sec.  1.904(b)-1 and this Sec.  
1.904(b)-2 to taxable years ending after July 20, 2004.

[T.D. 9141, 69 FR 43316, July 20, 2004; 69 FR 61761, Oct. 21, 2004]



Sec.  1.904(f)-0  Outline of regulation provisions.

    This section lists the headings for Sec. Sec.  1.904(f)-1 through 
1.904(f)-8 and 1.904(f)-12.

           Sec.  1.904(f)-0 Outline of regulation provisions.

    This section lists the headings for Sec. Sec.  1.904(f)-1 through 
1.904(f)-8 and 1.904(f)-12.

   Sec.  1.904(f)-1 Overall foreign loss and the overall foreign loss 
                                account.

    (a)(1) Overview of regulations.
    (2) Application to post-1986 taxable years.
    (b) Overall foreign loss accounts.
    (c) Determination of a taxpayer's overall foreign loss.
    (1) Overall foreign loss defined.
    (2) Separate limitation defined.
    (3) Method of allocation and apportionment of deductions.
    (d) Additions to the overall foreign loss account.
    (1) General rule.
    (2) Overall foreign losses of another taxpayer.

[[Page 845]]

    (3) Additions to overall foreign loss account created by loss 
carryovers.
    (4) Adjustments for capital gains and losses.
    (e) Reductions of overall foreign loss accounts.
    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers.
    (2) Reduction for amounts recaptured.
    (f) Illustrations.
    (g) Effective/applicability date.

          Sec.  1.904(f)-2 Recapture of overall foreign losses.

    (a) In general.
    (b) Determination of taxable income from sources without the United 
States for purposes of recapture.
    (1) In general.
    (c) Section 904(f)(1) recapture.
    (1) In general.
    (2) Election to recapture more of the overall foreign loss than is 
required under paragraph (c)(1).
    (3) Special rule for recapture of losses incurred prior to section 
936 election.
    (4) Recapture of pre-1983 overall foreign losses determined on a 
combined basis.
    (5) Illustrations.
    (d) Recapture of overall foreign losses from dispositions under 
section 904(f)(3).
    (1) In general.
    (2) Treatment of net capital gain.
    (3) Dispositions where gain is recognized irrespective of section 
904(f)(3).
    (i) Foreign source gain.
    (ii) U.S. source gain.
    (4) Dispositions in which gain would not otherwise be recognized.
    (i) Recognition of gain to the extent of the overall foreign loss 
account.
    (ii) Basis adjustment.
    (iii) Recapture of overall foreign loss to the extent of amount 
recognized.
    (iv) Priorities among dispositions in which gain is deemed to be 
recognized.
    (5) Definitions.
    (i) Disposition.
    (ii) Property used in a trade or business.
    (iii) Property used predominantly outside the United States.
    (iv) Property which is a material factor in the realization of 
income.
    (6) Carryover of overall foreign loss accounts in a corporate 
acquisition to which section 381(a) applies.
    (7) Illustrations.
    (e) Effective/applicability.

    Sec.  1.904(f)-4 Recapture of foreign losses out of accumulation 
                   distributions from a foreign trust.

    (a) In general.
    (b) Effect of recapture on foreign tax credit limitation under 
section 667(d).
    (c) Recapture if taxpayer deducts foreign taxes deemed distributed.
    (d) Illustrations.

 Sec.  1.904(f)-5 Special rules for recapture of overall foreign losses 
                          of a domestic trust.

    (a) In general.
    (b) Recapture of trust's overall foreign loss.
    (1) Trust accumulates income.
    (2) Trust distributes income.
    (3) Trust accumulates and distributes income.
    (c) Amounts allocated to beneficiaries.
    (d) Section 904(f)(3) dispositions to which Sec.  1.904(f)-
2(d)(4)(i) is applicable.
    (e) Illustrations.

  Sec.  1.904(f)-6 Transitional rule for recapture of FORI and general 
  limitation overall foreign losses incurred in taxable year beginning 
 before January 1, 1983, from foreign source taxable income subject to 
  the general limitation in taxable years beginning after December 31, 
                                  1982.

    (a) General Rule.
    (b) Recapture of pre-1983 FORI and general limitation overall 
foreign losses from post-1982 income.
    (1) Recapture from income subject to the same limitation.
    (2) Recapture from income subject to the other limitation.
    (c) Coordination of recapture of pre-1983 and post-1982 overall 
foreign losses.
    (d) Illustrations.

 Sec.  1.904(f)-7 Separate limitation loss and the separate limitation 
                              loss account.

    (a) Overview of regulations.
    (b) Definitions.
    (1) Separate category.
    (2) Separate limitation income.
    (3) Separate limitation loss.
    (c) Separate limitation loss account.
    (d) Additions to separate limitation loss accounts.
    (1) General rule.
    (2) Separate limitation losses of another taxpayer.
    (3) Additions to separate limitation loss account created by loss 
carryovers.
    (e) Reductions of separate limitation loss accounts.
    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers.
    (2) Reduction for offsetting loss accounts.
    (3) Reduction for amounts recaptured.
    (f) Effective/applicability date.

    Sec.  1.904(f)-8 Recapture of separate limitation loss accounts.

    (a) In general.
    (b) Effect of recharacterization of separate limitation income on 
associated taxes.
    (c) Effective/applicability date.

[[Page 846]]

                   Sec.  1.904(f)-12 Transition rules.

    (a) Recapture in years beginning after December 31, 1986, of overall 
foreign losses incurred in taxable years beginning before January 1, 
1987.
    (1) In general.
    (2) Rule for general limitation losses.
    (i) In general.
    (ii) Exception.
    (3) Priority of recapture of overall foreign losses incurred in pre-
effective date taxable years.
    (4) Examples.
    (b) Treatment of overall foreign losses that are part of net 
operating losses incurred in pre-effective date taxable years which are 
carried forward to post-effective date taxable years.
    (1) Rule.
    (2) Example.
    (c) Treatment of overall foreign losses that are part of net 
operating losses incurred in post-effective date taxable years which are 
carried back to pre-effective date taxable years.
    (1) Allocation to analogous income category.
    (2) Allocation to U.S. source income.
    (3) Allocation to other separate limitation categories.
    (4) Examples.
    (d) Recapture of FORI and general limitation overall foreign losses 
incurred in taxable years beginning before January 1, 1983.
    (e) Recapture of pre-1983 overall foreign losses determined on a 
combined basis.
    (f) Transition rules for taxable years beginning before December 31, 
1990.
    (g) Recapture in years beginning after December 31, 2002, of 
separate limitation losses and overall foreign losses incurred in years 
beginning before January 1, 2003, with respect to the separate category 
for dividends from a noncontrolled section 902 corporation.
    (1) Recapture of separate limitation loss or overall foreign loss in 
a separate category for dividends from a noncontrolled section 902 
corporation.
    (2) Recapture of separate limitation loss in another separate 
category.
    (3) Exception.
    (4) Examples.
    (5) Effective/applicability date.
    (h) Recapture in years beginning after December 31, 2006, of 
separate limitation losses and overall foreign losses incurred in years 
beginning before January 1, 2007.
    (1) Losses related to pre-2007 separate categories for passive 
income, certain dividends from a DISC or former DISC, taxable income 
attributable to certain foreign trade income or certain distributions 
from a FSC or former FSC.
    (i) Recapture of separate limitation loss or overall foreign loss 
incurred in a pre-2007 separate category for passive income, certain 
dividends from a DISC or former DISC, taxable income attributable to 
certain foreign trade income or certain distributions from a FSC or 
former FSC.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for passive income, certain dividends from a DISC 
or former DISC, taxable income attributable to certain foreign trade 
income or certain distributions from a FSC or former FSC.
    (2) Losses related to pre-2007 separate categories for shipping, 
financial services income or general limitation income.
    (i) Recapture of separate limitation loss or overall foreign loss 
incurred in a pre-2007 separate category for shipping income, financial 
services income or general limitation income.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for shipping income, financial services income or 
general limitation income.
    (3) Losses related to a pre-2007 separate category for high 
withholding tax interest.
    (i) Recapture of separate limitation loss or overall foreign loss 
incurred in a pre-2007 separate category for high withholding tax 
interest.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for high withholding tax interest.
    (4) Elimination of certain separate limitation loss accounts.
    (5) Alternative method.
    (6) Effective/applicability date.

[T.D. 9371, 72 FR 72596, Dec. 21, 2007; T.D. 9452, 74 FR 27886, June 11, 
2009, T.D. 9521, 76 FR 19273, Apr. 7, 2011; T.D. 9595, 77 FR 37578, June 
22, 2012]



Sec.  1.904(f)-1  Overall foreign loss and the overall foreign loss account.

    (a)(1) Overview of regulations. In general, section 904(f) and these 
regulations apply to any taxpayer that sustains an overall foreign loss 
(as defined in paragraph (c)(1) of this section) in a taxable year 
beginning after December 31, 1975. For taxable years ending after 
December 31, 1984, and beginning before January 1, 1987, there can be 
five types of overall foreign losses: a loss under each of the five 
separate limitations contained in former section 904(d)(1)(A) (passive 
interest limitation), (d)(1)(B) (DISC dividend limitation), (d)(1)(C) 
(foreign trade income limitation), (d)(1)(D) (foreign sales corporation 
(FSC) distributions limitation), and (d)(1)(E) (general limitation). For 
taxable years beginning after December 31, 1982, and ending before 
January 1, 1985,

[[Page 847]]

there can be three types of overall foreign losses under former section 
904(d)(1)(A) (passive interest limitation), former section 904(d)(1)(B) 
(DISC dividend limitation) and former section 904(d)(1)(C) (general 
limitation). For taxpayers subject to section 907, the post-1982 general 
limitation overall foreign loss account may be further subdivided, as 
provided in Sec.  1.904(f)-6. For taxable years beginning after December 
31, 1975, and before January 1, 1983, taxpayers should have computed 
overall foreign losses separately under the passive interest limitation, 
the DISC dividend limitation, the general limitation, and the section 
907(b) (FORI) limitation. However, for taxable years beginning after 
December 31, 1975, and before January 1, 1983, taxpayers may have 
computed only two types of overall foreign losses: A foreign oil related 
loss under the FORI limitation and an overall foreign loss computed on a 
combined basis for the passive interest limitation, the DISC dividend 
limitation, and the general limitation. A taxpayer that computed overall 
foreign losses for these years on a combined basis will not be required 
to amend its return to recompute such losses on a separate basis. If a 
taxpayer computed its overall foreign losses for these years separately 
under the passive interest limitation, the DISC dividend limitation, and 
the general limitation, on returns previously filed, a taxpayer may not 
amend those returns to compute such overall foreign losses on a combined 
basis. Section 1.904(f)-1 provides rules for determining a taxpayer's 
overall foreign losses, for establishing overall foreign loss accounts, 
and for making additions to and reductions of such accounts for purposes 
of section 904(f). Section 1.904(f)-2 provides rules for recapturing the 
balance in any overall foreign loss account under the general recapture 
rule of section 904(f)(1) and under the special recapture rule of 
section 904(f)(3) when the taxpayer disposes of property used 
predominantly outside the United States in a trade or business. Section 
1.904(f)-3 provides rules for allocating overall foreign losses that are 
part of net operating losses or net capital losses to foreign source 
income in years to which such losses are carried. In addition, Sec.  
1.904(f)-3 provides transition rules for the treatment of net operating 
losses incurred in taxable years beginning after December 31, 1982, and 
carried back to taxable years beginning before January 1, 1983, and of 
net operating losses incurred in taxable years beginning before January 
1, 1983, and carried forward to taxable years beginning after December 
31, 1982. Section 1.904(f)-4 provides rules for recapture out of an 
accumulation distribution of a foreign trust. Section 1.904(f)-5 
provides rules for recapture of overall foreign losses of domestic 
trusts. Section 1.904(f)-6 provides a transition rule for recapturing a 
taxpayer's pre-1983 overall foreign losses under the general limitation 
and the FORI limitation out of taxable income subject to the general 
limitation in taxable years beginning after December 31, 1982. Section 
Sec.  1.1502-9 provides rules concerning the application of these 
regulations to corporations filing consolidated returns.
    (2) Application to post-1986 taxable years. The principles of 
Sec. Sec.  1.904(f)-1 through 1.904(f)-5 shall apply to any overall 
foreign loss sustained in taxable years beginning after December 31, 
1986, modified so as to take into account the effect of statutory 
amendments.
    (b) Overall foreign loss accounts. Any taxpayer that sustains an 
overall foreign loss under paragraph (c) of this section must establish 
an account for such loss. Separate types of overall foreign losses must 
be kept in separate accounts. For taxable years beginning prior to 
January 1, 1983, taxpayers that computed losses on a combined basis in 
accordance with Sec.  1.904(f)-1(c)(1) will keep one overall foreign 
loss account for such overall foreign loss. The balance in each overall 
foreign loss account represents the amount of such overall foreign loss 
subject to recapture by the taxpayer in a given year. From year to year, 
amounts may be added to or subtracted from the balances in such accounts 
as provided in paragraphs (d) and (e) of this section. The taxpayer must 
report the balances (if any) in its overall foreign loss accounts 
annually on a Form 1116 or 1118. Such forms must be filed for each 
taxable year ending after September 24, 1987. The balance in each 
account does

[[Page 848]]

not have to be attributed to the year or years in which the loss was 
incurred.
    (c) Determination of a taxpayer's overall foreign loss--(1) Overall 
foreign loss defined. For taxable years beginning after December 31, 
1982, and before January 1, 1987, a taxpayer sustains an overall foreign 
loss in any taxable year in which its gross income from sources without 
the United States subject to a separate limitation (as defined in 
paragraph (c)(2) of this section) is exceeded by the sum of the 
deductions properly allocated and apportioned thereto. Such losses are 
to be determined separately in accordance with the principles of the 
separate limitations. Accordingly, income and deductions subject to a 
separate limitation are not to be netted with income and deductions 
subject to another separate limitation for purposes of determining the 
amount of an overall foreign loss. A taxpayer may, for example, have an 
overall foreign loss under the general limitation in the same taxable 
year in which it has taxable income under the DISC dividend limitation. 
The same principles of calculating overall foreign losses on a separate 
limitation basis apply for taxable years beginning before January 1, 
1983, except that a taxpayer shall determine its overall foreign losses 
on a combined basis, except for income subject to the FORI limitation, 
if the taxpayer filed its pre-1983 returns on such basis. Thus, for 
taxable years beginning prior to January 1, 1983, a taxpayer can net 
income and losses among the passive interest limitation, the DISC 
dividend limitation, and the general limitation if the taxpayer 
calculated its overall foreign losses that way at the time. Taxpayers 
that computed overall foreign losses separately under each of the 
separate limitations on their returns filed for taxable years beginning 
prior to January 1, 1983, may not amend such returns to compute their 
overall foreign losses for pre-1983 years on a combined basis.
    (2) Separate limitation defined. For purposes of paragraph (c)(1) of 
this section and these regulations, the term separate limitation means 
any of the separate limitations under former section 904(d)(1)(A) 
(passive interest limitation), (B) (DISC dividend limitation), (C) 
(foreign trade income limitation), (D) (FSC distributions limitation), 
and (E) (general limitation) and the separate limitation under section 
907(b) (FORI limitation) (for taxable years ending after December 31, 
1975, and beginning before January 1, 1983).
    (3) Method of allocation and apportionment of deductions. In 
determining its overall foreign loss, a taxpayer shall allocate and 
apportion expenses, losses, and other deductions to the appropriate 
category of gross income in accordance with section 862(b) and Sec.  
1.861-8 of the regulations. However, the following deductions shall not 
be taken into account:
    (i) The amount of any net operating loss deduction for such year 
under section 172(a); and
    (ii) To the extent such losses are not compensated for by insurance 
or otherwise, the amount of any--
    (A) Expropriation losses for such year (as defined in section 
172(h)), or
    (B) Losses for such year which arise from fire, storm, shipwreck, or 
other casualty, or from theft.
    (d) Additions to the overall foreign loss account--(1) General rule. 
A taxpayer's overall foreign loss as determined under paragraph (c) of 
this section shall be added to the applicable overall foreign loss 
account at the end of its taxable year to the extent that the overall 
foreign loss has reduced United States source income during the taxable 
year or during a year to which the loss has been carried back. For rules 
with respect to carryovers see paragraph (d)(3) of this section and 
Sec.  1.904(f)-3.
    (2) Overall foreign losses of another taxpayer. If any portion of 
any overall foreign loss of another taxpayer is allocated to the 
taxpayer in accordance with Sec.  1.904(f)-5 (relating to overall 
foreign losses of domestic trusts) or Sec.  1.1502-9 (relating to 
consolidated overall foreign losses), the taxpayer shall add such amount 
to its applicable overall foreign loss account.
    (3) Additions to overall foreign loss account created by loss 
carryovers. Subject to the adjustments under Sec.  1.904(f)-1(d)(4), the 
taxpayer shall add to each overall foreign loss account--

[[Page 849]]

    (i) All net operating loss carryovers to the current taxable year 
attributable to the same limitation to the extent that overall foreign 
losses included in the net operating loss carryovers reduced United 
States source income for the taxable year, and
    (ii) All capital loss carryovers to the current taxable year 
attributable to the same limitation to the extent that foreign source 
capital loss carryovers reduced United States source capital gain net 
income for the taxable year.
    (4) Adjustments for capital gains and losses and qualified dividend 
income. If a taxpayer has capital gains or losses or qualified dividend 
income, as defined in section 1(h)(11), the taxpayer shall make 
adjustments to such capital gains and losses and qualified dividend 
income to the extent required under section 904(b)(2) and Sec.  
1.904(b)-1 before applying the provisions of Sec.  1.904(f)-1. See Sec.  
1.904(b)-1(h).
    (e) Reductions of overall foreign loss accounts. The taxpayer shall 
subtract the following amounts from its overall foreign loss accounts at 
the end of its taxable year in the following order, if applicable:
    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers. An overall foreign loss account is reduced by the amount of 
any overall foreign loss which is allocated to another taxpayer in 
accordance with Sec.  1.904(f)-5 (relating to overall foreign losses of 
domestic trusts) or Sec.  1.1502-9 (relating to consolidated overall 
foreign losses).
    (2) Reduction for amounts recaptured. An overall foreign loss 
account is reduced by the amount of any foreign source income that is 
subject to the same limitation as the loss that resulted in the account 
and that is recaptured in accordance with Sec.  1.904(f)-2 (c) (relating 
to recapture under section 904(f)(1)); Sec.  1.904(f)-2 (d) (relating to 
recapture when the taxpayer disposes of certain properties under section 
904(f)(3)); and Sec.  1.904(f)-4 (relating to recapture when the 
taxpayer receives an accumulation distribution from a foreign trust 
under section 904(f)(4)).
    (f) Illustrations. The rules of this section are illustrated by the 
following examples.

    Example 1. X Corporation is a domestic corporation with foreign 
branch operations in country C. X's taxable income and losses for its 
taxable year 1983 are as follows:

U.S. Source taxable income........................................$1,000
Foreign source taxable income (loss) subject to the general limitation 
                                                                  ($500)
Foreign source taxable income subject to the passive interest limitation
                                                                    $200

    X has a general limitation overall foreign loss of $500 for 1983 in 
accordance with paragraph (c) (1) of this section. Since the general 
limitation overall foreign loss is not considered to offset income under 
the separate limitation for passive interest income, it therefore 
offsets $500 of United States source taxable income. This amount is 
added to X's general limitation overall foreign loss account at the end 
of 1983 in accordance with paragraphs (c) (1) and (d) (1) of this 
section.
    Example 2. Y Corporation is a domestic corporation with foreign 
branch operations in Country C. Y's taxable income and losses for its 
taxable year 1982 are as follows:

U.S. source taxable income........................................$1,000
Foreign source taxable income (loss) subject to the general limitation 
                                                                  ($500)
Foreign source taxable income subject to the passive interest limitation
                                                                    $250

    For its pre-1983 taxable years, Y filed its returns determining its 
overall foreign losses on a combined basis. In accordance with 
paragraphs (a) and (c) (1) of this section, Y may net the foreign source 
income and loss before offsetting the United States source income. Y 
therefore has a section 904(d)(1)(A-C) overall foreign loss account of 
$250 at the end of 1982.
    Example 3. X Corporation is a domestic corporation with foreign 
branch operations in country C. For its taxable year 1985, X has taxable 
income (loss) determined as follows:

U.S. source taxable income..........................................$200
Foreign source taxable income (loss) subject to the general limitation 
                                                                ($1,000)
Foreign source taxable income (loss) subject to the passive limitation 
                                                                  $1,800

    X has a general limitation overall foreign loss of $1,000 in 
accordance with paragraph (c)(1) of this section. The overall foreign 
loss offsets $200 of United States source taxable income in 1985 and, 
therefore, X has a $200 general limitation overall foreign loss account 
at the end of 1985. The remaining $800 general limitation loss is offset 
by the passive interest limitation income in 1985 so that X has no net 
operating loss carryover that is attributable to the general limitation 
loss and no additional amount attributable

[[Page 850]]

to that loss will be added to the overall foreign loss account in 1985 
or in any other year.
    (g) Effective/applicability date. Paragraphs (a)(2) and (d)(4) of 
this section shall apply to taxable years beginning on or after January 
1, 2012. Taxpayers may choose to apply paragraphs (a)(2) and (d)(4) of 
this section to other taxable years beginning after December 21, 2007, 
including periods covered by 26 CFR 1.904(f)-1T (revised as of April 1, 
2010).

[T.D. 8153, 52 FR 31994, Aug. 25, 1987; 52 FR 43434, Nov. 12, 1987, as 
amended by T.D. 9371, 72 FR 72597, Dec. 21, 2007; T.D. 9595, 77 FR 
37578, June 22, 2012]



Sec.  1.904(f)-2  Recapture of overall foreign losses.

    (a) In general. A taxpayer shall be required to recapture an overall 
foreign loss as provided in this section. Recapture is accomplished by 
treating as United States source income a portion of the taxpayer's 
foreign source taxable income of the same limitation as the foreign 
source loss that resulted in an overall foreign loss account. As a 
result, if the taxpayer elects the benefits of section 901 or section 
936, the taxpayer's foreign tax credit limitation with respect to such 
income is decreased. As provided in Sec.  1.904 (f)-1(e)(2), the balance 
in a taxpayer's overall foreign loss account is reduced by the amount of 
loss recaptured. Recapture continues until such time as the amount of 
foreign source taxable income recharacterized as United States source 
income equals the amount in the overall foreign loss account. As 
provided in Sec.  1.904 (f)-1(e)(2), the balance in an overall foreign 
loss account is reduced at the end of each taxable year by the amount of 
the loss recaptured during that taxable year. Regardless of whether 
recapture occurs in a year in which a taxpayer elects the benefits of 
section 901 or in a year in which a taxpayer deducts its foreign taxes 
under section 164, the overall foreign loss account is recaptured only 
to the extent of foreign source taxable income remaining after applying 
the appropriate section 904(b) adjustments, if any, as provided in 
paragraph (b) of this section.
    (b) Determination of taxable income from sources without the United 
States for purposes of recapture--(1) In general. For purposes of 
determining the amount of an overall foreign loss subject to recapture, 
the taxpayer's taxable income from sources without the United States 
shall be computed with respect to each of the separate limitations 
described in Sec.  1.904 (f)-1(c)(2) in accordance with the rules set 
forth in Sec.  1.904 (f)-1(c) (1) and (3). This computation is made 
without taking into account foreign source taxable income (and 
deductions properly allocated and apportioned thereto) subject to other 
separate limitations. Before applying the recapture rules to foreign 
source taxable income, the following provisions shall be applied to such 
income in the following order:
    (i) Former section 904(b)(3)(C) (prior to its removal by the Tax 
Reform Act of 1986) and the regulations thereunder shall be applied to 
treat certain foreign source gain as United States source gain; and
    (ii) Section 904(b)(2) and the regulations thereunder shall be 
applied to make adjustments in the foreign tax credit limitation 
fraction for certain capital gains and losses.
    (c) Section 904(f)(1) recapture--(1) In general. In a taxable year 
in which a taxpayer elects the benefits of section 901 or section 30A, 
the section 904(f)(1) recapture amount is the amount of foreign source 
taxable income subject to recharacterization in a taxable year in which 
recapture of an overall foreign loss is required under paragraph (a) of 
this section. The section 904(f)(1) recapture amount equals the lesser 
of the aggregate amount of maximum potential recapture in all overall 
foreign loss accounts or fifty percent of the taxpayer's total foreign 
source taxable income. If the aggregate amount of maximum potential 
recapture in all overall foreign loss accounts exceeds fifty percent of 
the taxpayer's total foreign source taxable income, foreign source 
taxable income in each separate category with an overall foreign loss 
account is recharacterized in an amount equal to the section 904(f)(1) 
recapture amount, multiplied by the maximum

[[Page 851]]

potential recapture in the overall foreign loss account, divided by the 
aggregate amount of maximum potential recapture in all overall foreign 
loss accounts. The maximum potential recapture in an overall foreign 
loss account in a separate category is the lesser of the balance in that 
overall foreign loss account or the foreign source taxable income for 
the year in the same separate category as the loss account. If, in any 
taxable year, in accordance with sections 164(a) and 275(a)(4)(A), a 
taxpayer deducts rather than credits its foreign taxes, recapture is 
applied to the extent of the lesser of--
    (i) The balance in the overall foreign loss account in each separate 
category; or
    (ii) Foreign source taxable income (net of foreign taxes) in each 
separate category.
    (2) Election to recapture more of the overall foreign loss than is 
required under paragraph (c)(1). In a year in which a taxpayer elects 
the benefits of sections 901 or 936, a taxpayer may make an annual 
revocable election to recapture a greater portion of the balance in an 
overall foreign loss account than is required to be recaptured under 
paragraph (c)(1) of this section. A taxpayer may make such an election 
or amend a prior election by attaching a statement to its annual Form 
1116 or 1118. If an amendment is made to a prior year's election, an 
amended tax return should be filed. The statement attached to the Form 
1116 or 1118 must indicate the percentage and dollar amount of the 
taxpayer's foreign source taxable income that is being recharacterized 
as United States source income and the percentage and dollar amount of 
the balance (both before and after recapture) in the overall foreign 
loss account that is being recaptured. Except for the special recapture 
rules for section 936 corporations and for recapture of pre-1983 overall 
foreign losses determined on a combined basis, the taxpayer that elects 
to credit its foreign taxes may not elect to recapture an amount in 
excess of the taxpayer's foreign source taxable income subject to the 
same limitation as the loss that resulted in the overall foreign loss 
account.
    (3) Special rule for recapture of losses incurred prior to section 
936 election. If a corporation elects the application of section 936 and 
at the time of the election has a balance in any overall foreign loss 
account, such losses will be recaptured from the possessions source 
income of the electing section 936 corporation that qualifies for the 
section 936 credit, including qualified possession source investment 
income as defined in section 936(d)(2), even though the overall foreign 
loss to be recaptured may not be attributable to a loss in an income 
category of a type that would meet the definition of qualified 
possession source investment income. For purposes of recapturing an 
overall foreign loss incurred by a consolidated group including a 
corporation that subsequently elects to use section 936, the electing 
section 936 corporation's possession source income that qualifies for 
the section 936 credit, including qualified possession source investment 
income, shall be used to recapture the section 936 corporation's share 
of previously incurred overall foreign loss accounts. Rules for 
determining the section 936 corporation's share of the consolidated 
groups overall foreign loss accounts are provided in Sec.  1.1502-9(c).
    (4) Recapture of pre-1983 overall foreign losses determined on a 
combined basis. If a taxpayer computed its overall foreign losses on a 
combined basis in accordance with Sec.  1.904(f)-1(c)(1) for taxable 
years beginning before January 1, 1983, any losses recaptured in taxable 
years beginning after December 31, 1982, shall be recaptured from income 
subject to the general limitation, subject to the rules in Sec.  
1.904(f)-6 (a) and (b). Ordering rules for recapture of these losses are 
provided in Sec.  1.904(f)-6(c).
    (5) Illustrations. The rules of this paragraph (c) are illustrated 
by the following examples, all of which assume a United States corporate 
tax rate of 50 percent unless otherwise stated.

    Example 1. X Corporation is a domestic corporation that does 
business in the United States and abroad. On December 31, 1983, the 
balance in X's general limitation overall foreign loss account is $600, 
all of which is attributable to a loss incurred in 1983. For 1984, X has 
United States source taxable income of $500 and foreign source taxable 
income subject to the general limitation of $500. For 1984, X pays $200 
in foreign taxes and elects

[[Page 852]]

section 901. Under paragraph (c)(1) of this section, X is required to 
recapture $250 (the lesser of $600 or 50 percent of $500) of its overall 
foreign loss. As a consequence, X's foreign tax credit limitation under 
the general limitation is $250/$1,000 x $500, or $125, instead of $500/
$1,000 x $500, or $250. The balance in X's general limitation overall 
foreign loss account is reduced by $250 in accordance with Sec.  
1.904(f)-1(e)(2).
    Example 2. The facts are the same as in example 1 except that X 
makes an election to recapture its overall foreign loss to the extent of 
80 percent of its foreign source taxable income subject to the general 
limitation (or $400) in accordance with paragraph (c)(2) of this 
section. As a result of recapture, X's 1984 foreign tax credit 
limitation for income subject to the general limitation is $100/$1,000 x 
$500, or $50, instead of $500/$1,000 x $500, or $250. X's general 
limitation overall foreign loss account is reduced by $400 in accordance 
with Sec.  1.904(f)-1(e)(2).
    Example 3. The facts are the same as in example 1 except that X does 
not elect the benefits of section 901 in 1984 and instead deducts its 
foreign taxes paid. In 1984, X recaptures $300 of its overall foreign 
loss, the difference between X's foreign source taxable income of $500 
and $200 of foreign taxes paid. The balance in X's general limitation 
overall foreign loss account is reduced by $300 in accordance with Sec.  
1.904(f)-1(e)(2).
    Example 4. Y Corporation is a domestic corporation that does 
business in the United States and abroad. On December 31, 2007, the 
balance in Y's general category overall foreign loss account is $500, 
all of which is attributable to a loss incurred in 2007. Y has no other 
loss accounts subject to recapture. For 2008, Y has U.S. source taxable 
income of $400 and foreign source taxable income of $300 in the general 
category and $900 in the passive category. Under paragraph (c)(1) of 
this section, the amount of Y's general category income subject to 
recharacterization is the lesser of the aggregate maximum potential 
recapture or 50% of the total foreign source taxable income. In this 
case, Y's aggregate maximum potential recapture is $300 (the lesser of 
the $500 balance in the general category overall foreign loss account or 
$300 foreign source income in the general category for the year), which 
is less than 50% of Y's total foreign source taxable income ($1200 x 50% 
= $600). Therefore, pursuant to paragraph (c) of this section, $300 of 
foreign source income in the general category is recharacterized as U.S. 
source income. The balance in Y's general category overall foreign loss 
account is reduced to $200 in accordance with Sec.  1.904(f)-1(e)(2).
    Example 5. On December 31, 1980, V, a domestic corporation that does 
business in the United States and abroad, has a balance in its section 
904(d)(1)(A-C) overall foreign loss account of $600. V also has a 
balance in its FORI limitation overall foreign loss account of $900. For 
1981, V has foreign source taxable income subject to the general 
limitation of $500 and $500 of United States source income. V also has 
foreign source taxable income subject to the FORI limitation of $800. V 
is required to recapture $250 of its section 904(d)(1)(A-C) overall 
foreign loss account (the lesser of $600 or 50% of $500) and its general 
limitation foreign tax credit limitation is $250/$1,800 x $900, or $125 
instead of $500/$1,800 x $900, or $250. V is also required to recapture 
$400 of its FORI limitation overall foreign loss account (the lesser of 
$900 or 50% of $800). V's foreign tax credit limitation for FORI is 
$400/$1,800 x $900, or $200, instead of $800/$1,800 x $900, or $400. The 
balance in V's FORI limitation overall foreign loss account is reduced 
to $500 and the balance in V's section 904(d)(1)(A-C) account is reduced 
to $350, in accordance with Sec.  1.904(f)-1(e)(2).
    Example 6. This example assumes a United States corporate tax rate 
of 46 percent (under section 11(b)) and an alternative rate of tax under 
section 1201(a) of 28 percent. W is a domestic corporation that does 
business in the United States and abroad. On December 31, 1984, W has 
$350 in its general limitation overall foreign loss account. For 1985, W 
has $500 of United States source taxable income, and has foreign source 
income subject to the general limitation as follows:

Foreign source taxable income other than net capital gain........   $720
Foreign source net capital gain..................................   $460
 

    Under paragraph (b)(2) of this section, foreign source taxable 
income for purposes of recapture includes foreign source capital gain 
net income, reduced, under section 904(b)(2), by the rate differential 
portion of foreign source net capital gain, which adjusts for the 
reduced tax rate for net capital gain under section 1201(a):

Foreign source capital gain net income.........................     $460
Rate differential portion of foreign source net capital gain        -180
 (18/46 of $460)...............................................
                                                                --------
Foreign source capital gain included in foreign source taxable      $280
 income........................................................
 

    The total foreign source taxable income of W for purposes of 
recapture in 1985 is $1,000 ($720 + $280). Under paragraph (c)(1) of 
this section, W is required to recapture $350 (the lesser of $350 or 50 
percent of $1,000), and W's general limitation overall foreign loss 
account is reduced to zero. W's foreign tax credit limitation for income 
subject to the general limitation is $650/$1,500 x $690 ((.46) (500 + 
720) + (.28) (460)), or $299, instead of $1,000/$1,500 x $690, or $460.
    (d) Recapture of overall foreign losses from dispositions under 
section 904(f)(3)-- (1) In general. If a taxpayer disposes of property 
used or held for use predominantly without the United States in a trade 
or business during a taxable year

[[Page 853]]

and that property generates foreign source taxable income subject to a 
separate limitation to which paragraph (a) of this section applies, the 
applicable overall foreign loss account shall be recaptured as provided 
in paragraphs (d)(2), (d)(3), and (d)(4) of this section. See paragraph 
(d)(5) of this section for definitions. See the ordering rules under 
Sec.  1.904(g)-3(f) and (i) for coordination with other loss recapture 
under section 904(f) and (g).
    (2) Treatment of net capital gain. If the gain from a disposition of 
property to which this paragraph (d) applies is treated as net capital 
gain, all references to such gain in paragraphs (d)(3) and (d)(4) of 
this section shall mean such gain as adjusted under paragraph (b) of 
this section. The amount by which the overall foreign loss account shall 
be reduced shall be determined from such adjusted gain.
    (3) Dispositions where gain is recognized irrespective of section 
904 (f)(3)--(i) Foreign source gain. If a taxpayer recognizes foreign 
source gain in a separate category on the disposition of property 
described in paragraph (d)(1) of this section, and there is a balance in 
a taxpayer's overall foreign loss account that is attributable to a loss 
in such separate category after applying paragraph (c) of this section, 
an additional portion of such balance shall be recaptured in accordance 
with paragraphs (a) and (b) of this section. The amount recaptured shall 
be the lesser of such balance or the full amount of the foreign source 
gain recognized on the disposition that was not previously 
recharacterized.
    (ii) U.S. source gain. If a taxpayer recognizes U.S. source gain on 
the disposition of property described in paragraph (d)(1) of this 
section, and there is a balance in a taxpayer's overall foreign loss 
account that is attributable to a loss in the separate category to which 
the income generated by such property is assigned after applying 
paragraph (c) of this section, an amount of the gain shall be treated as 
foreign source and an additional portion of such balance equal to that 
amount shall be recaptured in accordance with paragraphs (a) and (b) of 
this section. The amount of gain treated as foreign source and the 
amount of overall foreign loss recaptured shall be the lesser of the 
balance in the overall foreign loss account or the full amount of the 
gain recognized on the disposition.
    (4) Dispositions in which gain would not otherwise be recognized--
(1) Recognition of gain to the extent of the overall foreign loss 
account. If a taxpayer makes a disposition of property described in 
paragraph (d)(1) of this section in which any amount of gain otherwise 
would not be recognized in the year of the disposition, and such 
property was used or held for use to generate foreign source taxable 
income subject to a separate limitation under which the taxpayer had a 
balance in its overall foreign loss account (including a balance that 
arose in the year of the disposition), the taxpayer shall recognize 
foreign source taxable income in an amount equal to the lesser of:
    (A) The sum of the balance in the applicable overall foreign loss 
account (but only after such balance has been increased by amounts added 
to the account for the year of the disposition or has been reduced by 
amounts recaptured for the year of the disposition under paragraph (c) 
and paragraph (d)(3) of this section) plus the amount of any overall 
foreign loss that would be part of a net operating loss for the year of 
the disposition if gain from the disposition were not recognized under 
section 904(f)(3), plus the amount of any overall foreign loss that is 
part of a net operating loss carryover from a prior year, or
    (B) The excess of the fair market value of such property over the 
taxpayer's adjusted basis in such property.


The excess of the fair market value of such property over its adjusted 
basis shall be determined on an asset by asset basis. Losses from the 
disposition of an asset shall not be recognized. Any foreign source 
taxable income deemed received and recognized under this paragraph 
(d)(4)(i) will have the same character as if the property had been sold 
or exchanged in a taxable transaction and will constitute gain for all 
purposes.
    (ii) Basis adjustment. The basis of the property received in an 
exchange to which this paragraph (d)(4) applies shall be increased by 
the amount of gain deemed recognized, in accordance

[[Page 854]]

with applicable sections of subchapters C (relating to corporate 
distributions and adjustments), K (relating to partners and 
partnerships), O (relating to gain or loss on the disposition of 
property), and P (relating to capital gains and losses). If the property 
to which this paragraph (d)(4) applies was transferred by gift, the 
basis of such property in the hands of the donor immediately preceding 
such gift shall be increased by the amount of the gain deemed 
recognized.
    (iii) Recapture of overall foreign loss to the extent of amount 
recognized. The provisions of paragraphs (a) and (b) of this section 
shall be applied to the extent of 100 percent of the foreign source 
taxable income which is recognized under paragraph (d)(4)(i) of this 
section. However, amounts of foreign source gain that would not be 
recognized except by application of section 904(f)(3) and paragraph 
(d)(4)(i) of this section, and which are treated as United States source 
gain by application of section 904(b)(3)(C) (prior to its removal by the 
Tax Reform Act of 1986) and paragraph (b)(1) of this section, shall 
reduce the overall foreign loss account (subject to the adjustments 
described in paragraph (d)(2) of this section) if such gain is net 
capital gain, notwithstanding the fact that such amounts would otherwise 
not be recaptured under the ordering rules in paragraph (b) of this 
section.
    (iv) Priorities among dispositions in which gain is deemed to be 
recognized. If, in a single taxable year, a taxpayer makes more than one 
disposition to which this paragraph (d)(4) is applicable, the rules of 
this paragraph (d)(4) shall be applied to each disposition in succession 
starting with the disposition which occurred earliest, until the balance 
in the applicable overall foreign loss account is reduced to zero. If 
the taxpayer simultaneously makes more than one disposition to which 
this paragraph (d)(4) is applicable, the rules of paragraph (d)(4) shall 
be applied so that the balance in the applicable overall foreign loss 
account to be recaptured will be allocated pro rata among the assets in 
proportion to the excess of the fair market value of each asset over the 
adjusted basis of each asset.
    (5) Definitions--(i) Disposition. A disposition to which this 
paragraph (d) applies includes a sale; exchange; distribution; gift; 
transfer upon the foreclosure of a security interest (but not a mere 
transfer of title to a creditor upon creation of a security interest or 
to a debtor upon termination of a security interest); involuntary 
conversion; contribution to a partnership, trust, or corporation; 
transfer at death; or any other transfer of property whether or not gain 
or loss is recognized under other provisions of the Code. However, a 
disposition to which this paragraph (d) applies does not include:
    (A) A distribution or transfer of property to a domestic corporation 
described in section 381 (a) (provided that paragraph (d)(6) of this 
section applies);
    (B) A disposition of property which is not a material factor in the 
realization of income by the taxpayer (as defined in paragraph 
(d)(5)(iv) of this section);
    (C) A transaction in which gross income is not realized; or
    (D) The entering into of a unitization or pooling agreement (as 
defined in Sec.  1.614-8(b)(6) of the regulations) containing a valid 
election under section 761(a)(2), and in which the source of the entire 
gain from any disposition of the interest created by the agreement would 
be determined to be foreign source under section 862(a)(5) if the 
disposition occurred presently.
    (ii) Property used in a trade or business. Property is used in a 
trade or business if it is held for the principal purpose of promoting 
the present or future conduct of the trade or business. This generally 
includes property acquired and held in the ordinary course of a trade or 
business or otherwise held in a direct relationship to a trade or 
business. In determining whether an asset is held in a direct 
relationship to a trade or business, principal consideration shall be 
given to whether the asset is used in the trade or business. Property 
will be treated as held in a direct relationship to a trade or business 
if the property was acquired with funds generated by that trade or 
business or if income generated from the asset is available for use in 
that trade or business. Property used in a trade or business may be 
tangible or intangible, real

[[Page 855]]

or personal property. It includes property, such as equipment, which is 
subject to an allowance for depreciation under section 167 or cost 
recovery under section 168. Property may be considered used in a trade 
or business even if it is a capital asset in the hands of the taxpayer. 
However, stock of another corporation shall not be considered property 
used in a trade or business if a substantial investment motive exists 
for acquiring and holding the stock. On the other hand, stock acquired 
or held to assure a source of supply for a trade or business shall be 
considered property used in that trade or business. Inventory is 
generally not considered property used in a trade or business. However, 
when disposed of in a manner not in the ordinary course of a trade or 
business, inventory will be considered property used in the trade or 
business. A partnership interest will be treated as property used in a 
trade or business if the underlying assets of the partnership would be 
property used in a trade or business. For purposes of section 904(f) (3) 
and Sec.  1.904(f)-2 (d) (1) and (5), a disposition of a partnership 
interest to which this section applies will be treated as a disposition 
of a proportionate share of each of the assets of the partnership. For 
purposes of allocating the purchase price of the interest and the 
seller's basis in the interest to those assets, the principles of Sec.  
1.751-1(a) will apply.
    (iii) Property used predominantly outside the United States. 
Property will be considered used predominantly outside the United States 
if for a 3-year period ending on the date of the disposition (or, if 
shorter, the period during which the property has been used in the trade 
or business) such property was 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 if, during the 3-year (or shorter) 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 outside the United States.
    (iv) Property which is a material factor in the realization of 
income. For purposes of this section, property used in a trade or 
business will be considered a material factor in the realization of 
income unless the taxpayer establishes that it is not (or, if the 
taxpayer did not realize income from the trade or business in the 
taxable year, would not be expected to be) necessary to the realization 
of income by the taxpayer.
    (6) Carryover of overall foreign loss accounts in a corporate 
acquisition to which section 381(a) applies. In the case of a 
distribution or transfer described in section 381(a), an overall foreign 
loss account of the distributing or transferor corporation shall be 
treated as an overall foreign loss account of the acquiring or 
transferee corporation as of the close of the date of the distribution 
or transfer. If the transferee corporation had an overall foreign loss 
account under the same separate limitation prior to the distribution or 
transfer, the balance in the transferor's account must be added to the 
transferee's account. If not, the transferee must adopt the transferor's 
overall foreign loss account. An overall foreign loss of the transferor 
will be treated as incurred by the transferee in the year prior to the 
year of the transfer.
    (7) Illustrations. The rules of this paragraph (d) are illustrated 
by the following examples which assume that the United States corporate 
tax rate is 50 percent (unless otherwise stated). For purposes of these 
examples, none of the foreign source gains are treated as net capital 
gains (unless so stated).

    Example 1. X Corporation has a balance in its general limitation 
overall foreign loss account of $600 at the close of its taxable year 
ending December 31, 1984. In 1985, X sells assets used predominantly 
outside the United States in a trade or business and recognizes $1,000 
of gain on the sale under section 1001. This gain is subject to the 
general limitation. This sale is a disposition within the meaning of 
paragraph (d)(5)(i) of this section, and to which this paragraph (d) 
applies. X has no other foreign source taxable income in 1985 and has 
$1,000 of United States source taxable income. Under paragraph (c), X is 
required to recapture $500 (the lesser of the balance in X's general 
limitation overall foreign loss account ($600) or 50 percent of $1,000) 
of its overall foreign loss account. The

[[Page 856]]

balance in X's general limitation overall foreign loss account is 
reduced to $100 in accordance with Sec.  1.904(f)-1(e)(2). In addition, 
under paragraph (d)(3) of this section, X is required to recapture $100 
(the lesser of the remaining balance in its general limitation overall 
foreign loss account ($100) or 100 percent of its foreign source taxable 
income recognized on such disposition that has not been previously 
recharacterized ($500)). The total amount recaptured is $600. X's 
foreign tax credit limitation for income subject to the general 
limitation in 1985 is $200 ($400/$2,000 x $1,000) instead of $500 
($1,000/$2,000 x $1,000). The balance in X's general limitation overall 
foreign loss account is reduced to zero in accordance with Sec.  
1.904(f)-1(e)(2).
    Example 2. On December 31, 1984, Y Corporation has a balance in its 
general limitation overall foreign loss account of $1,500. In 1985, Y 
has $500 of United States source taxable income and $200 of foreign 
source taxable income subject to the general limitation. Y's foreign 
source taxable income is from the sale of property used predominantly 
outside of the United States in a trade or business. This sale is a 
disposition to which this paragraph (d) is applicable. In 1985, Y also 
transferred property used predominantly outside of the United States in 
a trade or business to another corporation. Under section 351, no gain 
was recognized on this transfer. Such property had been used to generate 
foreign source taxable income subject to the general limitation. The 
excess of the fair market value of the property transferred over Y's 
adjusted basis in such property was $2,000. In accordance with paragraph 
(c) of this section, Y is required to recapture $100 (the lesser of 
$1,500, the amount in Y's general limitation overall foreign loss 
account, or 50 percent of $200, the amount of general limitation foreign 
source taxable income for the current year) of its general limitation 
overall foreign loss. Y is then required to recapture an additional $100 
of its general limitation overall foreign loss account under paragraph 
(d)(3) of this section out of the remaining gain recognized on the sale 
of assets, because 100 percent of such gain is subject to recapture. The 
balance in Y's general limitation overall foreign loss account is 
reduced to $1,300 in accordance with Sec.  1.904(f)-1(e)(2). Y 
corporation is then required to recognize $1,300 of foreign source 
taxable income on its section 351 transfer under paragraph (d)(4) of 
this section. The remaining $700 of potential gain associated with the 
section 351 transfer is not recognized. Under paragraph (d)(4), 100 
percent of the $1,300 is recharacterized as United States source taxable 
income, and Y's general limitation overall foreign loss account is 
reduced to zero. Y's entire taxable income for 1985 is:

U.S. source taxable income.................................         $500
Foreign source taxable income subject to the general                 200
 limitation that is recharacterized as U.S. source income
 by paragraphs (c) and (d)(3) of this section..............
Gain recognized under section 904(f)(3) and paragraph              1,300
 (d)(4) of this section, and recharacterized as U.S. source
 income....................................................
                                                            ------------
    Total..................................................       $2,000
 


Y's foreign tax credit limitation for 1985 for income subject to the 
general limitation is $0 ($0/$2,000 x $1,000) instead of $100 ($200/$700 
x $350).
    Example 3. W Corporation is a calendar year domestic corporation 
with foreign branch operations in country C. As of December 31, 1984, W 
has no overall foreign loss accounts and has no net operating loss 
carryovers. W's entire taxable income in 1985 is:

U.S. source taxable income.................................         $800
Foreign source taxable income (loss) subject to the general     ($1,000)
 limitation................................................
 


W cannot carry back its 1985 NOL to any earlier year. As of December 31, 
1985, W therefore has $800 in its general limitation overall foreign 
loss account. In 1986, W earns $400 United States source taxable income 
and has an additional $1,000 loss from the operations of the foreign 
branch. Income in the loss category would be subject to the general 
limitation. Also in 1986, W disposes of property used predominately 
outside the United States in a trade or business. Such property 
generated income subject to the general limitation. The excess of the 
property's fair market value over its adjusted basis is $3,000. The 
disposition is of a type described in Sec.  1.904 (f)-2(d)(4)(i). W has 
no other income in 1986. Under Sec.  1.904 (f)-2(d)(4)(i), W is required 
to recognize foreign source taxable income on the disposition in an 
amount equal to the lesser of $2,000 ($800 (the balance in the general 
limitation overall foreign loss account as of 1985) + $400 (the increase 
in the general limitation overall foreign loss account attributable to 
the disposition year) + $600 (the general limitation overall foreign 
loss that is part of the NOL from 1986) + $200 (the general limitation 
overall foreign loss that is part of the NOL from 1985)) or $3,000. The 
$2,000 foreign source income required to be recognized under section 
904(f)(3) is reduced to $1,200 by the remaining $600 loss in 1986 and 
the $200 net operating loss carried forward from 1985. This $1,200 of 
income is subject to the general limitation. In computing foreign tax 
credit limitation for general limitation income, the $1,200 of foreign 
source income is treated as United States source income and, therefore, 
W's foreign tax credit limitation for income subject to the general 
limitation is zero. W's overall foreign loss account is reduced to zero.
    Example 4. Z Corporation has a balance in its FORI overall foreign 
loss account of $1,500 at the end of its taxable year 1980. In

[[Page 857]]

1981, Z has $1,600 of foreign oil related income subject to the separate 
limitation for FORI income and no United States source income. In 
addition, in 1981, Z makes two dispositions of property used 
predominantly outside the United States in a trade or business on which 
no gain was recognized. Such property generated foreign oil related 
income. The excess of the fair market value of the property transferred 
in the first disposition over Z's adjusted basis in such property is 
$575. The excess of the fair market value of the property transferred in 
the second disposition over Z's adjusted basis in such property is 
$1,000. Under paragraph (c) of this section, Z is required to recapture 
$800 (the lesser of 50 percent of its foreign oil related income of 
$1,600 or the balance ($1,500) in its FORI overall foreign loss account) 
of its foreign oil related loss. In accordance with paragraphs (d)(4) 
(i) and (iv) of this section, Z is required to recognize foreign oil 
related income in the amount of $575 on the first disposition and, since 
the foreign oil related loss account is now reduced by $1,375 (the $800 
and $575 amounts previously recaptured), Z is required to recognize 
foreign oil related income in the amount of $125 on the second 
disposition. In accordance with paragraph (d)(4)(iii) of this section, 
the entire amount recognized is treated as United States source income 
and the balance in the FORI overall foreign loss account is reduced to 
zero under Sec.  1.904 (f)-1 (e)(2). Z's foreign tax credit limitation 
for FORI is $400 ($800/$2,300 x $1,150) instead of $800 ($1,600/$1,600 x 
$800).
    Example 5. The facts are the same as in example 4, except that the 
gain from the two dispositions of property is treated as net capital 
gain and the United States corporate tax rate is assumed to be 46 
percent. As in example 4, Z is required to recapture $800 of its foreign 
oil related loss from its 1981 ordinary foreign oil related income. In 
accordance with paragraph (d)(4) (i) and (iv) of this section, Z is 
first required to recognize foreign oil related income (which is net 
capital gain) on the first disposition in the amount of $575. Under 
paragraphs (b) and (d) (2) of this section, this net capital gain is 
adjusted by subtracting the rate differential portion of such gain from 
the total amount of such gain to determine the amount by which the 
foreign oil related loss account is reduced, which is $350 ($575- ($575 
x 18/46)). The balance remaining in Z's foreign oil related loss account 
after this step is $350. Therefore, this process will be repeated, in 
accordance with paragraph (d)(4)(iv) of this section, to recapture that 
remaining balance out of the gain deemed recognized on the second 
disposition, resulting in reduction of the foreign oil related loss 
account to zero and net capital gain required to be recognized from the 
second dispostion in the amount of $575, which must also be adjusted by 
subtracting the rate differential portion to determine the amount by 
which the foreign oil related loss account is reduced (which is $350). 
The $575 of net capital gain from each disposition is recharacterized as 
United States source net capital gain. Z's section 907 (b) foreign tax 
credit limitation is the same as in example 4, and Z has $1,150 ($575 + 
$575) of United States source net capital gain.
    (e) Effective/applicability date. Paragraphs (c)(1), (c)(5) Example 
4, (d)(1), and (d)(3) of this section shall apply to taxable years 
beginning on or after January 1, 2012. Taxpayers may choose to apply 
paragraphs (c)(1), (c)(5) Example 4, (d)(1), and (d)(3) of this section 
to other taxable years beginning after December 21, 2007, including 
periods covered by 26 CFR 1.904(f)-2T (revised as of April 1, 2010).

[T.D. 8153, 52 FR 31997, Aug. 25, 1987; 52 FR 43434, Nov. 12, 1987, as 
amended by T.D. 9371, 72 FR 72597, Dec. 21, 2007; T.D. 9595, 77 FR 
37578, June 22, 2012]



Sec.  1.904(f)-3  Allocation of net operating losses and net capital losses.

    For rules relating to the allocation of net operating losses and net 
capital losses, see Sec.  1.904(g)-3T.

[T.D. 9371, 72 FR 72598, Dec. 21, 2007]



Sec.  1.904(f)-4  Recapture of foreign losses out of accumulation 
distributions from a foreign trust.

    (a) In general. If a taxpayer receives a distribution of foreign 
source taxable income subject to a separate limitation in which the 
taxpayer had a balance in an overall foreign loss account and that 
income is treated under section 666 as having been distributed by a 
foreign trust in a preceding taxable year, a portion of the balance in 
the taxpayer's applicable overall foreign loss account shall be subject 
to recapture under this section. The amount subject to recapture shall 
be the lesser of the balance in the taxpayer's overall foreign loss 
account (after applying Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, 
and 1.904(f)-6 to the taxpayer's other income or loss in the current 
taxable year) or the entire amount of foreign source taxable income 
deemed distributed in a preceding year or years under section 666.
    (b) Effect of recapture on foreign tax credit limitation under 
section 667(d). If

[[Page 858]]

paragraph (a) of this section is applicable, then in applying the 
separate limitation (in accordance with section 667(d)(1) (A) and (C)) 
to determine the amount of foreign taxes deemed distributed under 
section 666 (b) and (c) that can be credited against the increase in tax 
in a computation year, a portion of the foreign source taxable income 
deemed distributed in such computation year shall be treated as United 
States source income. Such portion shall be determined by multiplying 
the amount of foreign source taxable income deemed distributed in the 
computation year by a fraction. The numerator of this fraction is the 
balance in the taxpayer's overall foreign loss account (after 
application of Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, and 
1.904(f)-6), and the denominator of the fraction is the entire amount of 
foreign source taxable income deemed distributed under section 666. 
However, the numerator of this fraction shall not exceed the denominator 
of the fraction.
    (c) Recapture if taxpayer deducts foreign taxes deemed distributed. 
If paragraph (a) of this section is applicable and if, in accordance 
with section 667(d)(1)(B), the beneficiary deducted rather than credited 
its taxes in the computation year, the beneficiary shall reduce its 
overall foreign loss account (but not below zero) by an amount equal to 
the lesser of the balance in the applicable overall foreign loss account 
or the amount of the actual distribution deemed distributed in the 
computation year (without regard to the foreign taxes deemed 
distributed).
    (d) Illustrations. The provisions of this section are illustrated by 
the following examples:

    Example 1. X Corporation is a domestic corporation that has a 
balance of $10,000 in its general limitation overall foreign loss 
account on December 31, 1980. For its taxable year beginning January 1, 
1981, X's only income is an accumulation distribution from a foreign 
trust of $20,000 of general limitation foreign source taxable income. 
Under section 666, the amount distributed and the foreign taxes paid on 
such amount ($4,000) are deemed distributed in two prior taxable years. 
In determining the partial tax on such distribution under section 
667(b), the amount added to each computation year is $12,000 (the sum of 
the actual distribution plus the taxes deemed distributed ($24,000) 
divided by the number of accumulation years (2)). Of that amount, $5,000 
($10,000/$24,000 x $12,000) is treated as United States source taxable 
income in accordance with paragraph (b) of this section. Assuming the 
United States tax rate is 50 percent, X's separate foreign tax credit 
limitation against the increase in tax in each computation year is 
$3,500 ($7,000/$12,000 x $6,000) instead of $6,000 ($12,000/$12,000 x 
$6,000). X's overall foreign loss account is reduced to zero in 
accordance with paragraph (a) of this section.
    Example 2. Assume the same facts as in Example 1, except that X 
deducted rather than credited its foreign taxes in the computation 
years. In 1979, the amount added to X's income is $12,000 under section 
667(b), $2,000 of which is deductible under section 667(d)(1)(B). X must 
reduce its overall foreign loss account by $10,000, the amount of the 
actual distribution that is deemed distributed in 1979 (without regard 
to the $2,000 foreign taxes also deemed distributed). The entire overall 
foreign loss account is therefore reduced to $0 in 1979.

[T.D. 8153, 52 FR 32002, Aug. 25, 1987]



Sec.  1.904(f)-5  Special rules for recapture of overall foreign losses 
of a domestic trust.

    (a) In general. Except as provided in this section, the rules 
contained in Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, 1.904(f)-4, 
and 1.904(f)-6 apply to domestic trusts.
    (b) Recapture of trust's overall foreign loss. In taxable years in 
which a trust has foreign source taxable income subject to a separate 
limitation in which the trust has a balance in its overall foreign loss 
account, the balance in the trust's overall foreign loss account shall 
be recaptured as follows:
    (1) Trust accumulates income. If the trust accumulates all of its 
foreign source taxable income subject to the same limitation as the loss 
that created the balance in the overall foreign loss account, its 
overall foreign loss shall be recaptured out of such income in 
accordance with Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, 1.904(f)-
4, and 1.904(f)-6.
    (2) Trust distributes income. If the trust distributes all of its 
foreign source taxable income subject to the same limitation as the loss 
that created the overall foreign loss account, the amount of the overall 
foreign loss that would be subject to recapture by the trust under 
paragraph (b)(1) of this

[[Page 859]]

section shall be allocated to the beneficiaries in proportion to the 
amount of such income which is distributed to each beneficiary in that 
year.
    (3) Trust accumulates and distributes income. If the trust 
accumulates part of its foreign source taxable income subject to the 
same limitation as the loss that created the overall foreign loss 
account and distributes part of such income, the portion of the overall 
foreign loss that would be subject to recapture by the trust under 
paragraph (b)(1) of this section if the distributed income were 
accumulated shall be allocated to the beneficiaries receiving income 
distributions. The amount of overall foreign loss to be allocated to 
such beneficiaries shall be the same portion of the total amount of such 
overall foreign loss that would be recaptured as the amount of such 
income which is distributed to each beneficiary bears to the total 
amount of such income of the trust for such year. That portion of the 
overall foreign loss subject to recapture in such year that is not 
allocated to the beneficiaries in accordance with this paragraph (b)(3) 
shall be recaptured by the trust in accordance with paragraph (b)(1).
    (c) Amounts allocated to beneficiaries. Amounts of a trust's overall 
foreign loss allocated to any beneficiary in accordance with paragraph 
(b)(2) or (3) of this section shall be added to the beneficiary's 
applicable overall foreign loss account and treated as an overall 
foreign loss of the beneficiary incurred in the taxable year preceding 
the year of such allocation. Such amounts shall be recaptured in 
accordance with Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, 1.904(f)-
4, and 1.904(f)-6 out of foreign source taxable income distributed by 
the trust which is subject to the same separate limitation.
    (d) Section 904(f)(3) dispositions to which Sec.  1.904(f)-
2(d)(4)(i) is applicable. Foreign source taxable income recognized by a 
trust under Sec.  1.904(f)-2(d)(4) on a disposition of property used in 
a trade or business outside the United States shall be deemed to be 
accumulated by the trust. All such income shall be used to recapture the 
trust's overall foreign loss in accordance with Sec.  1.904(f)-2(d)(4).
    (e) Illustrations. The provisions of this section are illustrated by 
the following examples:

    Example 1. T, a domestic trust, has a balance of $2,000 in a general 
limitation overall foreign loss account on December 31, 1983. For its 
taxable year ending on December 31, 1984, T has foreign source taxable 
income subject to the general limitation of $1,600, all of which it 
accumulates. Under paragraph (b)(1) of this section, T is required to 
recapture $800 in 1984 (the lesser of the overall foreign loss or 50 
percent of the foreign source taxable income). This amount is treated as 
United States source income for purposes of taxing T in 1984 and upon 
subsequent distribution to T's beneficiaries. At the end of its 1984 
taxable year, T has a balance of $1,200 in its overall foreign loss 
account.
    Example 2. The facts are the same as in example 1. In 1985, T has 
general limitation foreign source taxable income of $1,000, which it 
distributes to its beneficiaries as follows: $500 to A, $250 to B, and 
$250 to C. Under paragraph (b)(1) of this section, T would have been 
required to recapture $500 of its overall foreign loss if it had 
accumulated all of such income. Therefore, under paragraph (b)(2) of 
this section, T must allocate $500 of its overall foreign loss to A, B, 
and C as follows: $250 to A ($500 x $500/$1,000), $125 to B ($500 x 
$250/$1,000), and $125 to C ($500 x $250/$1,000). Under paragraph (c) of 
this section and Sec.  1.904(f)-1(d)(4), A, B, and C must add the 
amounts of general limitation overall foreign loss allocated to them 
from T to their overall foreign loss accounts and treat such amounts as 
overall foreign losses incurred in 1984. A, B, and C must then apply the 
rules of Sec. Sec.  1.904(f)-1, 1.904(f)-2, 1.904(f)-3, 1.904(f)-4, and 
1.904(f)-6 to recapture their overall foreign losses. T's overall 
foreign loss account is reduced in accordance with Sec.  1.904(f)-
1(e)(1) by the $500 that is allocated to A, B, and C. At the end of 
1985, T's general limitation overall foreign loss account has a balance 
of $700.
    Example 3. The facts are the same as in example 2, including an 
overall foreign loss account at the end of 1984 of $1,200, except that 
in 1985 T's general limitation foreign source taxable income is $1,500 
instead of $1,000, and T accumulates the additional $500. Under 
paragraph (b)(1) of this section, T would be required to recapture $750 
of its overall foreign loss if it accumulated all of the $1,500. Under 
paragraph (b)(3) of this section, T must allocate $500 of its overall 
foreign loss to A, B, and C as follows: $250 to A ($750 x $500/$1,500) 
and $125 each to B and C (750 x $250/$1,500). T must also recapture $250 
of its overall foreign loss, which is the amount subject to recapture in 
1985 that is not allocated to the beneficiaries ($750-$500 = $250). 
Under Sec.  1.904(f)-1(e)(1), T reduces its general limitation overall 
foreign loss account by

[[Page 860]]

$500. Under Sec.  1.904(f)-1(e)(2), T reduces its general limitation 
overall foreign loss account by $250. At the end of 1985 there is a 
balance in the general limitation overall foreign loss account of $450 
(($1,200-$500)-$250).

[T.D. 8153, 52 FR 32002, Aug. 25, 1987; 52 FR 43434, Nov. 12, 1987]



Sec.  1.904(f)-6  Transitional rule for recapture of FORI and general 
limitation overall foreign losses incurred in taxable years beginning 
before January 1, 1983, from foreign source taxable income subject to 
the general limitation in taxable years beginning after December 31, 1982.

    (a) General rule. For taxable years beginning after December 31, 
1982, foreign source taxable income subject to the general limitation 
includes foreign oil related income (as defined in section 907(c)(2) 
prior to its amendment by section 211 of the Tax Equity and Fiscal 
Responsibility Act of 1982). However, for purposes of recapturing 
general limitation overall foreign losses incurred in taxable years 
beginning before January 1, 1983 (pre-1983) out of foreign source 
taxable income subject to the general limitation in taxable years 
beginning after December 31, 1982 (post-1982), the taxpayer shall make 
separate determinations of foreign oil related income and other general 
limitation income (as if the FORI limitation under ``old section 
907(b)'' (prior to its amendment by section 211 of the Tax Equity and 
Fiscal Responsibility Act of 1982) were still in effect), and shall 
apply the rules set forth in this section. The taxpayer shall maintain 
separate accounts for its pre-1983 FORI limitation overall foreign 
losses, its pre-1983 general limitation overall foreign losses (or its 
pre-1983 section 904(d)(1)(A-C) overall foreign losses if such losses 
were computed on a combined basis), and its post-1982 general limitation 
overall foreign losses. The taxpayer shall continue to maintain such 
separate accounts, make such separate determinations, and apply the 
rules of this section separately to each account until the earlier of--
    (1) Such time as the taxpayer's entire pre-1983 FORI limitation 
overall foreign loss account and pre-1983 general limitation overall 
foreign loss account (or, if the taxpayer determined pre-1983 overall 
foreign losses on a combined basis, the section 904(d)(1)(A-C) account) 
have been recaptured, or
    (2) The end of the taxpayer's 8th post-1982 taxable year, at which 
time the taxpayer shall add any remaining balance in its pre-1983 FORI 
limitation account and pre-1983 general limitation overall foreign loss 
account (or the section 904(d)(1)(A-C) account) to its post-1982 general 
limitation overall foreign loss account.
    (b) Recapture of pre-1983 FORI and general limitation overall 
foreign losses from post-1982 income. A taxpayer having a balance in its 
pre-1983 FORI limitation overall foreign loss account or its pre-1983 
general limitation overall foreign loss account (or its pre-1983 section 
904(d)(1)(A-C) account) in a post-1982 taxable year shall recapture such 
overall foreign loss as follows:
    (1) Recapture from income subject to the same limitation. The 
taxpayer shall first apply the rules of Sec. Sec.  1.904(f)-1 through 
1.904(f)-5 to the taxpayer's separately determined foreign oil related 
income to recapture the pre-1983 FORI limitation overall foreign loss 
account, and shall apply such rules to the taxpayer's separately 
determined general limitation income (exclusive of foreign oil related 
income) to recapture the pre-1983 general limitation overall foreign 
loss account (or the section 904(d)(1)(A-C) overall foreign loss 
account. Rules for determining the recapture of the pre-1983 section 904 
(d)(1)(A-C) losses are contained in Sec.  1.904(f)-2(c)(4).
    (2) Recapture from income subject to the other limitation. The 
taxpayer shall next apply the rules of Sec. Sec.  1.904(f)-1 through 
1.904(f)-5 to the taxpayer's separately determined foreign oil related 
income to recapture the pre-1983 general limitation overall foreign loss 
account (or the section 904(d)(1)(A-C) overall foreign loss account) and 
shall apply such rules to the taxpayer's separately determined general 
limitation income to recapture foreign oil related losses to the extent 
that--
    (i) The amount recaptured from such separately determined income 
under paragraph (b)(1) of this section is less than 50 percent (or such 
larger percentage as the taxpayer elects) of such separately determined 
income, and
    (ii) The amount recaptured from such separately determined income 
under

[[Page 861]]

this paragraph (b)(2) does not exceed an amount equal to 12\1/2\ percent 
of the balance in the taxpayer's pre-1983 FORI limitation overall 
foreign loss account or the pre-1983 general limitation overall foreign 
loss account (or the section 904(d)(1)(A-C) overall foreign loss 
account) at the beginning of the taxpayer's first post-1982 taxable 
year, multiplied by the number of post-1982 taxable years (including the 
year to which this rule is being applied) which have elapsed, less the 
amount (if any) recaptured in prior post-1982 taxable years under this 
paragraph (b)(2) from such separately determined income.
    The taxpayer may elect to recapture a pre-1983 overall foreign loss 
from post-1982 income subject to the general limitation at a faster rate 
than is required by this paragraph (b)(2). This election shall be made 
in the same manner as an election to recapture more than 50 percent of 
the income subject to recapture under section 904(f)(1), as provided in 
Sec.  1.904(f)-2(c)(2).
    (c) Coordination of recapture of pre-1983 and post-1982 overall 
foreign losses. A taxpayer incurring a general limitation overall 
foreign loss in any post-1982 taxable year in which the taxpayer has a 
balance in a pre-1983 FORI limitation or its pre-1983 general limitation 
overall foreign loss account (or the section 904(d)(1)(A-C) overall 
foreign loss account) shall establish a separate overall foreign loss 
account for such loss. The taxpayer shall recapture its overall foreign 
losses in succeeding taxable years by first applying the rules of this 
section to recapture its pre-1983 overall foreign losses, and then 
applying the rules of Sec. Sec.  1.904(f)-1 through 1.904(f)-5 to 
recapture its post-1982 general limitation overall foreign loss. A post-
1982 general limitation overall foreign loss is required to be 
recaptured only to the extent that the amount of foreign source taxable 
income recharacterized under paragraph (b) of this section is less than 
50 percent of the taxpayer's total general limitation foreign source 
taxable income (including foreign oil related income)) for such taxable 
year (except as required by section 904(f)(3)). However, a taxpayer may 
elect to recapture at a faster rate.
    (d) Illustrations. The provisions of this section are illustrated by 
the following examples:

    Example 1. X Corporation is a domestic corporation which has the 
calendar year as its taxable year. On December 31, 1982, X has a balance 
of $1,000 in its section 904(d)(1)(A-C) overall foreign loss account. X 
does not have a balance in a FORI limitation overall foreign loss 
account. For 1983, X has income of $1,200, which was subject to the 
general limitation and includes foreign oil related income of $1,000 and 
other general limitation income of $200. In 1983, X is required to 
recapture $225 of its pre-1983 section 904(d)(1)(A-C) overall foreign 
loss account computed as follows:

Amount recaptured under paragraph (b)(1) of this section............$100

    The amount recaptured from general limitation income exclusive of 
foreign oil related income is the lesser of $1,000 (the pre-1983 loss 
reflected in the section 904(d)(1)(A-C) overall foreign loss account) or 
50 pecent of $200 (the separately determined general limitation income 
(exclusive of foreign oil related income).

Amount recaptured under paragraph (b)(2) of this section............$125

    The amount recaptured from foreign oil related income is the lesser 
of $900 (the remaining pre-1983 section 904(d)(1)(A-C) overall foreign 
loss account after recapture under paragraph (b)(1) of this section) or 
50 percent of $1,000 (the separately determined foreign oil related 
income), but as limited by paragraph (b)(2)(ii) of this section to 
(12\1/2\ percent of $1,000 x 1)-$0, which is $125.

Total amount recaptured in 1983.....................................$225
    Example 2. The facts are the same as in example 1, except that X has 
general limitation income of $50 for 1984 and $600 for 1985, all of 
which is foreign oil related income. X is required to recapture $25 in 
1984 and $225 in 1985 of its pre-1983 section 904(d)(1)(A-C) overall 
foreign loss account computed as follows:

Amount recaptured under paragraph (b)(2) of this section in 1984.....$25

    The amount recaptured from foreign oil related income is the lesser 
of $775 (the remaining pre-1983 section 904(d)(1)(A-C) overall foreign 
loss account or 50 percent of $50 (the separately determined foreign oil 
related income).This amount is within the limitation of paragraph 
(b)(2)(ii) of this section, (12\1/2\ percent of $1,000 x 2)-$125, which 
is $125.

Amount recaptured under paragraph (b)(2) of this section in 1985....$225

    The amount recaptured from foreign oil related income is the lesser 
of $750 (the remaining pre-1983 section 904(d)(1)(A-C) overall foreign 
loss account) or 50 percent of $600 (the separately determined foreign 
oil related income), but as limited by paragraph

[[Page 862]]

(b)(2)(ii) of this section to (12\1/2\ percent of $1,000 x 3)-($125 + 
$25), which is $225. ($125 is the amount recaptured in 1983 under 
paragraph (b)(2) of this section, and $25 is the amount recaptured in 
1984 under paragraph (b)(2) of this section.)
    Example 3. Y Corporation is a domestic corporation which has the 
calendar year as its taxable year. On December 31, 1982, Y has a balance 
of $400 in its section 904(d)(1)(A-C) overall foreign loss account. Y 
does not have a balance in a FORI overall foreign loss account. For 
1983, Y has a general limitation overall foreign loss of $200. For 1984, 
Y has general limitation income of $1,200, all of which is foreign oil 
related income. In 1984, Y is required to recapture a total of $300 
computed as follows:

Amount of pre-1983 overall foreign loss recaptured under paragraph 
(b)(2) of this section..............................................$100

    The amount of the pre-1983 section 904(d)(1)(A-C) overall foreign 
loss account attributable to a general limitation loss recaptured from 
foreign oil related income is the lesser of $400 (the loss) or 50 
percent of $1,200 (the separately determined foreign oil related 
income), but as limited by paragraph (b)(2)(ii) of this section to 
(12\1/2\ percent of $400 x 2) - $0, which is $100.

Amount of post-1982 overall foreign loss recaptured under paragraph (c) 
of this section.....................................................$200

    The amount of post-1982 general limitation overall foreign loss 
recaptured is the amount computed under Sec.  1.904 (f)-2(c)(1), which 
is the lesser of $200 (the post-1982 loss) or 50 percent of $1,200 (the 
income), but only to the extent that the amount of pre-1983 loss 
recaptured under paragraph (b) of this section is less than 50 percent 
of such income ((50 percent of $1,200)--$100 recaptured under paragraph 
(b) = $500).

Total amount recaptured in 1984.....................................$300

    At the end of 1984, Y has a balance in its pre-1983 section 
904(d)(1)(A-C) overall foreign loss account of $300, and has reduced its 
post-1982 general limitation overall foreign loss account to zero.
    Example 4. Z is a domestic corporation which has the calendar year 
as its taxable year. On December 31, 1982, Z has a balance of $400 in 
its section 904 (d)(1)(A-C) overall foreign loss account, and a balance 
of $1,000 in its FORI limitation overall foreign loss account. For 1983, 
Z has general limitation income of $2,000, which includes foreign oil 
related income of $1,000 and other general limitation income of $1,000. 
Keeping these amounts separate for purposes of this section, Z is 
required to recapture a total of $1,000 in 1983, computed as follows:

Amount recaptured under paragraph (b)(1) of this section............$900

    The amount of pre-1983 section 904(d)(1)(A-C) overall foreign loss 
account recaptured from general limitation income exclusive of foreign 
oil related income, in accordance with Sec.  1.904 (f)-2(c)(1), is the 
lesser of $400 (the section 904(d)(1)(A-C) overall foreign loss) or 50 
percent of $1,000, the general limitation income exclusive of foreign 
oil related income), which is $400.
    The amount of pre-1983 FORI overall foreign loss recaptured from 
foreign oil related income, in accordance with Sec.  1.904(f)-2(c)(1), 
is the lesser of $1,000 (the FORI overall foreign loss) or 50 percent of 
$1,000 (the foreign oil related income), which is $500.

Amount recaptured under paragraph (b)(2) of this section............$100

    The amount of pre-1983 FORI 907(b) overall foreign loss recaptured 
from section general limitation income exclusive of foreign oil related 
income is the lesser of $500 (the remaining balance in that loss 
account) or 50 percent of $1,000 (the general limitation income 
exclusive of foreign oil related income), but only to the extent that 
the amount recaptured from such income under paragraph (b)(1) of this 
section is less than 50 percent of such income, or $100 (50 percent of 
$1,000)--$400 recaptured due to section 904(d)(1)(A-C) overall foreign 
loss account, and only up to the amount permitted by paragraph 
(b)(2)(ii) of this section, which is (12\1/2\ percent of $1,000 x 1)-$0, 
or $125.

Total amount recaptured in 1983...................................$1,000

    At the end of 1983, Z has reduced its pre-1983 section 904(d)(1)(A-
C) overall foreign loss account to zero, and has a balance in its pre-
1983 FORI overall foreign loss account of $400.

[T.D. 8153, 52 FR 32003, Aug. 25, 1987; 52 FR 43434, Nov. 12, 1987]



Sec.  1.904(f)-7  Separate limitation loss and the separate 
limitation loss account.

    (a) Overview of regulations. This section provides rules for 
determining a taxpayer's separate limitation losses, for establishing 
separate limitation loss accounts, and for making additions to and 
reducing such accounts for purposes of section 904(f). Section 1.904(f)-
8 provides rules for recharacterizing the balance in any separate 
limitation loss account under the general recharacterization rule of 
section 904(f)(5)(C).
    (b) Definitions. The definitions in paragraphs (b)(1) through (b)(4) 
of this section apply for purposes of this section and Sec. Sec.  
1.904(f)-8 and 1.904(g)-3.
    (1) Separate category means each separate category of income 
described in

[[Page 863]]

section 904(d) and any other category of income described in Sec.  
1.904-4(m). For example, income subject to section 901(j) or section 
904(h)(10) is income in a separate category.
    (2) Separate limitation income means, with respect to any separate 
category, the taxable income from sources outside the United States, 
separately computed for that category for the taxable year. Separate 
limitation income shall be determined by taking into account any 
adjustments for capital gains and losses and qualified dividend income, 
as defined in section 1(h)(11), under section 904(b)(2) and Sec.  
1.904(b)-1. See Sec.  1.904(b)-1(h)(1)(i).
    (3) Separate limitation loss means, with respect to any separate 
category, the amount by which the foreign source gross income in that 
category is exceeded by the sum of expenses, losses and other deductions 
(not including any net operating loss deduction under section 172(a) or 
any expropriation loss or casualty loss described in section 
907(c)(4)(D)(iii)) properly apportioned or allocated to that separate 
category for the taxable year. Separate limitation losses shall be 
determined by taking into account any adjustments for capital gains and 
losses and qualified dividend income under section 904(b)(2) and Sec.  
1.904(b)-1. See Sec.  1.904(b)-1(h)(1)(i).
    (c) Separate limitation loss account. Any taxpayer that sustains a 
separate limitation loss that is allocated to reduce separate limitation 
income in one or more other separate categories of the taxpayer under 
the rules of Sec.  1.904(g)-3 must establish a separate limitation loss 
account for the loss with respect to each such other separate category. 
The balance in any separate limitation loss account represents the 
amount of such separate limitation loss that is subject to recapture in 
a given taxable year pursuant to Sec.  1.904(f)-8 and section 
904(f)(5)(F). From year to year, amounts may be added to or subtracted 
from the balance in such loss accounts, as provided in paragraphs (d) 
and (e) of this section.
    (d) Additions to separate limitation loss accounts--(1) General 
rule. A taxpayer's separate limitation loss as defined in paragraph 
(b)(3) of this section shall be added to the applicable separate 
limitation loss accounts at the end of its taxable year to the extent 
that the separate limitation loss reduces separate limitation income in 
one or more other separate categories in that taxable year or in a year 
to which the loss has been carried back. For rules with respect to net 
operating loss carryovers, see paragraph (d)(3) of this section and 
Sec.  1.904(g)-3.
    (2) Separate limitation losses of another taxpayer. If any portion 
of any separate limitation loss account of another taxpayer is allocated 
to the taxpayer in accordance with Sec.  1.1502-9 (relating to 
consolidated separate limitation losses) the taxpayer shall add such 
amount to its applicable separate limitation loss account.
    (3) Additions to separate limitation loss account created by loss 
carryovers. The taxpayer shall add to each separate limitation loss 
account all net operating loss carryovers to the current taxable year to 
the extent that separate limitation losses included in the net operating 
loss carryovers reduced foreign source income in one or more other 
separate categories for the taxable year.
    (e) Reductions of separate limitation loss accounts. The taxpayer 
shall subtract the following amounts from its separate limitation loss 
accounts at the end of its taxable year in the following order as 
applicable:
    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers. A separate limitation loss account is reduced by the amount 
of any separate limitation loss account that is allocated to another 
taxpayer in accordance with Sec.  1.1502-9 (relating to consolidated 
separate limitation losses).
    (2) Reduction for offsetting loss accounts. A separate limitation 
loss account is reduced to take into account any netting of separate 
limitation loss accounts under Sec.  1.904(g)-3(d)(1).
    (3) Reduction for amounts recaptured. A separate limitation loss 
account is reduced by the amount of any separate limitation income that 
is earned in the same separate category as the separate

[[Page 864]]

limitation loss and that is recharacterized in accordance with Sec.  
1.904(f)-8 (relating to recapture of separate limitation losses) or 
section 904(f)(5)(F) (relating to recapture of separate limitation loss 
accounts out of gain realized from certain dispositions).
    (f) Effective/applicability date. This section applies to taxpayers 
that sustain separate limitation losses in taxable years beginning on or 
after January 1, 2012. Taxpayers may choose to apply this section to 
separate limitation losses sustained in other taxable years beginning 
after December 21, 2007, including periods covered by 26 CFR 1.904(f)-7T 
(revised as of April 1, 2010). For rules relating to taxable years 
beginning after December 31, 1986, and on or before December 21, 2007, 
see section 904(f)(5).

[T.D. 9595, 77 FR 37579, June 22, 2012]



Sec.  1.904(f)-8  Recapture of separate limitation loss accounts.

    (a) In general. A taxpayer shall recapture a separate limitation 
loss account as provided in this section. If the taxpayer has a separate 
limitation loss account or accounts in any separate category (the ``loss 
category'') and the loss category has income in a subsequent taxable 
year, the income shall be recharacterized as income in that other 
category or categories. The amount of income recharacterized shall not 
exceed the aggregate balance in all separate limitation loss accounts 
for the loss category as determined under Sec.  1.904(f)-7. If the 
taxpayer has more than one separate limitation loss account in a loss 
category, and there is not enough income in the loss category to 
recapture all of the loss accounts, then separate limitation income in 
the loss category shall be recharacterized as separate limitation income 
in the other separate categories on a proportionate basis. This is 
determined by multiplying the total separate limitation income subject 
to recharacterization by a fraction, the numerator of which is the 
amount in a particular separate limitation loss account and the 
denominator of which is the total amount in all separate limitation loss 
accounts for the loss category.
    (b) Effect of recharacterization of separate limitation income on 
associated taxes. Recharacterization of income under paragraph (a) of 
this section shall not result in the recharacterization of any tax. The 
rules of Sec.  1.904-6, including the rules that the taxes are allocated 
on an annual basis and that foreign taxes paid on U.S. source income 
shall be allocated to the separate category that includes that U.S. 
source income (see Sec.  1.904-6(a)), shall apply for purposes of 
allocating taxes to separate categories. Allocation of taxes pursuant to 
Sec.  1.904-6 shall be made before the recapture of any separate 
limitation loss accounts of the taxpayer pursuant to the rules of this 
section.
    (c) Effective/applicability date. This section applies to taxpayers 
that sustain separate limitation losses in taxable years beginning on or 
after January 1, 2012. Taxpayers may choose to apply this section to 
separate limitation losses sustained in other taxable years beginning 
after December 21, 2007, including periods covered by 26 CFR Sec.  
1.904(f)-8T (revised as of April 1, 2010). For rules relating to taxable 
years beginning after December 31, 1986, and on or before December 21, 
2007, see section 904(f)(5).

[T.D. 9595, 77 FR 37580, June 22, 2012]



Sec. Sec.  1.904(f)-9--1.904(f)-11  [Reserved]



Sec.  1.904(f)-12  Transition rules.

    (a) Recapture in years beginning after December 31, 1986, of overall 
foreign losses incurred in taxable years beginning before January 1, 
1987--(1) In general. If a taxpayer has a balance in an overall foreign 
loss account at the end of its last taxable year beginning before 
January 1, 1987 (pre-effective date years), the amount of that balance 
shall be recaptured in subsequent years by recharacterizing income 
received in the income category described in section 904(d) as in effect 
for taxable years beginning after December 31, 1986 (post-effective date 
years), that is analogous to the income category for which the overall 
foreign loss account was established, as follows:
    (i) Interest income as defined in section 904(d)(1)(A) as in effect 
for pre-effective date taxable years is analogous to passive income as 
defined in section 904(d)(1)(A) as in effect for post-effective date 
years;

[[Page 865]]

    (ii) Dividends from a DISC or former DISC as defined in section 
904(d)(1)(B) as in effect for pre-effective date taxable years is 
analogous to dividends from a DISC or former DISC as defined in section 
904(d)(1)(F) as in effect for post-effective date taxable years;
    (iii) Taxable income attributable to foreign trade income as defined 
in section 904(d)(1)(C) as in effect for pre-effective date taxable 
years is analogous to taxable income attributable to foreign trade 
income as defined in section 904(d)(1)(G) as in effect for post-
effective date years;
    (iv) Distributions from a FSC (or former FSC) as defined in section 
904(d)(1)(D) as in effect for pre-effective date taxable years is 
analogous to distributions from a FSC (or former FSC) as defined in 
section 904(d)(1)(H) as in effect for post-effective date taxable years;
    (v) For general limitation income as described in section 
904(d)(1)(E) as in effect for pre-effective date taxable years, see the 
special rule in paragraph (a)(2) of this section.
    (2) Rule for general limitation losses--(i) In general. Overall 
foreign losses incurred in the general limitation category of section 
904(d)(1)(E), as in effect for pre-effective date taxable years, that 
are recaptured in post-effective date taxable years shall be recaptured 
from the taxpayer's general limitation income, financial services 
income, shipping income, and dividends from each noncontrolled section 
902 corporation. If the sum of the taxpayer's general limitation income, 
financial services income, shipping income and dividends from each 
noncontrolled section 902 corporation for a taxable year subject to 
recapture exceeds the overall foreign loss to be recaptured, then the 
amount of each type of separate limitation income that will be treated 
as U.S. source income shall be determined as follows:
[GRAPHIC] [TIFF OMITTED] TC07OC91.043


This recapture shall be made after the allocation of separate limitation 
losses pursuant to section 904(f)(5)(B) and before the 
recharacterization of post-effective date separate limitation income 
pursuant to section 904(f)(5)(C).
    (ii) Exception. If a taxpayer can demonstrate to the satisfaction of 
the district director that an overall foreign loss in the general 
limitation category of section 904(d)(1)(E), as in effect for pre-
effective date taxable years, is attributable, in sums certain, to 
losses in one or more separate categories of section 904(d)(1) 
(including for this purpose the passive income category and the high 
withholding tax interest category), as in effect for post-effective date 
taxable years, then the taxpayer may recapture the loss (in the amounts 
demonstrated) from those separate categories only.
    (3) Priority of recapture of overall foreign losses incurred in pre-
effective date taxable years. An overall foreign loss incurred by a 
taxpayer in pre-effective date taxable years shall be recaptured to the 
extent thereof before the taxpayer recaptures an overall foreign loss 
incurred in a post-effective date taxable year.
    (4) Examples. The following examples illustrate the application of 
this paragraph (a).

    Example 1. X corporation is a domestic corporation which operates a 
branch in Country Y. For its taxable year ending December 31, 1988, X 
has $800 of financial services income, $100 of general limitation income 
and $100 of shipping income. X has a balance of $100 in its general 
limitation overall foreign loss account which resulted from an overall 
foreign loss incurred during its 1986 taxable year. X is unable to 
demonstrate to which of the income categories set forth in section 
904(d)(1) as in effect for post-effective date taxable years the loss is 
attributable. In addition, X has a balance of $100 in its shipping 
overall

[[Page 866]]

foreign loss account attributable to a shipping loss incurred during its 
1987 taxable year. X has no other overall foreign loss accounts. 
Pursuant to section 904(f)(1), the full amount in each of X 
corporation's overall foreign loss accounts is subject to recapture 
since $200 (the sum of those amounts) is less than 50% of X's foreign 
source taxable income for its 1988 taxable year, or $500. X's overall 
foreign loss incurred during its 1986 taxable year is recaptured before 
the overall foreign loss incurred during its 1987 taxable year, as 
follows: $80 ($100 x 800/1000) of X's financial services income, $10 
($100 x 100/1000) of X's general limitation income, and $10 (100 x 100/
1000) of X's shipping income will be treated as U.S. source income. The 
remaining $90 of X corporation's 1988 shipping income will be treated as 
U.S. source income for the purpose of recapturing X's 100 overall 
foreign loss attributable to the shipping loss incurred in 1987. $10 
remains in X's shipping overall foreign loss account for recapture in 
subsequent taxable years.
    Example 2. The facts are the same as in Example 1 except that X has 
$800 of financial services income, $100 of general limitation income, a 
$100 dividend from a noncontrolled section 902 corporation and a ($100) 
shipping loss for its taxable year ending December 31, 1988. Separate 
limitation losses are allocated pursuant to the rules of section 
904(f)(5) before the recapture of overall foreign losses. Therefore, the 
($100) shipping loss incurred by X will be allocated to its separate 
limitation income as follows: $80 ($100 x 800/1000) will be allocated to 
X's financial services income, $10 ($100 x 100/1000) will be allocated 
to its general limitation income and $10 ($100 x 100/1000) will be 
allocated to X's dividend from the noncontrolled section 902 
corporation. Accordingly, after allocation of the 1988 shipping loss, X 
has $720 of financial services income, $90 of general limitation income, 
and a $90 dividend from the noncontrolled section 902 corporation. 
Pursuant to section 904(f)(1), the full amount in each of X 
corporation's overall foreign loss accounts is subject to recapture 
since $200 (the sum of those amounts) is less than 50% of X's net 
foreign source taxable income for its 1988 taxable year, or $450. X's 
overall foreign loss incurred during its 1986 taxable year is recaptured 
as follows: $80 ($100 x 720/900) of X's financial services income, $10 
($100 x 90/900) of its general limitation income and $10 ($100 x 90/900) 
of its dividend from the noncontrolled section 902 corporation will be 
treated as U.S. source income. Accordingly, after application of section 
904(f), X has $100 of U.S. source income, $640 of financial services 
income, $80 of general limitation income and a $80 dividend from the 
noncontrolled section 902 corporation for its 1988 taxable year. X must 
establish a separate limitation loss account for each portion of the 
1988 shipping loss that was allocated to its financial services income, 
general limitation income and dividends from the noncontrolled section 
902 corporation. X's overall foreign loss account for the 1986 general 
limitation loss is reduced to zero. X still has a $100 balance in its 
overall foreign loss account that resulted from the 1987 shipping loss.
    Example 3. Y is a domestic corporation which has a branch operation 
in Country Z. For its 1988 taxable year, Y has $5 of shipping income, 
$15 of general limitation income and $100 of financial services income. 
Y has a balance of $100 in its general limitation overall foreign loss 
account attributable to its 1986 taxable year. Y has no other overall 
foreign loss accounts. Pursuant to section 904(f)(1), $60 of the overall 
foreign loss is subject to recapture since 50% of Y's foreign source 
income for 1988 is less than the balance in its overall foreign loss 
account. Y can demonstrate that the entire $100 overall foreign loss was 
attributable to a shipping limitation loss incurred in 1986. 
Accordingly, only Y's $5 of shipping limitation income received in 1988 
will be treated as U.S. source income, Because Y can demonstrate that 
the 1986 loss was entirely attributable to a shipping loss, none of Y's 
general limitation income or financial services income received in 1988 
will be treated as U.S. source income.
    Example 4. The facts are the same as in Example 3 except that Y can 
only demonstrate that $50 of the 1986 overall foreign loss account was 
attributable to a shipping loss incurred in 1986. Accordingly, Y's $5 of 
shipping limitation income received in 1988 will be treated as U.S. 
source income. The remaining $50 of the 1986 overall foreign loss that Y 
cannot trace to a particular separate limitation will be recaptured and 
treated as U.S. source income as follows: $43 ($50 x 100/115) of Y's 
financial services income will be treated as U.S. source income and $7 
($50 x 15/115) of Y's general limitation income will be treated as U.S. 
source income. Y has $45 remaining in its overall foreign loss account 
to be recaptured from shipping income in a future year.

    (b) Treatment of overall foreign losses that are part of net 
operating losses incurred in pre-effective date taxable years which are 
carried forward to post-effective date taxable years--(1) Rule. An 
overall foreign loss that is part of a net operating loss incurred in a 
pre-effective date taxable year which is carried forward, pursuant to 
section 172, to a post-effective date taxable year will be carried 
forward under the rules of section 904(f)(5) and the regulations under 
that section. See also Notice 89-3, 1989-1 C.B. 623. For this purpose 
the loss

[[Page 867]]

must be allocated to income in the category analogous to the income 
category set forth in section 904(d) as in effect for pre-effective date 
taxable years in which the loss occurred. The analogous category shall 
be determined under the rules of paragraph (a) of this section.
    (2) Example. The following example illustrates the rule of paragraph 
(b)(1) of this section.

    Example. Z is a domestic corporation which has a branch operation in 
Country D. For its taxable year ending December 31, 1988, Z has $100 of 
passive income and $200 of general limitation income. Z also has a $60 
net operating loss which was carried forward pursuant to section 172 
from its 1986 taxable year. The net operating loss resulted from an 
overall foreign loss attributable to the general limitation income 
category. Z can demonstrate that the loss is a shipping loss. Therefore, 
the net operating loss will be treated as a shipping loss for Z's 1988 
taxable year. Pursuant to section 904(f)(5), the shipping loss will be 
allocated as follows: $20 ($60 x 100/300) will be allocated to Z's 
passive income and $40 ($60 x 200/300) will be allocated to Z's general 
limitation income. Accordingly, after application of section 904(f), Z 
has $80 of passive income and $160 of general limitation income for its 
1988 taxable year. Although no addition to Z's overall foreign loss 
account for shipping income will result from the NOL carry forward, 
shipping income earned by Z in subsequent taxable years, will be subject 
to recharacterization as a passive income and general limitation income 
pursuant to the rules set forth in section 904(f)(5).

    (c) Treatment of overall foreign losses that are part of net 
operating losses incurred in post-effective date taxable years which are 
carried back to pre-effective date taxable years--(1) Allocation to 
analogous income category. An overall foreign loss that is part of a net 
operating loss incurred by the taxpayer in a post-effective date taxable 
year which is carried back, pursuant to section 172, to a pre-effective 
date taxable year shall be allocated first to income in the pre-
effective date income category analogous to the income category set 
forth in section 904(d) as in effect for post-effective date taxable 
years in which the loss occurred. Except for the general limitation 
income category, the pre-effective date income category that is 
analogous to a post-effective date income category shall be determined 
under paragraphs (a)(1) (i) through (iv) of this section. The general 
limitation income category for pre-effective date years shall be treated 
as the income category that is analogous to the post-effective date 
categories for general limitation income, financial services income, 
shipping income, dividends from each noncontrolled section 902 
corporation and high withholding tax interest income. If the net 
operating loss resulted from separate limitation losses in more than one 
post-effective date income category and more than one loss is carried 
back to pre-effective date general limitation income, then the losses 
shall be allocated to the pre-effective date general limitation income 
based on the following formula:
[GRAPHIC] [TIFF OMITTED] TC07OC91.044

    (2) Allocation to U.S. source income. If an overall foreign loss is 
carried back to a pre-effective date taxable year and the loss exceeds 
the foreign source income in the analogous category for the carry back 
year, the remaining loss shall be allocated against U.S. source income 
as set forth in Sec.  1.904(f)-3. The amount of the loss that offsets 
U.S. source income must be added to the taxpayer's overall foreign loss 
account. An addition to an overall foreign loss account resulting from 
the carry back of a net operating loss incurred by a

[[Page 868]]

taxpayer in a post-effective date taxable year shall be treated as 
having been incurred by the taxpayer in the year in which the loss arose 
and shall be subject to recapture pursuant to section 904(f) as in 
effect for post-effective date taxable years.
    (3) Allocation to other separate limitation categories. To the 
extent that an overall foreign loss that is carried back as part of a 
net operating loss exceeds the separate limitation income to which it is 
allocated and the U.S. source income of the taxpayer for the taxable 
year to which the loss is carried, the loss shall be allocated pro rata 
to other separate limitation income of the taxpayer for the taxable 
year. However, there shall be no recharacterization of separate 
limitation income pursuant to section 904(f)(5) as a result of the 
alloction of such a net operating loss to other separate limitation 
income of the taxpayer.
    (4) Examples. The following examples illustrate the rules of 
paragraph (c) of this section.

    Example 1. X is a domestic corporation which has a branch operation 
in Country A. For its taxable year ending December 31, 1987, X has a $60 
net operating loss which is carried back pursuant to section 172 to its 
taxable year ending December 31, 1985. The net operating loss resulted 
from a shipping loss; X had no U.S. source income in 1987. X had $20 of 
general limitation income, $40 of DISC limitation income and $10 of U.S. 
source income for its 1985 taxable year. The $60 NOL is allocated first 
to X's 1985 general limitation income to the extent thereof ($20) since 
the general limitation income category of section 904(d) as in effect 
for pre-effective date taxable years is the income category that is 
analogous to shipping income for post-effective date taxable years. 
Therefore, X has no general limitation income for its 1985 taxable year. 
Next, pursuant to section 904(f) as in effect for pre-effective date 
taxable years, the remaining $40 of the NOL is allocated first to X's 
$10 of U.S. source income and then to $30 of X's DISC limitation income 
for its 1985 taxable year. Accordingly, X has no U.S. source income and 
$10 of DISC limitation income for its 1985 taxable year after allocation 
of the NOL. X has a $10 balance in its shipping overall foreign loss 
account which is subject to recapture pursuant to section 904(f) as in 
effect for post-effective date taxable years. X will not be required to 
recharacterize, pursuant to section 904(f)(5), subsequent shipping 
income as DISC limitation income.
    Example 2. Y is a domestic corporation which has a branch operation 
in Country B. For its taxable year ending December 31, 1987, X has a 
$200 net operating loss which is carried back pursuant to section 172 to 
its taxable year ending December 31, 1986. The net operating loss 
resulted from a ($100) general limitation loss and a ($100) shipping 
loss. Y had $100 of general limitation income and $200 of U.S. source 
income for its taxable year ending December 31, 1986. The separate 
limitation losses for 1987 are allocated pro rata to Y's 1986 general 
limitation income as follows: $50 of the ($100) general limitation loss 
($100 x 100/200) and $50 of the ($100) shipping loss ($100 x 100/200) is 
allocated to Y's $100 of 1986 general limitation income. The remaining 
$50 of Y's general limitation loss and the remaining $50 of Y's shipping 
loss are allocated to Y's 1986 U.S. source income. Accordingly, Y has no 
foreign source income and $100 of U.S. source income for its 1986 
taxable year. Y has a $50 balance in its general limitation overall 
foreign loss account and a $50 balance in its shipping overall foreign 
loss account, both of which will be subject to recapture pursuant to 
section 904(f) as in effect for post-effective date taxable years.

    (d) Recapture of FORI and general limitation overall foreign losses 
incurred in taxable years beginning before January 1, 1983. For taxable 
years beginning after December 31, 1986, and before January 1, 1991, the 
rules set forth in Sec.  1.904 (f)-6 shall apply for purposes of 
recapturing general limitation and foreign oil related income (FORI) 
overall foreign losses incurred in taxable years beginning before 
January 1, 1983 (pre-1983). For taxable years beginning after December 
31, 1990, the rules set forth in this section shall apply for purposes 
of recapturing pre-1983 general limitation and FORI overall foreign 
losses.
    (e) Recapture of pre-1983 overall foreign losses determined on a 
combined basis. The rules set forth in paragraph (a)(2) of this section 
shall apply for purposes of recapturing overall foreign losses incurred 
in taxable years beginning before January 1, 1983, that were computed on 
a combined basis in accordance with Sec.  1.904 (f)-1(c) (1).
    (f) Transition rules for taxable years beginning before December 31, 
1990. For transition rules for taxable years beginning before January 1, 
1990, see 26 CFR 1.904 (f)-13T as it appeared in the Code of Federal 
Regulations revised as of April 1, 1990.

[[Page 869]]

    (g) Recapture in years beginning after December 31, 2002, of 
separate limitation losses and overall foreign losses incurred in years 
beginning before January 1, 2003, with respect to the separate category 
for dividends from a noncontrolled section 902 corporation--(1) 
Recapture of separate limitation loss or overall foreign loss in a 
separate category for dividends from a noncontrolled section 902 
corporation. To the extent that a taxpayer has a balance in any separate 
limitation loss or overall foreign loss account in a separate category 
for dividends from a noncontrolled section 902 corporation under section 
904(d)(1)(E) (prior to its repeal by Public Law 108-357, 118 Stat. 1418 
(October 22, 2004)) at the end of the taxpayer's last taxable year 
beginning before January 1, 2003 (or a later taxable year in which the 
taxpayer received a dividend subject to a separate limitation for 
dividends from that noncontrolled section 902 corporation), the amount 
of such balance shall be allocated on the first day of the taxpayer's 
next taxable year to the taxpayer's other separate categories. The 
amount of such balance shall be allocated in the same percentages as the 
taxpayer properly characterized the stock of the noncontrolled section 
902 corporation for purposes of apportioning the taxpayer's interest 
expense for its first taxable year ending after the first day of such 
corporation's first taxable year beginning after December 31, 2002, 
under Sec.  1.861-12T(c)(3) or Sec.  1.861-12(c)(4), as the case may be. 
To the extent a taxpayer has a balance in any separate limitation loss 
account in a separate category for dividends from a noncontrolled 
section 902 corporation with respect to another separate category, and 
the separate limitation loss would otherwise be assigned to that other 
category under this paragraph (g)(1), such balance shall be eliminated.
    (2) Recapture of separate limitation loss in another separate 
category. To the extent that a taxpayer has a balance in any separate 
limitation loss account in a separate category with respect to a 
separate category for dividends from a noncontrolled section 902 
corporation under section 904(d)(1)(E) (prior to its repeal by Public 
Law 108-357, 118 Stat. 1418 (October 22, 2004)) at the end of the 
taxpayer's last taxable year with or within which ends the last taxable 
year of the noncontrolled section 902 corporation beginning before 
January 1, 2003, such loss shall be recaptured in subsequent taxable 
years as income in the appropriate separate categories. The separate 
limitation loss shall be recaptured as income in other separate 
categories in the same percentages as the taxpayer properly 
characterizes the stock of the noncontrolled section 902 corporation for 
purposes of apportioning the taxpayer's interest expense in its first 
taxable year ending after the first day of the foreign corporation's 
first taxable year beginning after December 31, 2002, under Sec.  1.861-
12T(c)(3) or Sec.  1.861-12(c)(4), as the case may be. To the extent a 
taxpayer has a balance in a separate limitation loss account in a 
separate category that would have been recaptured as income in that same 
category under this paragraph (g)(2), such balance shall be eliminated.
    (3) Exception. Where a taxpayer formerly met the stock ownership 
requirements of section 902(a) with respect to a foreign corporation, 
but did not meet the requirements of section 902(a) on December 20, 2002 
(or on the first day of the taxpayer's first taxable year beginning 
after December 31, 2002, in the case of a transaction that was the 
subject of a binding contract in effect on December 20, 2002), if the 
taxpayer has a balance in any separate limitation loss or overall 
foreign loss account for a separate category for dividends from that 
foreign corporation under section 904(d)(1)(E) (prior to its repeal by 
Public Law 108-357, 118 Stat. 1418 (October 22, 2004)) at the end of the 
taxpayer's last taxable year beginning before January 1, 2003, then the 
amount of such balance shall not be subject to recapture under section 
904(f) and this section. If a separate limitation loss or overall 
foreign loss account for such category is not subject to recapture under 
this paragraph (g)(3), the taxpayer cannot carry over any unused foreign 
taxes in such separate category to any other limitation category. 
However, a taxpayer may elect to recapture the balances of all separate 
limitation loss and overall foreign loss accounts for all separate

[[Page 870]]

categories for dividends from such formerly-owned noncontrolled section 
902 corporations under the rules of paragraphs (g)(1) and (2) of this 
section. If a taxpayer so elects, it may carry over any unused foreign 
taxes in these separate categories to the appropriate separate 
categories as provided in Sec.  1.904-2(h).
    (4) Examples. The following examples illustrate the application of 
this paragraph (g):

    Example 1. X is a domestic corporation that meets the ownership 
requirements of section 902(a) with respect to Y, a foreign corporation 
the stock of which X owns 50 percent. Therefore, Y is a noncontrolled 
section 902 corporation with respect to X. Both X and Y use the calendar 
year as their taxable year. As of December 31, 2002, X had a $100 
balance in its separate limitation loss account for the separate 
category for dividends from Y, of which $60 offset general limitation 
income and $40 offset passive income. For purposes of apportioning X's 
interest expense for its 2003 taxable year, X properly characterized the 
stock of Y as a multiple category asset (80% general and 20% passive). 
Under paragraph (g)(1) of this section, on January 1, 2003, $80 ($100 x 
80/100) of the $100 balance in the separate limitation loss account is 
assigned to the general limitation category. Of this $80 balance, $32 
($80 x 40/100) is with respect to the passive category, and $48 ($80 x 
60/100) is with respect to the general limitation category and therefore 
is eliminated. The remaining $20 balance ($100 x 20/100) of the $100 
balance is assigned to the passive category. Of this $20 balance, $12 
($20 x 60/100) is with respect to the general limitation category, and 
$8 ($20 x 40/100) is with respect to the passive category and therefore 
is eliminated.
    Example 2. The facts are the same as in Example 1, except that as of 
December 31, 2002, X had a $30 balance in its separate limitation loss 
account in the general limitation category, and a $20 balance in its 
separate limitation loss account in the passive category, both of which 
offset income in the separate category for dividends from Y. Under 
paragraph (g)(2) of this section, the separate limitation loss accounts 
in the general limitation and passive categories with respect to the 
separate category for dividends from Y will be recaptured on and after 
January 1, 2003, from income in other separate categories, as follows. 
Of the $30 balance in X's separate limitation loss account in the 
general category with respect to the separate category for dividends 
from Y, $6 ($30 x 20/100) is with respect to the passive category, and 
$24 ($30 x 80/100) is with respect to the general limitation category 
and therefore is eliminated. Of the $20 balance in X's separate 
limitation loss account in the passive category with respect to the 
separate category for dividends from Y, $16 ($20 x 80/100) will be 
recaptured out of general limitation income, and $4 ($20 x 20/100) would 
otherwise be recaptured out of passive income and therefore is 
eliminated.

    (5) Effective/applicability date. This paragraph (g) applies to 
taxable years ending on or after April 20, 2009. See 26 CFR 1.904(f)-
12T(g) (revised as of April 1, 2009) for rules applicable to taxable 
years beginning after December 31, 2002, and ending before April 20, 
2009.
    (h) Recapture in years beginning after December 31, 2006, of 
separate limitation losses and overall foreign losses incurred in years 
beginning before January 1, 2007--(1) Losses related to pre-2007 
separate categories for passive income, certain dividends from a DISC or 
former DISC, taxable income attributable to certain foreign trade income 
or certain distributions from a FSC or former FSC--(i) Recapture of 
separate limitation loss or overall foreign loss incurred in a pre-2007 
separate category for passive income, certain dividends from a DISC or 
former DISC, taxable income attributable to certain foreign trade income 
or certain distributions from a FSC or former FSC. To the extent that a 
taxpayer has a balance in any separate limitation loss or overall 
foreign loss account in a pre-2007 separate category (as defined in 
Sec.  1.904-7(g)(1)(ii)) for passive income, certain dividends from a 
DISC or former DISC, taxable income attributable to certain foreign 
trade income or certain distributions from a FSC or former FSC, at the 
end of the taxpayer's last taxable year beginning before January 1, 
2007, the amount of such balance, or balances, shall be allocated on the 
first day of the taxpayer's next taxable year to the taxpayer's post-
2006 separate category (as defined in Sec.  1.904-7(g)(1)(iii)) for 
passive category income.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for passive income, certain dividends from a DISC 
or former DISC, taxable income attributable to certain foreign trade 
income or certain distributions from a FSC or former FSC. To the extent 
that a taxpayer has a balance in any separate limitation loss account in 
any pre-2007 separate category with respect to a pre-2007 separate 
category for passive income, certain dividends from a DISC

[[Page 871]]

or former DISC, taxable income attributable to certain foreign trade 
income or certain distributions from a FSC or former FSC at the end of 
the taxpayer's last taxable year beginning before January 1, 2007, such 
loss shall be recaptured in subsequent taxable years as income in the 
post-2006 separate category for passive category income.
    (2) Losses related to pre-2007 separate categories for shipping, 
financial services income or general limitation income--(i) Recapture of 
separate limitation loss or overall foreign loss incurred in a pre-2007 
separate category for shipping income, financial services income or 
general limitation income. To the extent that a taxpayer has a balance 
in any separate limitation loss or overall foreign loss account in a 
pre-2007 separate category for shipping income, financial services 
income or general limitation income at the end of the taxpayer's last 
taxable year beginning before January 1, 2007, the amount of such 
balance, or balances, shall be allocated on the first day of the 
taxpayer's next taxable year to the taxpayer's post-2006 separate 
category for general category income.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for shipping income, financial services income or 
general limitation income. To the extent that a taxpayer has a balance 
in any separate limitation loss account in any pre-2007 separate 
category with respect to a pre-2007 separate category for shipping 
income, financial services income or general limitation income at the 
end of the taxpayer's last taxable year beginning before January 1, 
2007, such loss shall be recaptured in subsequent taxable years as 
income in the post-2006 separate category for general category income.
    (3) Losses related to a pre-2007 separate category for high 
withholding tax interest--(i) Recapture of separate limitation loss or 
overall foreign loss incurred in a pre-2007 separate category for high 
withholding tax interest. To the extent that a taxpayer has a balance in 
any separate limitation loss or overall foreign loss account in a pre-
2007 separate category for high withholding tax interest at the end of 
the taxpayer's last taxable year beginning before January 1, 2007, the 
amount of such balance shall be allocated on the first day of the 
taxpayer's next taxable year on a pro rata basis to the taxpayer's post-
2006 separate categories for general category and passive category 
income, based on the proportion in which any unused foreign taxes in the 
same pre-2007 separate category for high withholding tax interest are 
allocated under Sec.  1.904-2(i)(1). If the taxpayer, other than a 
financial services entity as defined in Sec.  1.904-4(e)(3), has no 
unused foreign taxes in the pre-2007 separate category for high 
withholding tax interest, then any loss account balance in that category 
shall be allocated to the post-2006 separate category for passive 
category income. If the taxpayer is a financial services entity, as 
defined in Sec.  1.904-4(e)(3), and has no unused foreign taxes in the 
pre-2007 separate category for high withholding tax interest, then any 
loss account balance in that category shall be allocated to the post-
2006 separate category for general category income.
    (ii) Recapture of separate limitation loss with respect to a pre-
2007 separate category for high withholding tax interest. To the extent 
that a taxpayer has a balance in a separate limitation loss account in 
any pre-2007 separate category with respect to a pre-2007 separate 
category for high withholding tax interest at the end of the taxpayer's 
last taxable year beginning before January 1, 2007, such loss shall be 
recaptured in subsequent taxable years on a pro rata basis as income in 
the post-2006 separate categories for general category and passive 
category income, based on the proportion in which any unused foreign 
taxes in the pre-2007 separate category for high withholding tax 
interest are allocated under Sec.  1.904-2(i)(1). If the taxpayer, other 
than a financial services entity as defined in Sec.  1.904-4(e)(3), has 
no unused foreign taxes in the pre-2007 separate category for high 
withholding tax interest, then the loss account balance shall be 
recaptured in subsequent taxable years solely as income in the post-2006 
separate category for passive category income. If the taxpayer is a 
financial services entity, as defined in Sec.  1.904-4(e)(3), and has no 
unused foreign taxes in the pre-2007 separate category for high 
withholding tax interest, then the loss account balance shall be 
recaptured in

[[Page 872]]

subsequent taxable years solely as income in the post-2006 separate 
category for general category income.
    (4) Elimination of certain separate limitation loss accounts. After 
application of paragraphs (h)(1) through (h)(3) of this section, any 
separate limitation loss account allocated to the post-2006 separate 
category for passive category income for which income is to be 
recaptured as passive category income, as determined under those same 
provisions, shall be eliminated. Similarly, after application of 
paragraphs (h)(1) through (h)(3) of this section, any separate 
limitation loss account allocated to the post-2006 separate category for 
general category income for which income is to be recaptured as general 
category income, as determined under those same provisions, shall be 
eliminated.
    (5) Alternative method. In lieu of applying the rules of paragraphs 
(h)(1) through (h)(3) of this section, a taxpayer may apply the 
principles of paragraphs (g)(1) and (g)(2) of this section to determine 
recapture in taxable years beginning after December 31, 2006, of 
separate limitation losses and overall foreign losses incurred in 
taxable years beginning before January 1, 2007. A taxpayer may choose to 
use the alternative method on a timely filed (original or amended) tax 
return or during an audit. A taxpayer that uses the alternative method 
on an amended return or in the course of an audit must make appropriate 
adjustments to eliminate any double benefit arising from application of 
the alternative method to years that are not open for assessment. A 
taxpayer's choice to use the alternative method is evidenced by 
employing the method. The taxpayer need not file any separate statement.
    (6) Effective/applicability date. This paragraph (h) shall apply to 
taxable years beginning after December 31, 2006, and ending on or after 
December 21, 2007. However, taxpayers may choose to apply 26 CFR 
1.904(f)-12T(h) as it appeared in the Code of Federal Regulations as of 
April 1, 2010, in lieu of this paragraph (h) to taxable years beginning 
after December 31, 2006 and ending on or after December 21, 2007, but 
ending before April 7, 2011 provided that appropriate adjustments are 
made to eliminate duplicate benefits arising from application of 26 CFR 
1.904(f)-12T(h) to taxable years that are not open for assessment. In 
addition, if a taxpayer that is a financial services entity (as defined 
in Sec.  1.904-4(e)(3)) chooses to apply 26 CFR 1.904(f)-12T(h) to 
taxable years ending before April 7, 2011, then as of the beginning of 
the taxpayer's first taxable year ending on or after April 7, 2011 any 
remaining balance in a passive category loss account that is 
attributable to a loss account in a pre-2007 separate category for high 
withholding tax interest shall be allocated to the general category or 
eliminated pursuant to Sec.  1.904(f)-12(h)(4), and any remaining 
balance in a separate limitation loss account with respect to passive 
category income that is attributable to a loss account with respect to a 
pre-2007 separate category for high withholding tax interest will be 
recaptured in such year and subsequent taxable years as general category 
income or eliminated pursuant to Sec.  1.904(f)-12(h)(4).

[T.D. 8306, 55 FR 31381, Aug. 2, 1990, as amended by T.D. 9260, 71 FR 
24539, Apr. 25, 2006; T.D. 9368, 72 FR 72591, Dec. 21, 2007; T.D. 9452, 
74 FR 27886, June 11, 2009; T.D. 9521, 76 FR 19273, Apr. 7, 2011]



Sec.  1.904(g)-0  Outline of regulation provisions.

    This section lists the headings for Sec. Sec.  1.904(g)-1 through 
1.904(g)-3.

  Sec.  1.904(g)-1 Overall domestic loss and the overall domestic loss 
                                account.

    (a) Overview of regulations.
    (b) Overall domestic loss accounts.
    (1) In general.
    (2) Taxable year in which overall domestic loss is sustained.
    (c) Determination of a taxpayer's overall domestic loss.
    (1) Overall domestic loss defined.
    (2) Domestic loss defined.
    (3) Qualified taxable year defined.
    (4) Method of allocation and apportionment of deductions.
    (d) Additions to overall domestic loss accounts.
    (1) General rule.
    (2) Overall domestic loss of another taxpayer.
    (3) Adjustments for capital gains and losses.
    (e) Reductions of overall domestic loss accounts.

[[Page 873]]

    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers.
    (2) Reduction for amounts recaptured.
    (f) Effective/applicability date.

         Sec.  1.904(g)-2 Recapture of overall domestic losses.

    (a) In general.
    (b) Determination of U.S. source taxable income for purposes of 
recapture.
    (c) Section 904(g)(1) recapture.
    (d) Effective/applicability date.

  Sec.  1.904(g)-3 Ordering rules for the allocation of net operating 
losses, net capital losses, U.S. source losses, and separate limitation 
losses, and for recapture of separate limitation losses, overall foreign 
                  losses, and overall domestic losses.

    (a) In general.
    (b) Step One: Allocation of net operating loss and net capital loss 
carryovers.
    (1) In general.
    (2) Full net operating loss carryover.
    (3) Partial net operating loss carryover.
    (4) Net capital loss carryovers.
    (c) Step Two: Section 904(b) adjustments.
    (d) Step Three: Allocation of separate limitation losses.
    (e) Step Four: Allocation of U.S. source losses.
    (f) Step Five: Recapture of overall foreign loss accounts.
    (g) Step Six: Recapture of separate limitation loss accounts.
    (h) Step Seven: Recapture of overall domestic loss accounts.
    (i) [Reserved]
    (j) Examples.
    (k) Effective/applicability date.

[T.D. 9371, 72 FR 72599, Dec. 21, 2007, as amended by T.D. 9595, 77 FR 
37580, June 22, 2012]



Sec.  1.904(g)-1  Overall domestic loss and the overall domestic loss account.

    (a) Overview of regulations. This section provides rules for 
determining a taxpayer's overall domestic losses, for establishing 
overall domestic loss accounts, and for making additions to and reducing 
such accounts for purposes of section 904(g). Section 1.904(g)-2 
provides rules for recapturing the balance in any overall domestic loss 
account under the general recharacterization rule of section 904(g)(1). 
Section 1.904(g)-3 provides ordering rules for the allocation of net 
operating losses, net capital losses, U.S. source losses, and separate 
limitation losses, and the recapture of separate limitation losses, 
overall foreign losses and overall domestic losses.
    (b) Overall domestic loss accounts--(1) In general. Any taxpayer 
that sustains an overall domestic loss under paragraph (c) of this 
section must establish an overall domestic loss account for such loss 
with respect to each separate category, as defined in Sec.  1.904(f)-
7(b)(1), of the taxpayer in which foreign source income is offset by the 
domestic loss. The balance in each overall domestic loss account 
represents the amount of such overall domestic loss subject to recapture 
in a given taxable year. From year to year, amounts may be added to or 
subtracted from the balances in such loss accounts as provided in 
paragraphs (d) and (e) of this section.
    (2) Taxable year in which overall domestic loss is sustained. When a 
domestic loss is carried back or carried forward as part of a net 
operating loss, and offsets foreign source income in a carryover year, 
the resulting overall domestic loss is treated as sustained in the later 
of the year in which the domestic loss was incurred or the year to which 
the loss was carried. Accordingly, when a taxpayer incurs a domestic 
loss that is carried back as part of a net operating loss to offset 
foreign source income in a qualified taxable year, as defined in 
paragraph (c)(3) of this section, the resulting overall domestic loss is 
treated as sustained in the later year in which the domestic loss was 
incurred and not in the earlier year in which the loss offset foreign 
source income. In addition, when a taxpayer incurs a domestic loss that 
is carried forward as part of a net operating loss and applied to offset 
foreign source income in a later taxable year, the resulting overall 
domestic loss is treated as sustained in the later year in which the 
domestic loss offsets foreign source income and not in the earlier year 
in which the loss was incurred. For example, if a taxpayer incurs a 
domestic loss in the 2007 taxable year that is carried back to the 2006 
qualified taxable year and offsets foreign source income in 2006, the 
resulting overall domestic loss is treated as sustained in the 2007 
taxable year. If a taxpayer incurs a domestic loss in a pre-2007 taxable 
year that

[[Page 874]]

is carried forward to a post-2006 qualified taxable year and offsets 
foreign source income in the post-2006 year, the resulting overall 
domestic loss is treated as sustained in the post-2006 year. An overall 
domestic loss account is established, or increased under paragraph (d) 
of this section, at the end of the taxable year in which the overall 
domestic loss is treated as sustained and will be recaptured from U.S. 
source income arising in subsequent taxable years.
    (c) Determination of a taxpayer's overall domestic loss--(1) Overall 
domestic loss defined. For taxable years beginning after December 31, 
2006, a taxpayer sustains an overall domestic loss--
    (i) In any qualified taxable year in which its domestic loss for 
such taxable year offsets foreign source taxable income for the taxable 
year or for any preceding qualified taxable year by reason of a 
carryback; and
    (ii) In any other taxable year in which the domestic loss for such 
taxable year offsets foreign source taxable income for any preceding 
qualified taxable year by reason of a carryback.
    (2) Domestic loss defined. For purposes of this section and 
Sec. Sec.  1.904(g)-2 and 1.904(g)-3, the term domestic loss means the 
amount by which the U.S. source gross income for the taxable year is 
exceeded by the sum of the expenses, losses, and other deductions 
properly apportioned or allocated to such income, taking into account 
any net operating loss carried forward from a prior taxable year, but 
not any loss carried back. If a taxpayer has any capital gains or losses 
or qualified dividend income, as defined in section 1(h)(11), the amount 
of the taxpayer's domestic loss that offsets foreign source income must 
be determined taking into account adjustments under section 904(b)(2). 
See Sec.  1.904(g)-1(d)(3) for further guidance.
    (3) Qualified taxable year defined. For purposes of this section and 
Sec. Sec.  1.904(g)-2 and 1.904(g)-3, the term qualified taxable year 
means any taxable year for which the taxpayer chooses the benefits of 
section 901.
    (4) Method of allocation and apportionment of deductions. In 
determining its overall domestic loss, a taxpayer shall allocate and 
apportion expenses, losses, and other deductions to U.S. source gross 
income in accordance with sections 861(b) and 865 and the regulations 
thereunder, including Sec. Sec.  1.861-8 through 1.861-14T.
    (d) Additions to overall domestic loss accounts--(1) General rule. A 
taxpayer's overall domestic loss as determined under paragraph (c) of 
this section shall be added to the applicable overall domestic loss 
account at the end of its taxable year to the extent that the overall 
domestic loss either reduces foreign source income for the year (but 
only if such year is a qualified taxable year) or reduces foreign source 
income for a qualified taxable year to which the loss has been carried 
back.
    (2) Overall domestic loss of another taxpayer. If any portion of any 
overall domestic loss of another taxpayer is allocated to the taxpayer 
in accordance with Sec.  1.1502-9 (relating to consolidated overall 
domestic losses) the taxpayer shall add such amount to its applicable 
overall domestic loss account.
    (3) Adjustments for capital gains and losses. If the taxpayer has 
capital gains or losses or qualified dividend income, the amount by 
which a domestic loss is considered to reduce foreign source income in a 
taxable year shall equal the section 904(f)(5)(D) amount determined 
under Sec.  1.904(b)-1(h)(1)(iii), regardless of the amount of domestic 
loss that was determined before taking any section 904(b)(2) adjustments 
into account.
    (e) Reductions of overall domestic loss accounts. The taxpayer shall 
subtract the following amounts from its overall domestic loss accounts 
at the end of its taxable year in the following order, as applicable:
    (1) Pre-recapture reduction for amounts allocated to other 
taxpayers. An overall domestic loss account is reduced by the amount of 
any overall domestic loss which is allocated to another taxpayer in 
accordance with Sec.  1.1502-9 (relating to consolidated overall 
domestic losses).
    (2) Reduction for amounts recaptured. An overall domestic loss 
account is reduced by the amount of any U.S. source income that is 
recharacterized in accordance with Sec.  1.904(g)-2(c) (relating to 
recapture under section 904(g)(1)).

[[Page 875]]

    (f) Effective/applicability date. This section applies to taxpayers 
that sustain an overall domestic loss for a taxable year beginning on or 
after January 1, 2012. Taxpayers may choose to apply this section to 
overall domestic losses sustained in other taxable years beginning after 
December 31, 2006, including periods covered by 26 CFR Sec.  1.904(g)-1T 
(revised as of April 1, 2010).

[T.D. 9595, 77 FR 37580, June 22, 2012]



Sec.  1.904(g)-2  Recapture of overall domestic losses.

    (a) In general. A taxpayer shall recapture an overall domestic loss 
as provided in this section. Recapture is accomplished by treating a 
portion of the taxpayer's U.S. source taxable income as foreign source 
income. The recharacterized income is allocated among and increases 
foreign source income in separate categories in proportion to the 
balances of the overall domestic loss accounts with respect to those 
separate categories. As a result, if the taxpayer chooses the benefits 
of section 901, the taxpayer's foreign tax credit limitation is 
increased. As provided in Sec.  1.904(g)-1(e)(2), the balance in a 
taxpayer's overall domestic loss account with respect to a separate 
category is reduced at the end of each taxable year by the amount of 
loss recaptured during that taxable year. Recapture continues until the 
amount of U.S. source income recharacterized as foreign source income 
equals the amount in the overall domestic loss account.
    (b) Determination of U.S. source taxable income for purposes of 
recapture. For purposes of determining the amount of an overall domestic 
loss subject to recapture, the taxpayer's taxable income from U.S. 
sources shall be computed in accordance with the rules set forth in 
Sec.  1.904(g)-1(c)(4). U.S. source taxable income shall be determined 
by taking into account adjustments for capital gains and losses and 
qualified dividend income in a similar manner to the adjustments made to 
foreign source taxable income under section 904(b)(2) and Sec.  
1.904(b)-1, following the principles of Sec.  1.904(b)-1(h)(1)(i).
    (c) Section 904(g)(1) recapture. The amount of any U.S. source 
taxable income subject to recharacterization in a taxable year in which 
paragraph (a) of this section applies is the lesser of the aggregate 
balance of the taxpayer's overall domestic loss accounts or 50 percent 
of the taxpayer's U.S. source taxable income (as determined under 
paragraph (b) of this section).
    (d) Effective/applicability date. This section applies to taxpayers 
that sustain an overall domestic loss for a taxable year beginning on or 
after January 1, 2012. Taxpayers may choose to apply this section to 
overall domestic losses sustained in other taxable years beginning after 
December 31, 2006, including periods covered by 26 CFR 1.904(g)-2T 
(revised as of April 1, 2010).

[T.D. 9595, 77 FR 37581, June 22, 2012]



Sec.  1.904(g)-3  Ordering rules for the allocation of net operating losses, 
net capital losses, U.S. source losses, and separate limitation losses, 
and for the recapture of separate limitation losses, overall foreign losses, 
and overall domestic losses.

    (a) In general. This section provides ordering rules for the 
allocation of net operating losses, net capital losses, U.S. source 
losses, and separate limitation losses, and for the recapture of 
separate limitation losses, overall foreign losses, and overall domestic 
losses. The rules must be applied in the order set forth in paragraphs 
(b) through (i) of this section.
    (b) Step One: Allocation of net operating loss and net capital loss 
carryovers--(1) In general. Net operating losses from a current taxable 
year are carried forward or back to a taxable year in the following 
manner. Net operating losses that are carried forward pursuant to 
section 172 are combined with income or loss in the carryover year in 
the manner described in this paragraph (b). The combined amounts are 
then subject to the ordering rules provided in paragraphs (c) through 
(i) of this section. Net operating losses that are carried back to a 
prior taxable year pursuant to section 172 are allocated to income in 
the carryback year in the manner set forth in paragraphs (b)(2), (b)(3), 
(c), (d), and (e) of this section. The income in the carryback year to 
which the net operating loss is allocated is the foreign source income 
in each separate category and the U.S.

[[Page 876]]

source income after the application of sections 904(f) and 904(g) to 
income and loss in that previous year, including as a result of net 
operating loss carryovers or carrybacks from taxable years prior to the 
current taxable year.
    (2) Full net operating loss carryover. If the full net operating 
loss (that remains after carryovers to other taxable years) is less than 
or equal to the taxable income in a particular taxable year (carryover 
year), and so can be carried forward in its entirety to such carryover 
year, U.S. source losses and foreign source losses in separate 
categories that are part of a net operating loss from a particular 
taxable year that is carried forward in its entirety shall be combined 
with the U.S. source income or loss and the foreign source income or 
loss in the same separate categories in the carryover year.
    (3) Partial net operating loss carryover. If the full net operating 
loss (that remains after carryovers to other taxable years) exceeds the 
taxable income in a carryover year, and so cannot be carried forward in 
its entirety to such carryover year, the following rules apply:
    (i) Any U.S. source loss (not to exceed the net operating loss 
carryover) shall be carried over to the extent of any U.S. source income 
in the carryover year.
    (ii) If the net operating loss carryover exceeds the U.S. source 
loss carryover determined under paragraph (b)(3)(i) of this section, 
then separate limitation losses that are part of the net operating loss 
shall be tentatively carried over to the extent of separate limitation 
income in the same separate category in the carryover year. If the sum 
of the potential separate limitation loss carryovers determined under 
the preceding sentence exceeds the amount of the net operating loss 
carryover reduced by any U.S. source loss carried over under paragraph 
(b)(3)(i) of this section, then the potential separate limitation loss 
carryovers shall be reduced pro rata so that their sum equals such 
amount.
    (iii) If the net operating loss carryover exceeds the sum of the 
U.S. and separate limitation loss carryovers determined under paragraphs 
(b)(3)(i) and (ii) of this section, then a proportionate part of the 
remaining loss from each separate category shall be carried over to the 
extent of such excess and combined with the foreign source loss, if any, 
in the same separate categories in the carryover year.
    (iv) If the net operating loss carryover exceeds the sum of all the 
loss carryovers determined under paragraphs (b)(3)(i), (ii), and (iii) 
of this section, then any U.S. source loss not carried over under 
paragraph (b)(3)(i) of this section shall be carried over to the extent 
of such excess and combined with the U.S. source loss, if any, in the 
carryover year.
    (4) Net capital loss carryovers. Rules similar to the rules of 
paragraphs (b)(1) through (3) of this section apply for purposes of 
determining the components of a net capital loss carryover to a taxable 
year.
    (c) Step Two: Section 904(b) adjustments. The taxpayer shall make 
any required adjustments to capital gains and losses and qualified 
dividend income under section 904(b)(2).
    (d) Step Three: Allocation of separate limitation losses. The 
taxpayer shall allocate separate limitation losses sustained during the 
taxable year (increased, if appropriate, by any losses carried over 
under paragraph (b) of this section), in the following manner--
    (1) The taxpayer shall allocate its separate limitation losses for 
the taxable year to reduce its separate limitation income in other 
separate categories on a proportionate basis, and increase its separate 
limitation loss accounts appropriately. To the extent a separate 
limitation loss in one separate category is allocated to reduce separate 
limitation income in a second separate category, and the second category 
has a separate limitation loss account from a prior taxable year with 
respect to the first category, the two separate limitation loss accounts 
shall be netted against each other.
    (2) If the taxpayer's separate limitation losses for the taxable 
year exceed the taxpayer's separate limitation income for the year, so 
that the taxpayer has separate limitation losses remaining after the 
application of paragraph (d)(1) of this section, the taxpayer shall 
allocate those losses to its U.S. source income for the taxable year, to 
the extent thereof, and shall increase its

[[Page 877]]

overall foreign loss accounts to that extent in accordance with Sec.  
1.904(f)-1.
    (e) Step Four: Allocation of U.S. source losses. The taxpayer shall 
allocate U.S. source losses sustained during the taxable year 
(increased, if appropriate, by any losses carried over under paragraph 
(b) of this section) to separate limitation income on a proportionate 
basis, and shall increase its overall domestic loss accounts to the 
extent of such allocation in accordance with Sec.  1.904(g)-1.
    (f) Step Five: Recapture of overall foreign loss accounts. If the 
taxpayer's separate limitation income for the taxable year (reduced by 
any losses carried over under paragraph (b) of this section) exceeds the 
sum of the taxpayer's U.S. source loss and separate limitation losses 
for the year, so that the taxpayer has separate limitation income 
remaining after the application of paragraphs (d)(1) and (e) of this 
section, then the taxpayer shall recapture prior year overall foreign 
losses, if any, and reduce overall foreign loss accounts in accordance 
with Sec.  1.904(f)-2.
    (g) Step Six: Recapture of separate limitation loss accounts. To the 
extent the taxpayer has remaining separate limitation income for the 
year after the application of paragraph (f) of this section, then the 
taxpayer shall recapture prior year separate limitation losses, if any, 
in accordance with Sec.  1.904(f)-8 and reduce separate limitation loss 
accounts in accordance with Sec.  1.904(f)-7.
    (h) Step Seven: Recapture of overall domestic loss accounts. If the 
taxpayer's U.S. source income for the year (reduced by any losses 
carried over under paragraph (b) of this section or allocated under 
paragraph (d) of this section, but not increased by any recapture of 
overall foreign loss accounts under paragraph (f) of this section) 
exceeds the taxpayer's separate limitation losses for the year, so that 
the taxpayer has U.S. source income remaining after the application of 
paragraph (d)(2) of this section, then the taxpayer shall recapture its 
prior year overall domestic losses, if any, and reduce overall domestic 
loss accounts in accordance with Sec.  1.904(g)-2.
    (i) [Reserved]
    (j) Examples. The following examples illustrate the rules of this 
section. Unless otherwise noted, all corporations use the calendar year 
as the U.S. taxable year.

    Example 1. (i) Facts. (A) Z Corporation is a domestic corporation 
with foreign branch operations in Country B. For 2009, Z has a net 
operating loss of ($500), determined as follows:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
          ($300)                       $0                  ($200)
------------------------------------------------------------------------

    (B) For 2008, Z had the following taxable income and losses after 
application of section 904(f) and (g) to income and loss in 2008:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
            $400                     $200                    $110
------------------------------------------------------------------------

    (ii) Net operating loss allocation. Because Z's taxable income for 
2008 exceeds its total net operating loss for 2009, the full net 
operating loss is carried back. Under Step 1, each component of the net 
operating loss is carried back and combined with its same category in 
2008. See paragraph (b)(2) of this section. After allocation of the net 
operating loss, Z has the following taxable income and losses for 2008:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
            $100                     $200                   ($90)
------------------------------------------------------------------------

    (iii) Loss allocation. Under Step 4, the ($90) of U.S. loss is 
allocated proportionately to reduce the general category and passive 
category income. Accordingly, $30 ($90 x $100/$300) of the U.S. loss is 
allocated to general category income and $60 ($90 x $200/$300) of the 
U.S. loss is allocated to passive category income, with a corresponding 
creation or increase to Z's overall domestic loss accounts.
    Example 2. (i) Facts. (A) X Corporation is a domestic corporation 
with foreign branch operations in Country C. As of January 1, 2007, X 
has no loss accounts subject to recapture. For 2007, X has a net 
operating loss of ($1400), determined as follows:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
          ($400)                   ($200)                  ($800)
------------------------------------------------------------------------

    (B) X has no taxable income in 2005 or 2006 available for offset by 
a net operating loss carryback. For 2008, X has the following taxable 
income and losses:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
            $500                   ($100)                   $1200
------------------------------------------------------------------------

    (ii) Net operating loss allocation. Under Step 1, because X's total 
taxable income for 2008 of $1600 ($1200 + $500 - $100) exceeds the total

[[Page 878]]

2007 net operating loss, the full $1400 net operating loss is carried 
forward. Under paragraph (b)(2) of this section, each component of the 
net operating loss is carried forward and combined with its same 
category in 2008. After allocation of the net operating loss, X has the 
following taxable income and losses:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
            $100                   ($300)                    $400
------------------------------------------------------------------------

    (iii) Loss allocation. Under Step 3, $100 of the passive category 
loss offsets the $100 of general category income, resulting in a passive 
category separate limitation loss account with respect to general 
category income, and the other $200 of passive category loss offsets 
$200 of the U.S. source taxable income, resulting in the creation of an 
overall foreign loss account in the passive category.
    Example 3. (i) Facts. Assume the same facts as in Example 2, except 
that in 2008, X had the following taxable income and losses:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
            $200                   ($100)                   $1200
------------------------------------------------------------------------

    (ii) Net operating loss allocation. Under Step 1, because the total 
net operating loss for 2007 of ($1400) exceeds total taxable income for 
2008 of $1300 ($1200 + $200 - $100), X has a partial net operating loss 
carryover to 2008 of $1300. Under paragraph (b)(3)(i) of this section, 
first, the $800 U.S. source component of the net operating loss is 
allocated to U.S. income for 2008. The tentative general category 
carryover under paragraph (b)(3)(ii) of this section ($200) does not 
exceed the remaining net operating loss carryover amount ($500). 
Therefore, $200 of the general category component of the net operating 
loss is next allocated to the general category income for 2008. Under 
paragraph (b)(3)(iii) of this section, the remaining $300 of net 
operating loss carryover ($1300 - $800 - $200) is carried over 
proportionally from the remaining net operating loss components in the 
general category ($200, or $400 total general category loss -$200 
general category loss already allocated) and passive category ($200). 
Therefore, $150 ($300 x $200/$400) of the remaining net operating loss 
carryover is carried over from the general category for 2007 and 
combined with the general category for 2008, and $150 ($300 x $200/$400) 
of the remaining net operating loss carryover is carried over from the 
passive category for 2007 and combined with the passive category for 
2008. After allocation of the net operating loss carryover from 2007 to 
the appropriate categories for 2008, X has the following taxable income 
and losses:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
          ($150)                   ($250)                    $400
------------------------------------------------------------------------

    (iii) Loss allocation. Under Step 3, the losses in the general and 
passive categories fully offset the U.S. source income, resulting in the 
creation of general category and passive category overall foreign loss 
accounts.
    Example 4. (i) Facts. Assume the same facts as in Example 2, except 
that in 2008, X has the following taxable income and losses:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
            $200                     $200                  ($200)
------------------------------------------------------------------------

    (ii) Net operating loss allocation. Under Step 1, because the total 
net operating loss of ($1400) exceeds total taxable income for 2008 of 
$200 ($200 + $200 - $200), X has a partial net operating loss carryover 
to 2008 of $200. Because X has no U.S. source income in 2008, under 
paragraph (b)(3)(i) of this section no portion of the U.S. source 
component of the net operating loss is initially carried into 2008. 
Because the total tentative carryover under paragraph (b)(3)(ii) of this 
section of $400 ($200 in each of the general and passive categories) 
exceeds the net operating loss carryover amount, the tentative carryover 
from each separate category is reduced proportionately by $100 ($200 x 
$200/$400). Accordingly, $100 ($200 - $100) of the general category 
component of the net operating loss is carried forward and $100 ($200 - 
$100) of the passive category component of the net operating loss is 
carried forward and combined with income in the same respective 
categories for 2008. After allocation of the net operating loss 
carryover from 2007, X has the following taxable income and losses:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
            $100                     $100                  ($200)
------------------------------------------------------------------------

    (iii) Loss allocation. Under Step 4, the $200 U.S. source loss 
offsets the remaining $100 of general category income and $100 of 
passive category income, resulting in the creation of overall domestic 
loss accounts with respect to the general and passive categories.
    Example 5. (i) Facts. Assume the same facts as in Example 2, except 
that in 2008, X has the following taxable income and losses:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
            $800                   ($100)                    $100
------------------------------------------------------------------------

    (ii) Net operating loss allocation. Under Step 1, because X's total 
net operating loss in 2007 of ($1400) exceeds its total taxable income 
for 2008 of $800 ($100 + $800 - $100), X has a partial net operating 
loss carryover to 2008 of $800. Under paragraph (b)(3)(i) of this 
section, $100 of the U.S. source component of the net operating loss is 
allocated to U.S. income for 2008. The tentative general category 
carryover under paragraph (b)(3)(ii) of this section does not exceed the 
remaining net operating

[[Page 879]]

loss carryover amount. Therefore, $400 of the general category component 
of the net operating loss is allocated to reduce general category income 
in 2008. Under paragraph (b)(3)(iii) of this section, of the remaining 
$300 of net operating loss carryover ($800 - $100 - $400), $200 is 
carried forward from the passive category component of the net operating 
loss and combined with the passive category for 2008. Under paragraph 
(b)(3)(iv) of this section, the remaining $100 ($300 - $200) of net 
operating loss carryover is carried forward from the U.S. source 
component of the net operating loss and combined with the U.S. source 
income (loss) for 2008. After allocation of the net operating loss 
carryover from 2007, X has the following taxable income and losses:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
            $400                   ($300)                  ($100)
------------------------------------------------------------------------

    (iii) Loss allocation. (A) Under Step 3, the $300 passive category 
loss offsets the $300 of income in the general category, resulting in 
the creation of a passive category separate limitation loss account with 
respect to the general category.
    (B) Under Step 4, the $100 U.S. source loss offsets the remaining 
$100 of the general category income, resulting in the creation of an 
overall domestic loss account with respect to the general category.
    Example 6. (i) Facts. (A) Y Corporation is a domestic corporation 
with foreign branch operations in Country D. Y has no net operating 
losses and does not make an election to recapture more than the required 
amount of overall foreign losses. As of January 1, 2007, Y has a ($200) 
general category overall foreign loss (OFL) account and a ($200) general 
category separate limitation loss (SLL) account with respect to the 
passive category. For 2007, Y has $400 of passive category income that 
is fully offset by a ($400) domestic loss in that taxable year, giving 
rise to the creation of an overall domestic loss (ODL) account with 
respect to the passive category. As of January 1, 2008, Y has the 
following balances in its OFL, SLL, and ODL accounts:

------------------------------------------------------------------------
                     General                               U.S.
------------------------------------------------------------------------
          OFL               OFL SLL (Passive)          ODL (Passive)
------------------------------------------------------------------------
            $200                     $200                    $400
------------------------------------------------------------------------

    (B) In 2008, Y has the following taxable income and losses:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
            $400                   ($100)                    $600
------------------------------------------------------------------------

    (ii) Loss allocation. Under Step 3, the $100 of passive category 
loss offsets $100 of the general category income, creating a passive 
category SLL account of $100 with respect to the general category. 
Because there is an offsetting general category SLL account of $200 with 
respect to the passive category from a prior taxable year, the two 
accounts are netted against each other so that all that remains is a 
$100 general category SLL account with respect to the passive category.
    (iii) OFL account recapture. Under Step 5, 50% of the remaining 
$300, or $150, of income in the general category is subject to 
recharacterization as U.S. source income as a recapture of part of the 
OFL account in the general category.
    (iv) SLL account recapture. Under Step 6, $100 of the remaining $150 
of income in the general category is recharacterized as passive category 
income as a recapture of the general category SLL account with respect 
to the passive category.
    (v) ODL account recapture. Under Step 7, 50% of the $600, or $300, 
of U.S. source income is subject to recharacterization as foreign source 
passive category income as a recapture of a part of the ODL account with 
respect to the passive category. None of the $150 of general category 
income that was recharacterized as U.S. source income under Step 5 is 
included here as income subject to recharacterization in connection with 
recapture of the overall domestic loss account.
    (vi) Results. (A) After the allocation of loss and recapture of loss 
accounts, X has the following taxable income and losses for 2008:

------------------------------------------------------------------------
        General                  Passive                   U.S.
------------------------------------------------------------------------
             $50                     $400                    $450
------------------------------------------------------------------------

    (B) As of January 1, 2009, Y has the following balances in its OFL, 
SLL and ODL accounts:

----------------------------------------------------------------------------------------------------------------
                         General                                    Passive                      U.S.
----------------------------------------------------------------------------------------------------------------
            OFL                     SLL (Passive)                SLL (General)               ODL (Passive)
----------------------------------------------------------------------------------------------------------------
                   $50                           $0                          $0                        $100
----------------------------------------------------------------------------------------------------------------


[[Page 880]]

    (k) Effective/applicability date. This section applies to taxable 
years beginning on or after January 1, 2012. Taxpayers may choose to 
apply this section to other taxable years beginning after December 31, 
2006, including periods covered by 26 CFR Sec.  1.904(g)-3T (revised as 
of April 1, 2010).

[T.D. 9595, 77 FR 37582, June 22, 2012]



Sec.  1.904(i)-0  Outline of regulation provisions.

    This section lists the headings for Sec.  1.904(i)-1.

 Sec.  1.904(i)-1 Limitation on use of deconsolidation to avoid foreign 
                         tax credit limitations.

    (a) General rule.
    (1) Determination of taxable income.
    (2) Allocation.
    (b) Definitions and special rules.
    (1) Affiliate.
    (i) Generally.
    (ii) Rules for consolidated groups.
    (iii) Exception for newly acquired affiliates.
    (2) Includible corporation.
    (c) Taxable years.
    (d) Consistent treatment of foreign taxes paid.
    (e) Effective date.

[T.D. 9371, 72 FR 72603, Dec. 21, 2007]



Sec.  1.904(i)-1  Limitation on use of deconsolidation to avoid 
foreign tax credit limitations.

    (a) General rule. If two or more includible corporations are 
affiliates, within the meaning of paragraph (b)(1) of this section, at 
any time during their taxable years, then, solely for purposes of 
applying the foreign tax credit provisions of section 59(a), sections 
901 through 908, and section 960, the rules of this section will apply.
    (1) Determination of taxable income--(i) Each affiliate must compute 
its net taxable income or loss in each separate category (as defined in 
Sec.  1.904-5(a)(1), and treating U.S. source income or loss as a 
separate category) without regard to sections 904(f) and 907(c)(4). Only 
affiliates that are members of the same consolidated group use the 
consolidated return regulations (other than those under sections 904(f) 
and 907(c)(4)) in computing such net taxable income or loss. To the 
extent otherwise applicable, other provisions of the Code and 
regulations must be used in the determination of an affiliate's net 
taxable income or loss in a separate category.
    (ii) The net taxable income amounts in each separate category 
determined under paragraph (a)(1)(i) of this section are combined for 
all affiliates to determine one amount for the group of affiliates in 
each separate category. However, a net loss of an affiliate (first 
affiliate) in a separate category determined under paragraph (a)(1)(i) 
of this section will be combined under this paragraph (a) with net 
income or loss amounts of other affiliates in the same category only if, 
and to the extent that, the net loss offsets taxable income, whether 
U.S. or foreign source, of the first affiliate. The consolidated return 
regulations that apply the principles of sections 904(f) and 907(c)(4) 
to consolidated groups will then be applied to the combined amounts in 
each separate category as if all affiliates were members of a single 
consolidated group.
    (2) Allocation. Any net taxable income in a separate category 
calculated under paragraph (a)(1)(ii) of this section for purposes of 
the foreign tax credit provisions must then be allocated among the 
affiliates under any consistently applied reasonable method, taking into 
account all of the facts and circumstances. A method is consistently 
applied if used by all affiliates from year to year. Once chosen, an 
allocation method may be changed only with the consent of the 
Commissioner. This allocation will only affect the source and foreign 
tax credit separate limitation character of the income for purposes of 
the foreign tax credit separate limitation of each affiliate, and will 
not otherwise affect an affiliate's total net income or loss. This 
section applies whether the federal income tax consequences of its 
application favor, or are adverse to, the taxpayer.
    (b) Definitions and special rules For purposes of this section only, 
the following terms will have the meanings specified.
    (1) Affiliate--(i) Generally. Affiliates are includible 
corporations--
    (A) That are members of the same affiliated group, as defined in 
section 1504(a); or

[[Page 881]]

    (B) That would be members of the same affiliated group, as defined 
in section 1504(a) if--
    (1) Any non-includible corporation meeting the ownership test of 
section 1504(a)(2) with respect to any such includible corporation was 
itself an includible corporation; or
    (2) The constructive ownership rules of section 1563(e) were applied 
for purposes of section 1504(a).
    (ii) Rules for consolidated groups. Affiliates that are members of 
the same consolidated group are treated as a single affiliate for 
purposes of this section. The provisions of paragraph (a) of this 
section shall not apply if the only affiliates under this definition are 
already members of the same consolidated group without operation of this 
section.
    (iii) Exception for newly acquired affiliates--(A) With respect to 
acquisitions after December 7, 1995, an includible corporation acquired 
from unrelated third parties (First Corporation) will not be considered 
an affiliate of another includible corporation (Second Corporation) 
during the taxable year of the First Corporation beginning before the 
date on which the First Corporation originally becomes an affiliate with 
respect to the Second Corporation.
    (B) With respect to acquisitions on or before December 7, 1995, an 
includible corporation acquired from unrelated third parties will not be 
considered an affiliate of another includible corporation during its 
taxable year beginning before the date on which the first includible 
corporation first becomes an affiliate with respect to that other 
includible corporation.
    (C) This exception does not apply where the acquisition of an 
includible corporation is used to avoid the application of this section.
    (2) Includible corporation. The term includible corporation has the 
same meaning it has in section 1504(b).
    (c) Taxable years. If all of the affiliates use the same U.S. 
taxable year, then that taxable year must be used for purposes of 
applying this section. If, however, the affiliates use more than one 
U.S. taxable year, then an appropriate taxable year must be used for 
applying this section. The determination whether a taxable year is 
appropriate must take into account all of the relevant facts and 
circumstances, including the U.S. taxable years used by the affiliates 
for general U.S. income tax purposes. The taxable year chosen by the 
affiliates for purposes of applying this section must be used 
consistently from year to year. The taxable year may be changed only 
with the prior consent of the Commissioner. Those affiliates that do not 
use the year determined under this paragraph (c) as their U.S. taxable 
year for general U.S. income tax purposes must, for purposes of this 
section, use their U.S. taxable year or years ending within the taxable 
year determined under this paragraph (c). If, however, the stock of an 
affiliate is disposed of so that it ceases to be an affiliate, then the 
taxable year of that affiliate will be considered to end on the 
disposition date for purposes of this section.
    (d) Consistent treatment of foreign taxes paid. All affiliates must 
consistently either elect under section 901(a) to claim a credit for 
foreign income taxes paid or accrued, or deemed paid or accrued, or 
deduct foreign taxes paid or accrued under section 164. See also Sec.  
1.1502-4(a); Sec.  1.905-1(a).
    (e) Effective date. Except as provided in paragraph (b)(1)(iii) of 
this section (relating to newly acquired affiliates), this section is 
effective for taxable years of affiliates beginning after December 31, 
1993.

[T.D. 8627, 60 FR 56119, Nov. 7, 1995]



Sec.  1.904(j)-0  Outline of regulation provisions.

    This section lists the headings for Sec.  1.904(j)-1.

  Sec.  1.904(j)-1 Certain individuals exempt from foreign tax credit 
                               limitation.

    (a) Election available only if all foreign taxes are creditable 
foreign taxes.
    (b) Coordination with carryover rules.
    (1) No carryovers to or from election year.
    (2) Carryovers to and from other years determined without regard to 
election years.
    (3) Determination of amount of creditable foreign taxes.
    (c) Examples.
    (d) Effective date.

[T.D. 9371, 72 FR 72603, Dec. 21, 2007]

[[Page 882]]



Sec.  1.904(j)-1  Certain individuals exempt from foreign tax 
credit limitation.

    (a) Election available only if all foreign taxes are creditable 
foreign taxes. A taxpayer may elect to apply section 904(j) for a 
taxable year only if all of the taxes for which a credit is allowable to 
the taxpayer under section 901 for the taxable year (without regard to 
carryovers) are creditable foreign taxes (as defined in section 
904(j)(3)(B)).
    (b) Coordination with carryover rules--(1) No carryovers to or from 
election year. If the taxpayer elects to apply section 904(j) for any 
taxable year, then no taxes paid or accrued by the taxpayer during such 
taxable year may be deemed paid or accrued under section 904(c) in any 
other taxable year, and no taxes paid or accrued in any other taxable 
year may be deemed paid or accrued under section 904(c) in such taxable 
year.
    (2) Carryovers to and from other years determined without regard to 
election years. The amount of the foreign taxes paid or accrued, and the 
amount of the foreign source taxable income, in any year for which the 
taxpayer elects to apply section 904(j) shall not be taken into account 
in determining the amount of any carryover to or from any other taxable 
year. However, an election to apply section 904(j) to any year does not 
extend the number of taxable years to which unused foreign taxes may be 
carried under section 904(c) and Sec.  1.904-2(b). Therefore, in 
determining the number of such carryover years, the taxpayer must take 
into account years to which a section 904(j) election applies.
    (3) Determination of amount of creditable foreign taxes. Otherwise 
allowable carryovers of foreign tax credits from other taxable years 
shall not be taken into account in determining whether the amount of 
creditable foreign taxes paid or accrued by an individual during a 
taxable year exceeds $300 ($600 in the case of a joint return) for 
purposes of section 904(j)(2)(B).
    (c) Examples. The following examples illustrate the provisions of 
this section:

    Example 1. In 2006, X, a single individual using the cash basis 
method of accounting for income and foreign tax credits, pays $100 of 
foreign taxes with respect to general limitation income that was earned 
and included in income for United States tax purposes in 2005. The 
foreign taxes would be creditable under section 901 but are not shown on 
a payee statement furnished to X. X's only income for 2006 from sources 
outside the United States is qualified passive income, with respect to 
which X pays $200 of creditable foreign taxes shown on a payee 
statement. X may not elect to apply section 904(j) for 2006 because some 
of X's foreign taxes are not creditable foreign taxes within the meaning 
of section 904(j)(3)(B).
    Example 2. (i) In 2009, A, a single individual using the cash basis 
method of accounting for income and foreign tax credits, pays creditable 
foreign taxes of $250 attributable to passive income. Under section 
904(c), A may also carry forward to 2009 $100 of unused foreign taxes 
paid in 2005 with respect to passive income, $300 of unused foreign 
taxes paid in 2005 with respect to general limitation income, $400 of 
unused foreign taxes paid in 2006 with respect to passive income, and 
$200 of unused foreign taxes paid in 2006 with respect to general 
limitation income. In 2009, A's only foreign source income is passive 
income described in section 904(j)(3)(A)(i), and this income is reported 
to A on a payee statement (within the meaning of section 6724(d)(2)). If 
A elects to apply section 904(j) for the 2009 taxable year, the unused 
foreign taxes paid in 2005 and 2006 are not deemed paid in 2009, and A 
therefore cannot claim a foreign tax credit for those taxes in 2009.
    (ii) In 2010, A again is eligible for and elects the application of 
section 904(j). The carryforwards from 2005 expire in 2010. The 
carryforward period established under section 904(c) is not extended by 
A's election under section 904(j). In 2011, A does not elect the 
application of section 904(j). The $600 of unused foreign taxes paid in 
2006 on passive and general limitation income are deemed paid in 2011, 
under section 904(c), without any adjustment for any portion of those 
taxes that might have been used as a foreign tax credit in 2009 or 2010 
if A had not elected to apply section 904(j) to those years.

    (d) Effective date. Section 1.904(j)-1 applies to taxable years 
beginning after July 20, 2004.

[T.D. 9141, 69 FR 43316, July 20, 2004]



Sec.  1.905-1  When credit for taxes may be taken.

    (a) In general. The credit for taxes provided in subpart A (section 
901 and following), part III, subchapter N, chapter 1 of the Code, may 
ordinarily be taken either in the return for the year in which the taxes 
accrued or in which the taxes were paid, dependent

[[Page 883]]

upon whether the accounts of the taxpayer are kept and his returns filed 
using an accrual method or using the cash receipts and disbursements 
method. Section 905(a) allows the taxpayer, at his option and 
irrespective of the method of accounting employed in keeping his books, 
to take such credit for taxes as may be allowable in the return for the 
year in which the taxes accrued. An election thus made under section 
905(a) (or under the corresponding provisions of prior internal revenue 
laws) must be followed in returns for all subsequent years, and no 
portion of any such taxes accrued in a year in which a credit is claimed 
will be allowed as a deduction from gross income in any year. See also 
Sec.  1.905-4.
    (b) Foreign income subject to exchange controls. If, however, under 
the provisions of the regulations under section 461, an amount otherwise 
constituting gross income for the taxable year from sources without the 
United States is, owing to monetary, exchange, or other restrictions 
imposed by a foreign country, not includible in gross income of the 
taxpayer for such year, the credit for income taxes imposed by such 
foreign country with respect to such amount shall be taken 
proportionately in any subsequent taxable year in which such amount or 
portion thereof is includible in gross income.



Sec.  1.905-2  Conditions of allowance of credit.

    (a) Forms and information. (1) Whenever the taxpayer chooses, in 
accordance with paragraph (d) of Sec.  1.901-1, to claim the benefits of 
the foreign tax credit, the claim for credit shall be accompanied by 
Form 1116 in the case of an individual or by Form 1118 in the case of a 
corporation.
    (2) The form must be carefully filled in with all the information 
called for and with the calculations of credits indicated. Except where 
it is established to the satisfaction of the district director that it 
is impossible for the taxpayer to furnish such evidence, the taxpayer 
must provide upon request the receipt for each such tax payment if 
credit is sought for taxes already paid or the return on which each such 
accrued tax was based if credit is sought for taxes accrued. The receipt 
or return must be either the original, a duplicate original, or a duly 
certified or authenticated copy. The preceding two sentences are 
applicable for returns whose original due date falls on or after January 
1, 1988. Any additional information necessary for the determination 
under part I (section 861 and following), subchapter N, chapter 1 of the 
Code, of the amount of income derived from sources without the United 
States and from each foreign country shall, upon the request of the 
district director, be furnished by the taxpayer. If the taxpayer upon 
request fails without justification to furnish any such additional 
information which is significant, including any significant information 
which he is requested to furnish pursuant to Sec.  1.861-8(f)(5) as 
proposed in the Federal Register for November 8, 1976, the District 
Director may disallow the claim of the taxpayer to the benefits of the 
foreign tax credit.
    (b) Secondary evidence. Where it has been established to the 
satisfaction of the District Director that it is impossible to furnish a 
receipt for such foreign tax payment, the foreign tax return, or direct 
evidence of the amount of tax withheld at the source, the District 
Director, may, in his discretion, accept secondary evidence thereof as 
follows:
    (1) Receipt for payment. In the absence of a receipt for payment of 
foreign taxes there shall be submitted a photostatic copy of the check, 
draft, or other medium of payment showing the amount and date thereof, 
with certification identifying it with the tax claimed to have been 
paid, together with evidence establishing that the tax was paid for 
taxpayer's account as his own tax on his own income. If credit is 
claimed on an accrual method, it must be shown that the tax accrued in 
the taxable year.
    (2) Foreign tax return. If the foreign tax return is not available, 
the foreign tax has not been paid, and credit is claimed on an accrual 
method, there shall be submitted--
    (i) A certified statement of the amount shall be submitted--
    (ii) Excerpts from the taxpayer's accounts showing amounts of 
foreign income and tax thereon accrued on its books.

[[Page 884]]

    (iii) A computation of the foreign tax based on income from the 
foreign country carried on the books and at current rates of tax to be 
established by data such as excerpts from the foreign law, assessment 
notices, or other documentary evidence thereof.
    (iv) A bond, if deemed necessary by the District Director, filed in 
the manner provided in cases where the foreign return is available, and
    (v) In case a bond is not required, a specific agreement wherein the 
taxpayer shall recognize its liability to report the correct amount of 
tax when ascertained, as required by the provisions of section 905 (c).


If at any time the foreign tax receipts or foreign tax returns become 
available to the taxpayer, they shall be promptly submitted to the 
district director.
    (3) Tax withheld at source. In the case of taxes withheld at the 
source from dividends, interest, royalties, compensation, or other form 
of income, where evidence of withholding and of the amount withheld 
cannot be secured from those who have made the payments, the district 
director may, in his discretion, accept secondary evidence of such 
withholding and of the amount of the tax so withheld, having due regard 
to the taxpayer's books of account and to the rates of taxation 
prevailing in the particular foreign country during the period involved.
    (c) Credit for taxes accrued but not paid. In the case of a credit 
sought for a tax accrued but not paid, the district director may, as a 
condition precedent to the allowance of a credit, require a bond from 
the taxpayer, in addition to Form 1116 or 1118. If such a bond is 
required, Form 1117 shall be used by an individual or by a corporation. 
It shall be in such sum as the Commissioner may prescribe, and shall be 
conditioned for the payment by the taxpayer of any amount of tax found 
due upon any redetermination of the tax made necessary by such credit 
proving incorrect, with such further conditions as the district director 
may require. This bond shall be executed by the taxpayer, or the agent 
or representative of the taxpayer, as principal, and by sureties 
satisfactory to and approved by the Commissioner. See also 6 U.S.C. 15.

[T.D. 6500, 25 FR 11910, Nov. 26, 1960, as amended by T.D. 7292, 38 FR 
33300, Dec. 3, 1973; 38 FR 34802, Dec. 19, 1973; T.D. 7456, 42 FR 1214, 
Jan. 6, 1977; T.D. 8210, 53 FR 23613, June 23, 1988; T.D. 8412, 57 FR 
20653, May 14, 1992; T.D. 8759, 63 FR 3813, Jan. 27, 1998]



Sec.  1.905-3T  Adjustments to United States tax liability and to the pools 
of post-1986 undistributed earnings and post-1986 foreign income taxes 
as a result of a foreign tax redetermination (temporary).

    (a) Effective/applicability dates--(1) Currency translation. Except 
as provided in Sec.  1.905-5T, paragraph (b) of this section applies to 
taxes paid or accrued in taxable years of United States taxpayers 
beginning on or after November 7, 2007 and to taxes paid or accrued by a 
foreign corporation in its taxable years which end with or within a 
taxable year of the domestic corporate shareholder beginning on or after 
November 7, 2007. For taxable years beginning after December 31, 1997, 
and before November 7, 2007, section 986(a), as amended by the Taxpayer 
Relief Act of 1997 and the American Jobs Creation Act of 2004, shall 
apply. For taxable years beginning after December 31, 1986, and before 
January 1, 1998, Sec.  1.905-3T (as contained in 26 CFR part 1, revised 
as of April 1, 2007) shall apply.
    (2) Foreign tax redeterminations. Paragraphs (c) and (d) of this 
section apply to foreign tax redeterminations occurring in taxable years 
of United States taxpayers beginning on or after November 7, 2007 where 
the foreign tax redetermination affects the amount of foreign taxes paid 
or accrued by a United States taxpayer. Where the redetermination of 
foreign tax paid or accrued by a foreign corporation affects the 
computation of foreign taxes deemed paid under section 902 or 960 with 
respect to post-1986 undistributed earnings of the foreign corporation, 
paragraphs (c) and (d) of this section apply to foreign tax 
redeterminations occurring in taxable years of a foreign corporation 
which end with or within a taxable year of the domestic corporate 
shareholder beginning on or after November 7, 2007. For corresponding 
rules

[[Page 885]]

applicable to foreign tax redeterminations occurring in taxable years 
beginning before November 7, 2007, see Sec. Sec.  1.905-3T and 1.905-5T 
(as contained in 26 CFR part 1, revised as of April 1, 2007).
    (b) Currency translation rules--(1) Translation of foreign taxes 
taken into account when accrued--(i) In general. Except as provided in 
paragraph (b)(1)(ii) of this section, in the case of a taxpayer or a 
member of a qualified group (as defined in section 902(b)(2)) that takes 
foreign income taxes into account when accrued, the amount of any 
foreign taxes denominated in foreign currency that have been paid or 
accrued, additional tax liability denominated in foreign currency, taxes 
withheld in foreign currency, or estimated taxes paid in foreign 
currency shall be translated into dollars using the average exchange 
rate (as defined in Sec.  1.989(b)-1) for the United States taxable year 
to which such taxes relate.
    (ii) Exceptions--(A) Taxes not paid within two years. Any foreign 
income taxes denominated in foreign currency that are paid more than two 
years after the close of the United States taxable year to which they 
relate shall be translated into dollars using the exchange rate as of 
the date of payment of the foreign taxes. To the extent any accrued 
foreign income taxes denominated in foreign currency remain unpaid two 
years after the close of the taxable year to which they relate, see 
paragraph (b)(3) of this section for translation rules for the required 
adjustments.
    (B) Taxes paid before taxable year begins. Any foreign income taxes 
paid before the beginning of the United States taxable year to which 
such taxes relate shall be translated into dollars using the exchange 
rate as of the date of payment of the foreign taxes.
    (C) Inflationary currency. Any foreign income taxes the liability 
for which is denominated in any inflationary currency shall be 
translated into dollars using the exchange rate as of the date of 
payment of the foreign taxes. For this purpose, the term inflationary 
currency means the currency of a country in which there is cumulative 
inflation during the base period of at least 30 percent, as determined 
by reference to the consumer price index of the country listed in the 
monthly issues of International Financial Statistics, or a successor 
publication, of the International Monetary Fund. For purposes of this 
paragraph (b)(1)(ii)(C), base period means, with respect to any taxable 
year, the thirty-six calendar months immediately preceding the last day 
of such taxable year (see Sec.  1.985-1(b)(2)(ii)(D)). Accrued but 
unpaid taxes denominated in an inflationary currency shall be translated 
into dollars at the exchange rate on the last day of the United States 
taxable year to which such taxes relate.
    (D) Election to translate taxes using exchange rate for date of 
payment. A taxpayer that is otherwise required to translate foreign 
income taxes that are denominated in foreign currency using the average 
exchange rate may elect to translate foreign income taxes described in 
this paragraph (b)(1)(ii)(D) into dollars using the exchange rate as of 
the date of payment of the foreign taxes, provided that the liability 
for such taxes is denominated in nonfunctional currency. A taxpayer may 
make an election under this paragraph (b)(1)(ii)(D) for all foreign 
income taxes, or for only those foreign income taxes that are 
denominated in nonfunctional currency and are attributable to qualified 
business units with United States dollar functional currencies. The 
election must be made by attaching a statement to the taxpayer's timely 
filed return (including extensions) for the first taxable year to which 
the election applies. The statement must identify whether the election 
is made for all foreign taxes or only for foreign taxes attributable to 
qualified business units with United States dollar functional 
currencies. Once made, the election shall apply for the taxable year for 
which made and all subsequent taxable years unless revoked with the 
consent of the Commissioner. Accrued but unpaid taxes subject to an 
election under this paragraph (b)(1)(ii)(D) shall be translated into 
dollars at the exchange rate on the last day of the United States 
taxable year to which such taxes relate. For taxable years beginning 
after December 31, 2004, and before November 7, 2007, the rules of 
Notice

[[Page 886]]

2006-47, 2006-20 IRB 892 (see Sec.  601.601(d)(2)(ii)(b)), shall apply.
    (E) Regulated investment companies. In the case of a regulated 
investment company (as defined in section 851 and the regulations under 
that section) which takes into account income on an accrual basis, 
foreign income taxes paid or accrued with respect to such income shall 
be translated into dollars using the exchange rate as of the date the 
income accrues.
    (2) Translation of foreign taxes taken into account when paid. In 
the case of a taxpayer that takes foreign income taxes into account when 
paid, the amount of any foreign tax liability denominated in foreign 
currency, additional tax liability denominated in foreign currency, or 
estimated taxes paid in foreign currency shall be translated into 
dollars using the exchange rate as of the date of payment of such 
foreign taxes. Foreign taxes withheld in foreign currency shall be 
translated into dollars using the exchange rate as of the date on which 
such taxes were withheld.
    (3) Refunds or other reductions of foreign tax liability. In the 
case of a taxpayer that takes foreign income taxes into account when 
accrued, a reduction in the amount of previously-accrued foreign taxes 
that is attributable to a refund of foreign taxes denominated in foreign 
currency, a credit allowed in lieu of a refund, the correction of an 
overaccrual, or an adjustment on account of accrued taxes denominated in 
foreign currency that were not paid by the date two years after the 
close of the taxable year to which such taxes relate, shall be 
translated into dollars using the exchange rate that was used to 
translate such amount when originally claimed as a credit or added to 
post-1986 foreign income taxes. In the case of foreign income taxes 
taken into account when accrued but translated into dollars on the date 
of payment, see paragraph (d) of this section for required adjustments 
to reflect a reduction in the amount of previously-accrued foreign taxes 
that is attributable to a difference in exchange rates between the date 
of accrual and date of payment. In the case of a taxpayer that takes 
foreign income taxes into account when paid, a refund or other reduction 
in the amount of foreign taxes denominated in foreign currency shall be 
translated into dollars using the exchange rate that was used to 
translate such amount when originally claimed as a credit. If a refund 
or other reduction of foreign taxes relates to foreign taxes paid or 
accrued on more than one date, then the refund or other reduction shall 
be deemed to be derived from, and shall reduce, the last payment of 
foreign taxes first, to the extent of that payment. See paragraphs 
(d)(1) (redetermination of United States tax liability for foreign taxes 
paid directly by a United States person) and (d)(2)(ii) (method of 
adjustment of a foreign corporation's pools of post-1986 undistributed 
earnings and post-1986 foreign income taxes) of this section.
    (4) Allocation of refunds of foreign tax. Refunds of foreign tax 
shall be allocated to the same separate category as foreign taxes to 
which the refunded taxes relate. Refunds are related to foreign taxes of 
a separate category if the foreign tax that was refunded was imposed 
with respect to that separate category. See section 904(d) and Sec.  
1.904-6 concerning the allocation of taxes to separate categories of 
income. Earnings and profits of a foreign corporation in the separate 
category to which the refund relates shall be increased to reflect the 
foreign tax refund.
    (5) Basis of foreign currency refunded--(i) In general. A recipient 
of a refund of foreign tax shall determine its basis in the currency 
refunded under the following rules.
    (ii) United States dollar functional currency. If the functional 
currency of the qualified business unit (QBU) (as defined in section 989 
and the regulations under that section) that paid the tax and received 
the refund is the United States dollar or the person receiving the 
refund is not a QBU, then the recipient's basis in the foreign currency 
refunded shall be the dollar value of the refund determined under 
paragraph (b)(3) of this section by using, as appropriate, either the 
average exchange rate for the taxable year to which such taxes relate or 
the other exchange rate that was used to translate such amount when 
originally claimed as a credit or

[[Page 887]]

added to post-1986 foreign income taxes.
    (iii) Nondollar functional currency. If the functional currency of 
the QBU receiving the refund is not the United States dollar and is 
different from the currency in which the foreign tax was paid, then the 
recipient's basis in the foreign currency refunded shall be equal to the 
functional currency value of the non-functional currency refund 
translated into functional currency at the exchange rate between the 
functional currency and the non-functional currency. Such exchange rate 
is determined under paragraph (b)(3) of this section by substituting the 
words ``functional currency'' for the word ``dollar'' and by using, as 
appropriate, either the average exchange rate for the taxable year to 
which such taxes relate or the other exchange rate that was used to 
translate such amount when originally claimed as a credit or added to 
post-1986 foreign income taxes.
    (iv) Functional currency tax liabilities. If the functional currency 
of the QBU receiving the refund is the currency in which the refund was 
made, then the recipient's basis in the currency received shall be the 
amount of the functional currency received.
    (v) Foreign currency gain or loss. For purposes of determining 
foreign currency gain or loss on the initial payment of accrued foreign 
tax in a non-functional currency, see section 988. For purposes of 
determining subsequent foreign currency gain or loss on the disposition 
of non-functional currency the basis of which is determined under this 
paragraph (b)(5), see section 988(c)(1)(C).
    (c) Foreign tax redetermination. For purposes of this section and 
Sec.  1.905-4T, the term foreign tax redetermination means a change in 
the foreign tax liability that may affect a taxpayer's foreign tax 
credit. A foreign tax redetermination includes: accrued taxes that when 
paid differ from the amounts added to post-1986 foreign income taxes or 
claimed as credits by the taxpayer (such as corrections to overaccruals 
and additional payments); accrued taxes that are not paid before the 
date two years after the close of the taxable year to which such taxes 
relate; any tax paid that is refunded in whole or in part; and, for 
taxes taken into account when accrued but translated into dollars on the 
date of payment, a difference between the dollar value of the accrued 
tax and the dollar value of the tax paid attributable to fluctuations in 
the value of the foreign currency relative to the dollar between the 
date of accrual and the date of payment.
    (d) Redetermination of United States tax liability--(1) Foreign 
taxes paid directly by a United States person. If a foreign tax 
redetermination occurs with respect to foreign tax paid or accrued by or 
on behalf of a United States taxpayer, then a redetermination of the 
United States tax liability is required for the taxable year for which 
the foreign tax was claimed as a credit. See Sec.  1.905-4T(b) which 
requires notification to the IRS of a foreign tax redetermination with 
respect to which a redetermination of United States liability is 
required, and see section 905(b) and the regulations under that section 
which require that a taxpayer substantiate that a foreign tax was paid 
and provide all necessary information establishing its entitlement to 
the foreign tax credit. However, a redetermination of United States tax 
liability is not required (and a taxpayer need not notify the IRS) if 
the foreign taxes are taken into account when accrued but translated 
into dollars as of the date of payment, the difference between the 
dollar value of the accrued tax and the dollar value of the tax paid is 
attributable to fluctuations in the value of the foreign currency 
relative to the dollar between the date of accrual and the date of 
payment, and the amount of the foreign tax redetermination with respect 
to each foreign country is less than the lesser of ten thousand dollars 
or two percent of the total dollar amount of the foreign tax initially 
accrued with respect to that foreign country for the United States 
taxable year. In such case, an appropriate adjustment shall be made to 
the taxpayer's United States tax liability in the taxable year during 
which the foreign tax redetermination occurs.
    (2) Foreign taxes deemed paid under sections 902 or 960--(i) 
Redetermination of United States tax liability not required. Subject to 
the special rule of paragraph

[[Page 888]]

(d)(3) of this section, a redetermination of United States tax liability 
is not required to account for the effect of a redetermination of 
foreign tax paid or accrued by a foreign corporation on the foreign 
taxes deemed paid by a United States corporation under section 902 or 
960. Instead, appropriate upward or downward adjustments shall be made, 
in accordance with paragraph (d)(2)(ii) of this section, at the time of 
the foreign tax redetermination to the foreign corporation's pools of 
post-1986 undistributed earnings and post-1986 foreign income taxes to 
reflect the effect of the foreign tax redetermination in calculating 
foreign taxes deemed paid with respect to distributions and inclusions 
(and the amount of such distributions and inclusions) that are 
includible in the United States taxable year in which the foreign tax 
redetermination occurred and subsequent taxable years. See Sec.  1.905-
4T(b)(2) for notification requirements where a redetermination of 
foreign tax paid or accrued by a foreign corporation affects the 
computation of foreign taxes deemed paid under section 902 or 960, and 
the taxpayer is required to adjust the foreign corporation's pools of 
post-1986 undistributed earnings and post-1986 foreign income taxes 
under this paragraph (d)(2).
    (ii) Adjustments to the pools of post-1986 undistributed earnings 
and post-1986 foreign income taxes--(A) Reduction in foreign tax paid or 
accrued. A foreign corporation's pool of post-1986 foreign income taxes 
in the appropriate separate category shall be reduced by the United 
States dollar amount of a foreign tax refund or other reduction in the 
amount of foreign tax paid or accrued, translated into United States 
dollars as provided in paragraph (b)(3) of this section. A foreign 
corporation's pool of post-1986 undistributed earnings in the 
appropriate separate category shall be increased by the functional 
currency amount of the foreign tax refund or other reduction in the 
amount of foreign tax paid or accrued. The allocation of the refund or 
other adjustment to the appropriate separate categories shall be made in 
accordance with paragraph (b)(4) of this section and Sec.  1.904-6. If a 
foreign corporation receives a refund of foreign tax in a currency other 
than its functional currency, that refund shall be translated into its 
functional currency, for purposes of computing the increase to its pool 
of post-1986 undistributed earnings, at the exchange rate between the 
functional currency and the non-functional currency, as determined under 
paragraph (b)(3) of this section, by substituting the words ``functional 
currency'' for the word ``dollar'' and by using the same average or spot 
rate exchange rate convention that applies for purposes of translating 
such foreign taxes into United States dollars.
    (B) Additional foreign tax paid or accrued. A foreign corporation's 
pool of post-1986 foreign income taxes in the appropriate separate 
category shall be increased by the United States dollar amount of the 
additional foreign tax paid or accrued, translated in accordance with 
the rules of paragraphs (b)(1) and (b)(2) of this section. A foreign 
corporation's pool of post-1986 undistributed earnings in the 
appropriate separate category shall be decreased by the functional 
currency amount of the additional foreign tax paid or accrued. The 
allocation of the additional amount of foreign tax among the separate 
categories shall be made in accordance with Sec.  1.904-6. If a foreign 
corporation pays or accrues foreign tax in a currency other than its 
functional currency, that tax shall be translated into its functional 
currency, for purposes of computing the decrease to its pool of post-
1986 undistributed earnings, at the exchange rate between the functional 
currency and the non-functional currency, as determined under paragraph 
(b)(3) of this section, by substituting the words ``functional 
currency'' for the word ``dollar'' and by using the same average or spot 
rate exchange rate convention that applies for purposes of translating 
such foreign taxes into United States dollars.
    (C) Refunds of foreign taxes of lower tier foreign corporations that 
cause deficits in foreign tax pools. If a lower tier foreign corporation 
receives a refund of foreign tax after making a distribution to an upper 
tier foreign corporation and the refund would have the effect of 
reducing below zero the lower tier corporation's pool of foreign taxes 
in any separate category, then both the lower tier and upper tier 
corporations shall

[[Page 889]]

adjust the appropriate pool of foreign taxes to reflect that refund. The 
upper tier foreign corporation shall adjust its pool of foreign taxes by 
the difference between the United States dollar amount of foreign tax 
deemed paid by the upper tier foreign corporation prior to the refund 
and the United States dollar amount of foreign tax recomputed as if the 
refund occurred prior to the distribution. The upper tier foreign 
corporation shall not make any adjustment to its earnings and profits 
because foreign taxes deemed paid by the upper tier corporation are not 
included in the upper tier corporation's earnings and profits. The lower 
tier foreign corporation shall adjust its pool of foreign taxes by the 
difference between the United States dollar amount of the refund and the 
United States dollar amount of the adjustment to the upper tier foreign 
corporation's pool of foreign taxes. The earnings and profits of the 
lower tier foreign corporation shall be adjusted to reflect the full 
amount of the refund. The provisions of this paragraph (d)(2)(ii)(C) do 
not apply to distributions or inclusions to a United States person. See 
paragraph (d)(3)(iv) of this section for rules relating to actual or 
deemed distributions made to a United States person.
    (D) Examples. The following examples illustrate the application of 
this paragraph (d)(2):

    Example 1. Controlled foreign corporation (CFC) is a wholly-owned 
subsidiary of its domestic parent, P. Both CFC and P are calendar year 
taxpayers. CFC has a functional currency, the u, other than the dollar 
and its pool of post-1986 undistributed earnings is maintained in that 
currency. CFC and P use the average exchange rate to translate foreign 
taxes. In 2008, CFC accrued and paid 100u of foreign income taxes with 
respect to non-subpart F income. The average exchange rate for 2008 was 
$1:1u. In 2009, CFC received a refund of 50u of foreign taxes with 
respect to its non-subpart F income in 2008. CFC made no distributions 
to P in 2008. In accordance with paragraph (d)(2)(ii)(A) of this section 
and subject to paragraph (d)(3) of this section, in 2009 CFC's pool of 
post-1986 foreign income taxes must be reduced by $50 (because the 
refund must be translated into dollars using the exchange rate that was 
used to translate such amount when added to CFC's post-1986 foreign 
income taxes, that is, $1:1u, the average exchange rate for 2008) and 
the CFC's pool of post-1986 undistributed earnings must be increased by 
50u (because the post-1986 undistributed earnings must be increased by 
the functional currency amount of the refund received). An income 
adjustment reflecting foreign currency gain or loss under section 988 
with respect to the refund of foreign taxes received by CFC is not 
required because the foreign taxes are denominated and paid in CFC's 
functional currency.
    Example 2. The facts are the same as in Example 1, except that in 
2008, CFC had general category post-1986 undistributed earnings 
attributable to non-subpart F income of 200u (net of foreign taxes), and 
CFC accrued and paid 160u in foreign income taxes with respect to those 
earnings. The average exchange rate for 2008 was $1:1u. Also in 2008, 
CFC made a distribution to P of 50u, and P was deemed to have paid $40 
of foreign taxes with respect to that distribution (50u/200u x $160). In 
2009, CFC received a refund of foreign taxes of 5u with respect to its 
nonsubpart F income in 2008. Also in 2009, CFC made a distribution to P 
of 50u. CFC had no income and paid no foreign taxes in 2009. In 
accordance with paragraph (d)(2)(ii) of this section, CFC's pool of 
general category post-1986 foreign income taxes is reduced in 2009 by $5 
to $115 (because the refund must be translated into dollars using the 
exchange rate that was used to translate such amount when added to CFC's 
post-1986 foreign income taxes, that is, $1:1u, the average exchange 
rate for 2008), and CFC's pool of general category post-1986 
undistributed earnings must be increased in 2009 by 5u to 155u (because 
the post-1986 undistributed earnings must be increased by the functional 
currency amount of the refund received). (An income adjustment 
reflecting foreign currency gain or loss under section 988 with respect 
to the refund of foreign taxes received by CFC is not required because 
the foreign taxes are denominated and paid in CFC's functional 
currency.) A redetermination of P's deemed paid credit and U.S. tax for 
2008 is not required, because the 5u refund, if taken into account in 
2008, would have reduced P's deemed paid taxes by less than 10% (50u/
205u x $155 = $37.80). See paragraph (d)(3)(ii) of this section. P is 
deemed to pay $37.10 of foreign taxes with respect to the distribution 
in 2009 of 50u (50u/155u x $115).
    Example 3. (i) CFC1 is a foreign corporation that is wholly-owned by 
P, a domestic corporation. CFC2 is a foreign corporation that is wholly-
owned by CFC1. The functional currency of CFC1 and CFC2 is the u, and 
the pools of post-1986 undistributed earnings of CFC1 and CFC2 are 
maintained in that currency. CFC1, CFC2, and P use the average exchange 
rate to translate foreign income taxes. In 2008, CFC2 had post-1986 
undistributed earnings attributable to non-subpart F income of 100u (net 
of foreign taxes) and paid 100u in foreign income taxes with respect to 
those earnings. The average exchange rate for 2008 was $1:1u. CFC1 had 
no income and

[[Page 890]]

no earnings and profits other than those resulting from distributions 
from CFC2, as provided in either Situation 1 or Situation 2. CFC1 paid 
no foreign taxes.
    (ii) Situation 1. In 2009, CFC2 received a refund of foreign taxes 
of 25u with respect to its 2008 taxable year. As of the close of 2009, 
CFC2 had 125u of post-1986 undistributed earnings (100u + 25u) and $75 
of post-1986 foreign income taxes ($100-$25). In 2010, CFC2 made a 
distribution to CFC1 of 50u. CFC1 was deemed to have paid $30 of foreign 
taxes with respect to that distribution (50u/125u x $75). (An income 
adjustment reflecting foreign currency gain or loss under section 988 
with respect to the refund of foreign taxes received by CFC1 is not 
required because the foreign taxes are denominated and paid in CFC1's 
functional currency.) At the end of 2010, CFC2 had 75u of post-1986 
undistributed earnings (125u-50u) and $45 of post-1986 foreign income 
taxes ($75-$30).
    (iii) Situation 2. The facts are the same as in Example 3(ii), 
Situation 1, except that CFC2 made a distribution of 50u in 2009 and 
received a refund of 75u of foreign tax in 2010. In 2009, the amount of 
foreign taxes deemed paid by CFC1 is $50 (50u/100u x $100). In 
accordance with paragraph (d)(2)(ii)(C) of this section, the pools of 
post-1986 foreign income taxes of CFC1, as well as CFC2, must be 
adjusted in 2010, because the 2010 refund would otherwise have the 
effect of reducing below zero CFC2's pool of post-1986 foreign income 
taxes. Under paragraph (d)(3)(iv) of this section, the pools would have 
to be adjusted in 2009, and a redetermination of P's United States tax 
liability would be required, if P had received or accrued a distribution 
or inclusion from CFC1 or CFC2 in 2009 and computed an amount of foreign 
taxes deemed paid. CFC1's pool of post-1986 foreign income taxes must be 
reduced in 2010 by $42.86, determined as follows: $50 (foreign taxes 
deemed paid on the distribution from CFC2) minus $7.14 (the foreign 
taxes that would have been deemed paid had the refund occurred prior to 
the distribution (50u/175u x $25)). CFC2's pool of foreign taxes must be 
reduced in 2010 by $32.14, determined as follows: $75 (75u refund 
translated into dollars using the exchange rate that was used to 
translate such amount when originally added to post-1986 foreign income 
taxes, that is, $1:1u, the average exchange rate for 2008) minus $42.86 
(the adjustment to CFC1's pool of post-1986 foreign income taxes). (An 
income adjustment reflecting foreign currency gain or loss under section 
988 with respect to the refund of foreign taxes received by CFC1 is not 
required because the foreign taxes are denominated and paid in CFC1's 
functional currency.) The following reflects the pools of post-1986 
undistributed earnings and post-1986 foreign income taxes of CFC1 and 
CFC2.

----------------------------------------------------------------------------------------------------------------
                                                                 Post-1986 earnings (u)     Foreign taxes ($)
----------------------------------------------------------------------------------------------------------------
CFC2:
2008..........................................................                      100                      100
2009..........................................................              100-50 = 50              100-50 = 50
2010..........................................................            50 + 75 = 125         50-32.14 = 17.86
CFC1:
2009..........................................................                       50                       50
2010..........................................................                       50          50-42.86 = 7.14
----------------------------------------------------------------------------------------------------------------

    (3) Exceptions. The provisions of paragraph (d)(2) of this section 
shall not apply and a redetermination of United States tax liability is 
required to account for the effect of a redetermination of foreign tax 
on foreign taxes deemed paid by a United States corporation under 
section 902 or section 960 to the extent provided in this paragraph 
(d)(3).
    (i) Hyperinflationary currencies. A redetermination of United States 
tax liability is required if the foreign tax liability is in a 
hyperinflationary currency. The term ``hyperinflationary currency'' 
means the currency of a country in which there is cumulative inflation 
during the base period of at least 100% as determined by reference to 
the consumer price index of the country listed in the monthly issues of 
International Financial Statistics, or a successor publication, of the 
International Monetary Fund. ``Base period'' means, with respect to any 
taxable year, the thirty-six calendar months immediately preceding the 
last day of such taxable year (see Sec.  1.985-2T(b)(2)).
    (ii) Deemed paid foreign tax adjustment of ten percent or more. A 
redetermination of United States tax liability is required if a foreign 
tax redetermination occurs with respect to foreign taxes paid by a 
foreign corporation and such foreign tax redetermination, if taken into 
account in the taxable year of the foreign corporation to which the 
foreign tax redetermination relates, has the effect of reducing by ten 
percent or

[[Page 891]]

more the domestic corporate shareholder's foreign taxes deemed paid 
under section 902 or 960 with respect to a distribution or inclusion 
from the foreign corporation in any taxable year of the domestic 
corporate shareholder. If a redetermination of United States tax is 
required under the preceding sentence for any taxable year, a 
redetermination of United States tax is also required for all subsequent 
taxable years in which the domestic corporate shareholder received or 
accrued a distribution or inclusion from the foreign corporation.
    (iii) Example. The following example illustrates the application of 
paragraph (d)(3)(ii) of this section:

    Example. (i) Facts. Controlled foreign corporation (CFC) is a 
wholly-owned subsidiary of its domestic parent, P. Both CFC and P use 
the calendar year as their taxable year. CFC has a functional currency, 
the u, other than the dollar, and its pool of post-1986 undistributed 
earnings is maintained in that currency. CFC and P use the average 
exchange rate to translate foreign income taxes. As of January 1, 2008, 
CFC had 500u of general category post-1986 undistributed earnings and 
$200 of general category post-1986 foreign income taxes. In 2008, when 
the average exchange rate for the year was $1:1u, CFC earned general 
category income of 600u, accrued 100u of foreign income tax with respect 
to that income, and made a distribution to P of 100u, 10% of CFC's post-
1986 undistributed earnings of 1,000u. P was deemed to have paid $30 of 
foreign income taxes in 2008 with respect to that distribution (100u/
1,000u x $300). In 2009, CFC paid its actual foreign tax liability for 
2008 of 80u. Also in 2009, for which the average exchange rate was 
$1:1.5u, CFC earned 500u of general category income, accrued 150u of tax 
with respect to that income, and distributed 100u to P. In 2010, CFC 
incurred a general category loss of (500u) and accrued no foreign tax. 
The loss was carried back to 2008 for foreign tax purposes, and CFC 
received a refund in 2011 of all 80u of foreign taxes paid for its 2008 
taxable year.
    (ii) Result in 2009. If the 20u overaccrual of tax for 2008 were 
taken into account in 2008, CFC's general category post-1986 
undistributed earnings would be 1,020u, CFC's general category post-1986 
foreign income taxes would be $280, and P would be deemed to pay $27.45 
of tax with respect to the 2008 distribution of 100u (100u/1020u x $280 
= $27.45). Because $2.55 is less than 10% of the $30 of foreign taxes 
deemed paid as originally calculated in 2008, P is not required to 
redetermine its deemed paid credit and U.S. tax liability for 2008 in 
2009. Instead, CFC's general category post-1986 foreign income taxes are 
reduced by $20 in 2009 (because the overaccrual for 2008 is translated 
into dollars using the exchange rate that was used to translate such 
amount when originally added to post-1986 foreign income taxes, that is, 
$1:1u, the average exchange rate for 2008), and the corresponding pool 
of general category post-1986 undistributed earnings is increased by 20u 
in 2009 (because the post-1986 undistributed earnings pool is increased 
by the functional currency amount of the overaccrual). CFC's general 
category post-1986 undistributed earnings are also increased in 2009 to 
1270u by the 350u earned in 2009 (900u + 20u + 350u = 1270u), and CFC's 
general category post-1986 foreign income taxes are increased by $100 to 
$350 ($270 - $20 + $100). P is deemed to pay $27.56 of foreign income 
taxes in 2009 with respect to the 100u distribution from CFC in that 
year (100u/1270u x $350).
    (iii) Result in 2011. If the 80u refund of tax for 2008 were taken 
into account in 2008, CFC's general category post-1986 undistributed 
earnings would be 1,100u, CFC's general category post-1986 foreign 
income taxes would be $200, and P would be deemed to pay $18.18 of tax 
with respect to the 2008 distribution of 100u (100u/1,100u x $200 = 
$18.18). Because $11.82 is more than 10% of the $30 of foreign taxes 
deemed paid as originally calculated in 2008, under paragraph (d)(3)(ii) 
of this section, P is required to redetermine its deemed paid credit and 
U.S. tax liability for 2008 and 2009 in 2011. As determined in 2011, 
CFC's post-1986 undistributed earnings for 2009 are 1350u (1,100u as 
revised for 2008, less 100u distributed in 2008, plus 350u earned in 
2009), and its post-1986 foreign income taxes for 2009 are $281.82 ($200 
as revised for 2008, less $18.18 deemed paid in 2008, plus $100 accrued 
for 2009). As redetermined in 2011, P's deemed paid credit with respect 
to the 100u distribution from CFC in 2009 is $20.88 (100u/1350u x 
$281.82).

    (iv) Deficit in foreign tax pool. A redetermination of United States 
tax liability is required if a foreign tax redetermination occurs with 
respect to foreign taxes deemed paid with respect to a subpart F 
inclusion or an actual distribution which has the effect of reducing 
below zero the distributing foreign corporation's pool of foreign taxes 
in any separate category. Whether a foreign corporation's pool of 
foreign taxes is reduced below zero shall be determined at the close of 
the taxable year of the foreign corporation in which the foreign tax 
redetermination occurred. In no case shall taxes paid or accrued with 
respect to one separate category

[[Page 892]]

be applied to offset a negative balance in any other separate category.
    (v) Example. The following example illustrates the application of 
paragraph (d)(3)(iv) of this section:

    Example. Controlled foreign corporation (CFC) is a wholly-owned 
subsidiary of its domestic parent, P. Both CFC and P are calendar year 
taxpayers. CFC has a functional currency, the u, other than the dollar, 
and its pool of post-1986 undistributed earnings is maintained in that 
currency. CFC and P use the average exchange rate to translate foreign 
taxes. The average exchange rate for both 2008 and 2009 was $1:1u. In 
2008, CFC earned 200u of general category income, accrued and paid 100u 
of foreign taxes with respect to that income, and made a distribution to 
P of 50u, half of CFC's post-1986 undistributed earnings of 100u. P is 
deemed to have paid $50 of foreign taxes with respect to that 
distribution (50u/100u x $100). In 2009, CFC received a refund of all 
100u of foreign taxes related to the general category income for 2008. 
In 2009, CFC earned an additional 290u of income, 200u of which was 
passive category income and 90u of which was general category income, 
and accrued and paid 95u of foreign tax, 40u of which was with respect 
to the passive category income and 45u of which was with respect to the 
general category income. In accordance with paragraph (d)(3)(iv) of this 
section, P is required to redetermine its United States tax liability 
for 2008 to account for the foreign tax redetermination occurring in 
2009 because, if an adjustment to CFC's pool of post-1986 foreign income 
taxes in the general category were made, the pool would be ($5). A 
deficit is not permitted to be carried in CFC's pool of post-1986 
foreign income taxes in any separate category.

    (vi) Reduction of corporate level tax on distribution of earnings 
and profits. If a United States shareholder of a controlled foreign 
corporation receives a distribution out of previously taxed earnings and 
profits and a foreign country has imposed tax on the income of the 
controlled foreign corporation, which tax is reduced on distribution of 
the earnings and profits of the corporation, then the United States 
shareholder shall redetermine its United States tax liability for the 
year or years affected.
    (e) Foreign tax imposed on foreign refund. If the redetermination of 
foreign tax for a taxable year or years is occasioned by the refund to 
the taxpayer of taxes paid to a foreign country or possession of the 
United States and the foreign country or possession imposed tax on the 
refund, then the amount of the refund shall be considered to be reduced 
by the amount of any tax described in section 901 imposed by the foreign 
country or possession of the United States with respect to such refund. 
In such case, no other credit under section 901, and no deduction under 
section 164, shall be allowed for any taxable year with respect to such 
tax imposed on such refund.
    (f) Expiration date. The applicability of this section expires on or 
before November 5, 2010.

[T.D. 8210, 53 FR 23613, June 23, 1988, as amended by T.D. 9362, 72 FR 
62780, Nov. 7, 2007; 72 FR 71787, Dec. 19, 2007]



Sec.  1.905-4T  Notification of foreign tax redetermination (temporary).

    (a) Application of this section. The rules of this section apply if, 
as a result of a foreign tax redetermination (as defined in Sec.  1.905-
3T(c)), a redetermination of United States tax liability is required 
under section 905(c) and Sec.  1.905-3T(d).
    (b) Time and manner of notification--(1) Redetermination of United 
States tax liability--(i) In general. Except as provided in paragraphs 
(b)(1)(iv), (v), and (b)(3) of this section, any taxpayer for which a 
redetermination of United States tax liability is required must notify 
the Internal Revenue Service (IRS) of the foreign tax redetermination by 
filing an amended return, Form 1118 (Foreign Tax Credit--Corporations) 
or Form 1116 (Foreign Tax Credit), and the statement required under 
paragraph (c) of this section for the taxable year with respect to which 
a redetermination of United States tax liability is required. Such 
notification must be filed within the time prescribed by this paragraph 
(b) and contain the information described in paragraph (c) of this 
section. Where a foreign tax redetermination requires an individual to 
redetermine the individual's United States tax liability, and as a 
result of such foreign tax redetermination the amount of creditable 
taxes paid or accrued by such individual during the taxable year does 
not exceed the applicable dollar limitation in section 904(k), the 
individual shall not be required to file Form 1116 with

[[Page 893]]

the amended return for such taxable year if the individual satisfies the 
requirements of section 904(k).
    (ii) Reduction in amount of foreign tax liability. Except as 
provided in paragraphs (b)(1)(iv), (v), and (b)(3) of this section, for 
each taxable year of the taxpayer with respect to which a 
redetermination of United States tax liability is required by reason of 
a foreign tax redetermination that reduces the amount of foreign taxes 
paid or accrued, or included in the computation of foreign taxes deemed 
paid, the taxpayer must file a separate notification for each such 
taxable year by the due date (with extensions) of the original return 
for the taxpayer's taxable year in which the foreign tax redetermination 
occurred.
    (iii) Increase in amount of foreign tax liability. Except as 
provided in paragraphs (b)(1)(iv), (v), and (b)(3) of this section, for 
each taxable year of the taxpayer with respect to which a 
redetermination of United States tax liability is required by reason of 
a foreign tax redetermination that increases the amount of foreign taxes 
paid or accrued, or included in the computation of foreign taxes deemed 
paid, the taxpayer must notify the Internal Revenue Service within the 
period provided by section 6511(d)(3)(A). Filing of such notification 
within the prescribed period shall constitute a claim for refund of 
United States tax.
    (iv) Multiple redeterminations of United States tax liability for 
same taxable year. Where more than one foreign tax redetermination 
requires a redetermination of United States tax liability for the same 
taxable year of the taxpayer and those redeterminations occur within two 
consecutive taxable years of the taxpayer, the taxpayer may file for 
such taxable year one amended return, Form 1118 or 1116, and the 
statement required under paragraph (c) of this section that reflect all 
such foreign tax redeterminations. If the taxpayer chooses to file one 
notification for such redeterminations, the taxpayer must file such 
notification by the due date (with extensions) of the original return 
for the taxpayer's taxable year in which the first foreign tax 
redetermination that reduces foreign tax liability occurred. Where a 
foreign tax redetermination with respect to the taxable year for which a 
redetermination of United States tax liability is required occurs after 
the date for providing such notification, more than one amended return 
may be required with respect to that taxable year.
    (v) Carryback and carryover of unused foreign tax. Where a foreign 
tax redetermination requires a redetermination of United States tax 
liability that would otherwise result in an additional amount of United 
States tax due, but such amount is eliminated as a result of a carryback 
or carryover of an unused foreign tax under section 904(c), the taxpayer 
may, in lieu of applying the rules of paragraphs (b)(1)(i) and (ii) of 
this section, notify the IRS of such redetermination by attaching a 
statement to the original return for the taxpayer's taxable year in 
which the foreign tax redetermination occurs. Such statement must be 
filed by the due date (with extensions) of the original return for the 
taxpayer's taxable year in which the foreign tax redetermination 
occurred and contain the information described in Sec.  1.904-2(f).
    (vi) Example. The following example illustrates the application of 
this paragraph (b)(1):

    Example. (i) X, a domestic corporation, is an accrual basis taxpayer 
and uses the calendar year as its United States taxable year. X conducts 
business through a branch in Country M, the currency of which is the m, 
and also conducts business through a branch in Country N, the currency 
of which is the n. X uses the average exchange rate to translate foreign 
income taxes. Assume that X is able to claim a credit under section 901 
for all foreign taxes paid or accrued.
    (ii) In 2008, X accrued and paid 100m of Country M taxes with 
respect to 400m of foreign source general category income. The average 
exchange rate for 2008 was $1:1m. Also in 2008, X accrued and paid 50n 
of Country N taxes with respect to 150n of foreign source general 
category income. The average exchange rate for 2008 was $1:1n. X claimed 
a foreign tax credit of $150 ($100 (100m at $1:1m) + $50 (50n at $1:1n)) 
with respect to its foreign source general category income on its United 
States tax return for 2008.
    (iii) In 2009, X accrued and paid 100n of Country N taxes with 
respect to 300n of foreign source general category income. The average 
exchange rate for 2009 was $1.50:1n. X claimed a foreign tax credit of 
$150 (100n at $1.5:1n) with respect to its foreign source

[[Page 894]]

general category income on its United States tax return for 2009.
    (iv) On June 15, 2012, when the spot exchange rate was $1.40:1n, X 
received a refund of 10n from Country N, and, on March 15, 2013, when 
the spot exchange rate was $1.20:1m, X was assessed by and paid Country 
M an additional 20m of tax. Both payments were with respect to X's 
foreign source general category income in 2008. On May 15, 2013, when 
the spot exchange rate was $1.45:1n, X received a refund of 5n from 
Country N with respect to its foreign source general category income in 
2009.
    (v) X must redetermine its United States tax liability for both 2008 
and 2009. With respect to 2008, X must notify the IRS of the June 15, 
2012, refund of 10n from Country N that reduced X's foreign tax 
liability by filing an amended return, Form 1118, and the statement 
required in paragraph (c) of this section for 2008 by the due date of 
the original return (with extensions) for 2012. The amended return and 
Form 1118 must reduce the amount of foreign taxes claimed as a credit 
under section 901 by $10 (10n refund translated at the average exchange 
rate for 2008, or $1:1n (see Sec.  1.905-3T(b)(3)). X will recognize 
foreign currency gain or loss under section 988 in or after 2012 on the 
conversion of the 10n refund into dollars. With respect to the March 15, 
2013, additional assessment of 20m by Country M, X must notify the IRS 
within the time period provided by section 6511(d)(3)(A), increasing the 
foreign taxes available as a credit by $24 (20m translated at the 
exchange rate on the date of payment, or $1.20:1m). See sections 
986(a)(1)(B)(i) and 986(a)(2)(A) and Sec.  1.905-3T(b)(1)(ii)(A). X may 
so notify the IRS by filing a second amended return, Form 1118, and the 
statement required in paragraph (c) of this section for 2008, within the 
time period provided by section 6511(d)(3)(A). Alternatively, when X 
redetermines its United States tax liability for 2008 to take into 
account the 10n refund from Country N which occurred in 2012, X may also 
take into account the 20m additional assessment by Country M which 
occurred on March 15, 2013. See Sec.  1.905-4T(b)(1)(iv). Where X 
reflects both foreign tax redeterminations on the same amended return, 
Form 1118, and in the statement required in paragraph (c) of this 
section for 2008, the amount of X's foreign taxes available as a credit 
would be:
    (A) Reduced by $10 (10n refund translated at $1:1n) and
    (B) Increased by $24 (20m additional assessment translated at the 
exchange rate on the date of payment, March 15, 2013, or $1.20:1m). The 
foreign taxes available as a credit therefore would be increased by $14 
($24 (additional assessment) - $10 (refund)). The due date of the 2008 
amended return, Form 1118, and the statement required in paragraph (c) 
of this section reflecting foreign tax redeterminations in both years 
would be the due date (with extensions) of X's original return for 2012.
    (vi) With respect to 2009, X must notify the IRS by filing an 
amended return, Form 1118, and the statement required in paragraph (c) 
of this section for 2009 that is separate from that filed for 2008. The 
amended return, Form 1118, and the statement required in paragraph (c) 
of this section for 2009 must be filed by the due date (with extensions) 
of X's original return for 2013. The amended return and Form 1118 must 
reduce the amount of foreign taxes claimed as a credit under section 901 
by $7.50 (5n refund translated at the average exchange rate for 2009, or 
$1.50:1n). X will recognize foreign currency gain or loss under section 
988 in or after 2013 on the conversion of the 5n refund into dollars.

    (2) Pooling adjustment in lieu of redetermination of United States 
tax liability. Where a redetermination of foreign tax paid or accrued by 
a foreign corporation affects the computation of foreign taxes deemed 
paid under section 902 or 960, and the taxpayer is required to adjust 
the foreign corporation's pools of post-1986 undistributed earnings and 
post-1986 foreign income taxes under Sec.  1.905-3T(d)(2), the taxpayer 
is required to notify the IRS of such redetermination by reflecting the 
adjustments to the foreign corporation's pools of post-1986 
undistributed earnings and post-1986 foreign income taxes on a Form 1118 
for the taxpayer's first taxable year with respect to which the 
redetermination affects the computation of foreign taxes deemed paid. 
Such Form 1118 must be filed by the due date (with extensions) of the 
original return for such taxable year. In the case of multiple 
redeterminations that affect the computation of foreign taxes deemed 
paid for the same taxable year and that are required to be reported 
under this paragraph (b)(2), a taxpayer may file one notification for 
all such redeterminations in lieu of filing a separate notification for 
each such redetermination. See section 905(b) and the regulations under 
that section which require that a taxpayer substantiate that a foreign 
tax was paid and provide all necessary information establishing its 
entitlement to the foreign tax credit.
    (3) Taxpayers under the jurisdiction of the Large and Mid-Size 
Business Division. The rules of this paragraph (b)(3) apply where a 
redetermination of United States tax liability is required by reason of 
a foreign tax redetermination

[[Page 895]]

that results in a reduction in the amount of foreign taxes paid or 
accrued, or included in the computation of foreign taxes deemed paid, 
and such foreign tax redetermination occurs while a taxpayer is under 
the jurisdiction of the Large and Mid-Size Business Division (or similar 
program). The taxpayer must, in lieu of applying the rules of paragraphs 
(b)(1)(i) and (ii) of this section (requiring the filing of an amended 
return, Form 1118, and a statement described in paragraph (c) of this 
section by the due date (with extensions) of the original return for the 
taxpayer's taxable year in which the foreign tax redetermination 
occurred), notify the IRS of such redetermination by providing to the 
examiner the statement described in paragraph (c) of this section during 
an examination of the return for the taxable year for which a 
redetermination of United States tax liability is required by reason of 
such foreign tax redetermination. The taxpayer must provide the 
statement to the examiner no later than 120 days after the latest of the 
date the foreign tax redetermination occurs, the opening conference of 
the examination, or the hand-delivery or postmark date of the opening 
letter concerning the examination. If, however, the foreign tax 
redetermination occurs more than 180 days after the latest of the 
opening conference or the hand-delivery or postmark date of the opening 
letter, the taxpayer may, in lieu of applying the rules of paragraphs 
(b)(1)(i) and (ii) of this section, provide the statement to the 
examiner within 120 days after the date the foreign tax redetermination 
occurs, and the IRS, in its discretion, may accept such statement or 
require the taxpayer to comply with the rules of paragraphs (b)(1)(i) 
and (ii) of this section. A taxpayer subject to the rules of this 
paragraph (b)(3) must satisfy the rules of this paragraph (b)(3) (in 
lieu of the rules of paragraphs (b)(1)(i) and (ii) of this section) in 
order not to be subject to the penalty relating to the failure to file 
notice of a foreign tax redetermination under section 6689 and the 
regulations under that section. This paragraph (b)(3) shall not apply 
where the due date specified in paragraph (b)(1)(ii) of this section for 
providing notice of the foreign tax redetermination precedes the latest 
of the opening conference or the hand-delivery or postmark date of the 
opening letter concerning an examination of the return for the taxable 
year for which a redetermination of United States tax liability is 
required by reason of such foreign tax redetermination. In addition, any 
statement that would otherwise be required to be provided under this 
paragraph (b)(3) on or before May 5, 2008 will be considered timely if 
provided on or before May 5, 2008.
    (4) Example. The following example illustrates the application of 
paragraph (b)(3) of this section:

    Example. X, a taxpayer under the jurisdiction of the Large and Mid-
Size Business Division, uses the calendar year as its United States 
taxable year. On October 15, 2009, X receives a refund of foreign tax 
that constitutes a foreign tax redetermination that necessitates a 
redetermination of United States tax liability for X's 2008 taxable 
year. Under paragraph (b)(1)(ii) of this section, X is required to 
notify the IRS of the foreign tax redetermination by filing an amended 
return, Form 1118, and the statement required in paragraph (c) of this 
section for its 2008 taxable year by September 15, 2010 (the due date 
(with extensions) of the original return for X's 2009 taxable year). On 
December 15, 2010, the IRS hand delivers an opening letter concerning 
the examination of the return for X's 2008 taxable year, and the opening 
conference for such examination is scheduled for January 15, 2011. 
Because the date for notifying the IRS of the foreign tax 
redetermination under paragraph (b)(1)(ii) of this section precedes the 
date of the opening conference concerning the examination of the return 
for X's 2008 taxable year, paragraph (b)(3) of this section does not 
apply, and X must notify the IRS of the foreign tax redetermination by 
filing a amended return, Form 1118, and the statement required in 
paragraph (c) of this section for the 2008 taxable year by September 15, 
2010.

    (c) Notification contents--(1) In general. In addition to satisfying 
the requirements of paragraph (b) of this section, the taxpayer must 
furnish a statement that contains information sufficient for the IRS to 
redetermine the taxpayer's United States tax liability where such a 
redetermination is required under section 905(c), and to verify 
adjustments to the pools of post-1986 undistributed earnings and post-
1986 foreign income taxes where such adjustments are required under 
Sec.  1.905-

[[Page 896]]

3T(d)(2). The information must be in a form that enables the IRS to 
verify and compare the original computations with respect to a claimed 
foreign tax credit, the revised computations resulting from the foreign 
tax redetermination, and the net changes resulting therefrom. The 
statement must include the taxpayer's name, address, identifying number, 
and the taxable year or years of the taxpayer that are affected by the 
foreign tax redetermination. In addition, the taxpayer must provide the 
information described in paragraph (c)(2) or (c)(3) of this section, as 
appropriate. If the statement is submitted to the IRS under paragraph 
(b)(3) of this section, which provides requirements with respect to 
reporting by taxpayers under the jurisdiction of the Large and Mid-Size 
Business Division, the statement must also include the following 
declaration signed by a person authorized to sign the return of the 
taxpayer: ``Under penalties of perjury, I declare that I have examined 
this written statement, and to the best of my knowledge and belief, this 
written statement is true, correct, and complete.''
    (2) Foreign taxes paid or accrued. Where a redetermination of United 
States tax liability is required by reason of a foreign tax 
redetermination as defined in Sec.  1.905-3T(c), in addition to the 
information described in paragraph (c)(1) of this section, the taxpayer 
must provide the following: the date or dates the foreign taxes were 
accrued, if applicable; the date or dates the foreign taxes were paid; 
the amount of foreign taxes paid or accrued on each date (in foreign 
currency) and the exchange rate used to translate each such amount, as 
provided in Sec.  1.905-3T(b)(1) or (b)(2); and information sufficient 
to determine any interest due from or owing to the taxpayer, including 
the amount of any interest paid by the foreign government to the 
taxpayer and the dates received. In addition, in the case of any foreign 
tax that is refunded in whole or in part, the taxpayer must provide the 
date of each such refund; the amount of such refund (in foreign 
currency); and the exchange rate that was used to translate such amount 
when originally claimed as a credit (as provided in Sec.  1.905-
3T(b)(3)) and the exchange rate for the date the refund was received 
(for purposes of computing foreign currency gain or loss under section 
988). In addition, in the case of any foreign taxes that were not paid 
before the date two years after the close of the taxable year to which 
such taxes relate, the taxpayer must provide the amount of such taxes in 
foreign currency, and the exchange rate that was used to translate such 
amount when originally added to post-1986 foreign income taxes or 
claimed as a credit. Where a redetermination of United States tax 
liability results in an amount of additional tax due, but the carryback 
or carryover of an unused foreign tax under section 904(c) only 
partially eliminates such amount, the taxpayer must also provide the 
information required in Sec.  1.904-2(f).
    (3) Foreign taxes deemed paid. Where a redetermination of United 
States tax liability is required under Sec.  1.905-3T(d)(3) to account 
for the effect of a redetermination of foreign tax paid or accrued by a 
foreign corporation on foreign taxes deemed paid under section 902 or 
960, in addition to the information described in paragraphs (c)(1) and 
(c)(2) of this section, the taxpayer must provide the balances of the 
pools of post-1986 undistributed earnings and post-1986 foreign income 
taxes before and after adjusting the pools in accordance with the rules 
of Sec.  1.905-3T(d)(2), the dates and amounts of any dividend 
distributions or other inclusions made out of earnings and profits for 
the affected year or years, and the amount of earnings and profits from 
which such dividends were paid for the affected year or years.
    (d) Payment or refund of United States tax. The amount of tax, if 
any, due upon a redetermination of United States tax liability shall be 
paid by the taxpayer after notice and demand has been made by the IRS. 
Subchapter B of chapter 63 of the Internal Revenue Code (relating to 
deficiency procedures) shall not apply with respect to the assessment of 
the amount due upon such redetermination. In accordance with sections 
905(c) and 6501(c)(5), the amount of additional tax due shall be 
assessed and collected without regard to the provisions of section 
6501(a) (relating to limitations on assessment

[[Page 897]]

and collection). The amount of tax, if any, shown by a redetermination 
of United States tax liability to have been overpaid shall be credited 
or refunded to the taxpayer in accordance with the provisions of section 
6511(d)(3)(A) and Sec.  301.6511(d)-3 of this chapter.
    (e) Interest and penalties--(1) In general. If a redetermination of 
United States tax liability is required by reason of a foreign tax 
redetermination, interest shall be computed on the underpayment or 
overpayment in accordance with sections 6601 and 6611 and the 
regulations under these sections. No interest shall be assessed or 
collected on any underpayment resulting from a refund of foreign tax for 
any period before the receipt of the refund, except to the extent 
interest was paid by the foreign country or possession of the United 
States on the refund for the period. In no case, however, shall interest 
assessed and collected pursuant to the preceding sentence for any period 
before receipt of the foreign tax refund exceed the amount that 
otherwise would have been assessed and collected under section 6601 and 
the regulations under this section for that period. Interest shall be 
assessed from the time the taxpayer (or the foreign corporation of which 
the taxpayer is a shareholder) receives a refund until the taxpayer pays 
the additional tax due the United States.
    (2) Adjustments to pools of foreign taxes. No underpayment or 
overpayment of United States tax liability results from a 
redetermination of foreign tax unless a redetermination of United States 
tax liability is required. Consequently, no interest shall be paid by or 
to a taxpayer as a result of adjustments to a foreign corporation's 
pools of post-1986 undistributed earnings and post-1986 foreign income 
taxes made in accordance with Sec.  1.905-3T(d)(2).
    (3) Imposition of penalty. Failure to comply with the provisions of 
this section shall subject the taxpayer to the penalty provisions of 
section 6689 and the regulations under that section.
    (f) Effective/applicability date--(1) In general. This section 
applies to foreign tax redeterminations (defined in Sec.  1.905-3T(c)) 
occurring in taxable years of United States taxpayers beginning on or 
after November 7, 2007, where the foreign tax redetermination affects 
the amount of foreign taxes paid or accrued by a United States taxpayer. 
Where the redetermination of foreign tax paid or accrued by a foreign 
corporation affects the computation of foreign taxes deemed paid under 
section 902 or 960 with respect to pre-1987 accumulated profits or post-
1986 undistributed earnings of the foreign corporation, this section 
applies to foreign tax redeterminations occurring in a taxable year of 
the foreign corporation which ends with or within a taxable year of its 
domestic corporate shareholder beginning on or after November 7, 2007. 
In no case, however, shall this paragraph (f)(1) operate to extend the 
statute of limitations provided by section 6511(d)(3)(A).
    (2) Foreign tax redeterminations occurring in taxable years 
beginning before November 7, 2007--(i) Scope. This paragraph (f)(2) 
applies to any foreign tax redetermination (as defined in Sec.  1.905-
3T(c)) which occurred in any of the three taxable years of a United 
States taxpayer immediately preceding the taxpayer's first taxable year 
beginning on or after November 7, 2007; reduced the amount of foreign 
taxes paid or accrued by the taxpayer; and requires a redetermination of 
United States tax liability for any taxable year. This paragraph (f)(2) 
also applies to any redetermination of foreign tax paid or accrued by a 
foreign corporation which occurred in a taxable year of the foreign 
corporation which ends with or within any of the three taxable years of 
a domestic corporate shareholder immediately preceding such 
shareholder's first taxable year beginning on or after November 7, 2007; 
reduced foreign taxes included in the computation of foreign taxes 
deemed paid by such shareholder under section 902 or 960; and requires a 
redetermination of United States tax liability under Sec.  1.905-
3T(d)(3) for any taxable year. For corresponding rules applicable to 
foreign tax redeterminations occurring in taxable years beginning before 
the third taxable year immediately preceding the taxable year beginning 
on or after November 7, 2007, see 26 CFR 1.905-4T and 1.905-5T (as 
contained in 26 CFR part 1, revised as of April 1, 2007).

[[Page 898]]

    (ii) Notification required. If, as of November 7, 2007, the taxpayer 
has not satisfied the notification requirements described in Sec.  
1.905-3T and this section (as contained in 26 CFR part 1, revised as of 
April 1, 2007, as modified by Notice 90-26, 1990-1 CB 336, see Sec.  
601.601(d)(2)(ii)(b) of this chapter), with respect to a foreign tax 
redetermination described in paragraph (f)(2)(i) of this section, the 
taxpayer must notify the IRS of the foreign tax redetermination by 
filing an amended return, Form 1118 or 1116, and the statement required 
in paragraph (c) of this section for the taxable year with respect to 
which a redetermination of United States tax liability is required. Such 
notification must be filed no later than the due date (with extensions) 
of the original return for the taxpayer's first taxable year following 
the taxable year in which these regulations are first applicable. Where 
the foreign tax redetermination requires an individual to redetermine 
the individual's United States tax liability, and as a result of such 
foreign tax redetermination the amount of creditable taxes paid or 
accrued by such individual during the taxable year does not exceed the 
applicable dollar limitation in section 904(k), the individual shall not 
be required to file Form 1116 with the amended return for such taxable 
year if the individual satisfies the requirements of section 904(k). The 
rules of paragraphs (b)(1)(iv) and (v) of this section (concerning 
multiple redeterminations of United States tax liability for the same 
taxable year, and the carryback and carryover of unused foreign tax) 
shall apply.
    (iii) Taxpayers under the jurisdiction of the Large and Mid-Size 
Business Division. If a taxpayer under the jurisdiction of the Large and 
Mid-Size Business Division is otherwise required under paragraph 
(f)(2)(ii) of this section to notify the IRS of a foreign tax 
redetermination described in paragraph (f)(2)(ii) of this section by 
filing an amended return, Form 1118, and the statement required in 
paragraph (c) of this section, such taxpayer may, in lieu of applying 
the rules of paragraph (f)(2)(ii) of this section, provide to the 
examiner the information described in paragraph (c) of this section 
during an examination of the return for the taxable year for which a 
redetermination of United States tax liability is required by reason of 
such foreign tax redetermination. The taxpayer must provide the 
information to the examiner on or before the date that is the later of 
May 5, 2008 or 120 days after the latest of the opening conference or 
the hand-delivery or postmark date of the opening letter concerning an 
examination of the return for the taxable year for which a 
redetermination of United States tax liability is required. However, if 
November 7, 2007 is more than 180 days after the latest of the opening 
conference or the hand-delivery or postmark date of the opening letter, 
the IRS, in its discretion, may accept such statement or require the 
taxpayer to comply with the rules of paragraph (f)(2)(ii) of this 
section. This paragraph (f)(2)(iii) shall not apply where the due date 
specified in paragraph (f)(2)(ii) of this section for providing notice 
of the foreign tax redetermination precedes the latest of the opening 
conference or the hand-delivery or postmark date of the opening letter 
concerning an examination of the return for the taxable year for which a 
redetermination of United States tax liability is required.
    (iv) Interest and penalties. Interest shall be computed in 
accordance with paragraph (e) of this section. Failure to comply with 
the provisions of this paragraph (f)(2) shall subject the taxpayer to 
the penalty provisions of section 6689 and the regulations under that 
section.
    (3) Expiration date. The applicability of this section expires on or 
before November 5, 2010.

[T.D. 9362, 72 FR 62784, Nov. 7, 2007; 72 FR 71787, Dec. 19, 2007]



Sec.  1.905-5T  Foreign tax redeterminations and currency translation rules 
for foreign tax redeterminations occurring in taxable years beginning 
prior to January 1, 1987 (temporary).

    (a) In general. This section sets forth rules governing the 
application of section 905(c) to foreign tax redeterminations occurring 
prior to January 1, 1987. However, the rules of this section also apply 
to foreign tax redeterminations occurring after December 31, 1986

[[Page 899]]

with respect to foreign tax deemed paid under section 902 or section 960 
with respect to pre-1987 accumulated profits (as defined in Sec.  1.902-
1(a)(10)(i).
    (b) Currency translation rules--(1) Foreign taxes paid by the 
taxpayer and certain foreign taxes deemed paid. Foreign taxes paid in 
foreign currency that are paid by or on behalf of a taxpayer or deemed 
paid under section 960 (or under section 902 in a deemed distribution 
under section 1248) shall be translated into dollars at the rate of 
exchange for the date of the payment of the foreign tax. Refunds of such 
taxes shall be translated into dollars at the rate of exchange for the 
date of the refund.
    (2) Foreign taxes deemed paid on an actual distribution. Foreign 
taxes deemed paid by a taxpayer under section 902 with respect to an 
actual distribution and refunds of such taxes shall be translated into 
dollars at the rate of exchange for the date of the distribution of the 
earnings to which the taxes relate.
    (c) Foreign tax redetermination. The term ``foreign tax 
redetermination'' means a foreign tax redetermination as defined in 
Sec.  1.905-3T(c).
    (d) Redetermination of United States tax liability--(1) In general. 
A redetermination of United States tax liability is required with 
respect to any foreign tax redetermination subject to this section and 
shall be subject to the requirements of Sec.  1.905-4T(b). The content 
of the notification required by this paragraph (d) shall be the same as 
provided in Sec.  1.905-4T(c), except as modified by paragraphs (d) (2), 
(3), and (4) of this section.
    (2) Refunds. In the case of any refund of foreign tax, the rate of 
exchange on the date of the refund shall be included in the information 
required bySec.  1.905-4T(c)(2).
    (3) Foreign taxes deemed paid under section 902. In the case of 
foreign taxes paid or accrued by a foreign corporation that are deemed 
paid or accrued under section 902 with respect to an actual distribution 
and with respect to which there was a redetermination of foreign tax, 
the United States taxpayer's information shall include, in lieu of the 
information required by Sec.  1.905-4T(c)(3), the following: the foreign 
corporation's name and identifying number (if any); the date on which 
the foreign taxes were accrued and the dates on which the foreign taxes 
were paid; the amounts of the foreign taxes accrued or paid in foreign 
currency on each such date; the dates on which any foreign taxes were 
refunded and the amounts thereof; the dates and amounts of any dividend 
distributions made out of earnings and profits for the affected year or 
years; the rate of exchange on the date of any such distribution; and 
the amount of earnings and profits from which such dividends were paid 
for the affected year or years.
    (4) Foreign taxes deemed paid under section 960. In the case of 
foreign taxes paid under section 960 (or under section 902 in the case 
of an amount treated as a dividend under section 1248), the rate of 
exchange determined under Sec.  1.964-1 for translating accrued foreign 
taxes shall be included in the information required by ;Sec.  1.905-
4T(c)(3).
    (e) Exception for de minimis currency fluctuations. A United States 
taxpayer need not notify the Service of a foreign tax redetermination 
that results solely from a currency fluctuation if the amount of such 
redetermination with respect to the foreign country is less than the 
lesser of ten thousand dollars or two percent of the total dollar amount 
of the foreign tax, prior to the adjustment, initially accrued with 
respect to that foreign country for the taxable year.
    (f) Special effective/applicability date. See Sec.  1.905-4T(f) for 
the applicability date of notification requirements relating to foreign 
tax redeterminations that affect foreign taxes deemed paid under section 
902 or section 960 with respect to pre-1987 accumulated profits 
accumulated in taxable years of a foreign corporation beginning on or 
after January 1, 1987. Failure to comply with the provisions of this 
section shall subject the taxpayer to the penalty provisions of section 
6689 and the regulations thereunder. In no case, however, shall this 
paragraph operate to extend the statute of limitations provided by 
section 6511(d)(3)(A).

[[Page 900]]

    (g) Expiration date. The applicability of this section expires on or 
before November 5, 2010.

[T.D. 8210, 53 FR 23618, June 23, 1988, as amended by T.D. 9362, 72 FR 
62787, Nov. 7, 2007]



Sec.  1.907-0  Outline of regulation provisions for section 907.

    This section lists the paragraphs contained in Sec. Sec.  1.907(a)-0 
through 1.907(f)-1.

    Sec.  1.907(a)-0 Introduction (for taxable years beginning after 
                           December 31, 1982).

    (a) Effective dates.
    (b) Key terms.
    (c) FOGEI tax limitation.
    (d) Reduction of creditable FORI taxes.
    (e) FOGEI and FORI.
    (f) Posted prices.
    (g) Transitional rules.
    (h) Section 907(f) carrybacks and carryovers.
    (i) Statutes covered.

  Sec.  1.907(a)-1 Reduction in taxes paid on FOGEI (for taxable years 
                   beginning after December 31, 1982).

    (a) Amount of reduction.
    (b) Foreign taxes paid or accrued.
    (1) Foreign taxes.
    (2) Foreign taxes paid or accrued.
    (c) Limitation level.
    (1) In general.
    (2) Limitation percentage of corporations.
    (3) Limitation percentage of individuals.
    (4) Losses.
    (5) Priority.
    (d) Illustrations.
    (e) Effect on other provisions.
    (1) Deduction denied.
    (2) Reduction inapplicable.
    (3) Section 78 dividend.
    (f) Section 904 limitation.

 Sec.  1.907(b)-1 Reduction of creditable FORI taxes (for taxable years 
                   beginning after December 31, 1982).

  Sec.  1.907(c)-1 Definitions relating to FOGEI and FORI (for taxable 
                years beginning after December 31, 1982).

    (a) Scope.
    (b) FOGEI.
    (1) General rule.
    (2) Amount.
    (3) Other circumstances.
    (4) Income directly related to extraction.
    (5) Income not included.
    (6) Fair market value.
    (7) Economic interest.
    (c) Carryover of foreign oil extraction losses.
    (1) In general.
    (2) Reduction.
    (3) Foreign oil extraction loss defined.
    (4) Affiliated groups.
    (5) FOGEI taxes.
    (6) Examples.
    (d) FORI.
    (1) In general.
    (2) Transportation.
    (3) Distribution or sale.
    (4) Processing.
    (5) Primary product from oil.
    (6) Primary product from gas.
    (7) Directly related income.
    (e) Assets used in a trade or business.
    (1) In general.
    (2) Section 907(c) activities.
    (3) Stock.
    (4) Losses on sale of stock.
    (5) Character of gain or loss.
    (6) Allocation of amount realized.
    (7) Interest.
    (f) Terms and items common to FORI and FOGEI.
    (1) Minerals
    (2) Taxable income.
    (3) Interest on working capital.
    (4) Exchange gain or loss.
    (5) Allocation.
    (6) Facts and circumstances.
    (g) Directly related income.
    (1) In general.
    (2) Directly related services.
    (3) Leases and licenses.
    (4) Related person.
    (5) Gross income.
    (h) Coordination with other provisions.
    (1) Certain adjustments.
    (2) Section 901(f).

 Sec.  1.907(c)-2 Section 907(c)(3) items (for taxable years beginning 
                        after December 31, 1982).

    (a) Scope.
    (b) Dividend.
    (1) Section 1248.
    (2) Section 78 dividend.
    (c) Taxes deemed paid.
    (1) Voting stock test.
    (2) Dividends and interest.
    (3) Amounts included under section 951(a).
    (d) Amount attributable to certain items.
    (1) Certain dividends.
    (2) Interest received from certain foreign corporations.
    (3) Dividends from domestic corporation.
    (4) Amounts with respect to which taxes are deemed paid under 
section 960(a).
    (5) Section 78 dividend.
    (6) Special rule.
    (7) Deficits.
    (8) Illustrations.
    (e) Dividends, interest, and other amounts from sources within a 
possession.
    (f) Income from partnerships, trusts, etc.

[[Page 901]]

Sec.  1.907(c)-3 FOGEI and FORI taxes (for taxable years beginning after 
                           December 31, 1982).

    (a) Tax characterization, allocation and apportionment.
    (1) Scope.
    (2) Three classes of income.
    (3) More than one class in a foreign tax base.
    (4) Allocation of tax within a base.
    (5) Modified gross income.
    (6) Allocation of tax credits.
    (7) Withholding taxes.
    (b) Dividends.
    (1) In general.
    (2) Section 78 dividend.
    (c) Includable amounts under section 951(a).
    (d) Partnerships.
    (e) Illustrations.

Sec.  1.907(d)-1 Disregard of posted prices for purposes of chapter 1 of 
     the Code (for taxable years beginning after December 31, 1982).

    (a) In general.
    (1) Scope.
    (2) Initial computation requirement.
    (3) Burden of proof.
    (4) Related parties.
    (b) Adjustments.
    (c) Definitions.
    (1) Foreign government.
    (2) Minerals.
    (3) Posted price.
    (4) Other pricing arrangement.
    (5) Fair market value.

   Sec.  1.907(f)-1 Carryback and carryover of credits disallowed by 
  section 907(a) (for amounts carried between taxable years that each 
                     begin after December 31, 1982).

    (a) In general.
    (b) Unused FOGEI.
    (1) In general.
    (2) Year of origin.
    (c) Tax deemed paid or accrued.
    (d) Excess extraction limitation.
    (e) Excess general section 904 limitation.
    (f) Section 907(f) priority.
    (g) Cross-reference.
    (h) Example.

[T.D. 8338, 56 FR 11063, Mar. 15, 1991; 56 FR 21926, May 13, 1991; T.D. 
8655, 61 FR 516, Jan. 8, 1996]



Sec.  1.907(a)-0  Introduction (for taxable years 
beginning after December 31, 1982).

    (a) Effective dates. The provisions of Sec. Sec.  1.907(a)-0 through 
1.907(f)-1 apply to taxable years beginning after December 31, 1982. For 
provisions that apply to taxable years beginning before January 1, 1983, 
see Sec. Sec.  1.907(a)-0A through 1.907(f)-1A.
    (b) Key terms. For purposes of the regulations under section 907--
    (1) FOGEI means foreign oil and gas extraction income.
    (2) FORI means foreign oil related income.
    (3) FOGEI taxes mean foreign oil and gas extraction taxes as defined 
in section 907(c)(5).
    (4) FORI taxes means foreign taxes on foreign oil related income. 
See Sec.  1.907(c)-3.
    (c) FOGEI tax limitation. Section 907(a) limits the foreign tax 
credit for taxes paid or accrued on FOGEI. See Sec.  1.907(a)-1.
    (d) Reduction of creditable FORI taxes. Section 907(b) 
recharacterizes FORI taxes as non-creditable deductible expenses to the 
extent that the foreign law imposing the FORI taxes is structured, or in 
fact operates, so that the amount of tax imposed with respect to FORI 
will be materially greater, over a reasonable period of time, than the 
amount generally imposed on income that is neither FOGEI nor FORI. See 
Sec.  1.907(b)-1.
    (e) FOGEI and FORI. FOGEI includes the taxable income from the 
extraction of minerals from oil or gas wells by a taxpayer (or another 
person) and from the sale or exchange of assets used in the extraction 
business. FORI includes taxable income from the activities of processing 
oil and gas into their primary products, transporting or distributing 
oil and gas and their primary products, and from the disposition of 
assets used in these activities. For this purpose, a disposition 
includes only a sale or exchange. FOGEI and FORI may also include 
taxable income from the performance of related services or from the 
lease of related property and certain dividends, interest, or amounts 
described in section 951(a). See Sec. Sec.  1.907(c)-1 through 1.907(c)-
3.
    (f) Posted prices. Certain sales prices are disregarded when 
computing FOGEI for purposes of chapter 1 of the Code. See Sec.  
1.907(d)-1.
    (g) Transitional rules. Section 907(e) provides rules for the 
carryover of unused FOGEI taxes from taxable years beginning before 
January 1, 1983, and carryback of FOGEI taxes arising in


[[Page 902]]

taxable years beginning after December 31, 1982. See Sec.  1.907(e)-1.
    (h) Section 907(f) carrybacks and carryovers. FOGEI taxes disallowed 
under section 907(a) may be carried back or forward to other taxable 
years. These FOGEI taxes may be absorbed in another taxable year to the 
extent of the lesser of the separate excess extraction limitation or the 
excess limitation in the general limitation category (section 
904(d)(1)(I)) for the carryback or carryover year. See Sec.  1.907(f)-1.
    (i) Statutes covered. The regulations under section 907 are issued 
as a result of the enactment of section 601 of the Tax Reduction Act of 
1975, of section 1035 of the Tax Reform Act of 1976, of section 
301(b)(14) of the Revenue Act of 1978, of section 211 of the Tax Equity 
and Fiscal Responsibility Act of 1982 and of section 1012(g)(6) (A)-(B) 
of the Technical and Miscellaneous Revenue Act of 1988.

[T.D. 8338, 56 FR 11065, Mar. 15, 1991]



Sec.  1.907(a)-1  Reduction in taxes paid on FOGEI (for taxable years 
beginning after December 31, 1982).

    (a) Amount of reduction. FOGEI taxes are reduced by the amount by 
which they exceed a limitation level (as defined in paragraph (c) of 
this section).
    (b) Foreign taxes paid or accrued. For purposes of the regulations 
under section 907--
    (1) Foreign taxes. The term ``foreign taxes'' means income, war 
profits, or excess profits taxes of foreign countries or possessions of 
the United States otherwise creditable under section 901 (including 
those creditable by reason of section 903).
    (2) Foreign taxes paid or accrued. The terms ``foreign taxes paid or 
accrued,'' ``FOGEI taxes paid or accrued,'' and ``FORI taxes paid or 
accrued'' include foreign taxes deemed paid under sections 902 and 960. 
Unless otherwise expressly provided, these terms do not include foreign 
taxes deemed paid by reason of sections 904(c) and 907(f).
    (c) Limitation level--(1) In general. The limitation level is FOGEI 
for the taxable year multiplied by the limitation percentage for that 
year.
    (2) Limitation percentage for corporations. A corporation's 
limitation percentage is the highest rate of tax specified in section 
11(b) for the particular year.
    (3) Limitation percentage for individuals. Section 907(a)(2)(B) 
provides that the limitation percentage for individual taxpayers is the 
effective rate of tax for those taxpayers. The effective rate of tax is 
computed by dividing the entire tax, before the credit under section 
901(a) is taken, by the taxpayer's entire taxable income.
    (4) Losses. (i) For purposes of determining whether income is FOGEI, 
a taxpayer's FOGEI will be recharacterized as foreign source non-FOGEI 
to the extent that FOGEI losses for preceding taxable years beginning 
after December 31, 1982, exceed the amount of FOGEI already 
recharacterized. See Sec.  1.907(c)-1(c). However, taxes that were paid 
or accrued on the recharacterized FOGEI will remain FOGEI taxes.
    (ii) Taxes paid or accrued by a person to a foreign country may be 
FOGEI taxes even though that person has under U.S. law a net operating 
loss from sources within that country.
    (iii) For purposes of determining whether income is FOGEI, a 
taxpayer's income will be treated as income from sources outside the 
United States even though all or a portion of that income may be 
resourced as income from sources within the United States under section 
904(f) (1) and (4).
    (5) Priority. (i) Section 907(a) applies before section 908, 
relating to reduction of credit for participation in or cooperation with 
an international boycott.
    (ii) Section 901(f) (relating to certain payments with respect to 
oil and gas not considered as taxes) applies before section 907.
    (d) Illustrations. Paragraphs (a) through (c) of this section are 
illustrated by the following examples.

    Example 1. M, a U.S. corporation, uses the accrual method of 
accounting and the calendar year as its taxable year. For 1984, M has 
$20,000 of FOGEI, derived from operations in foreign countries X and Y, 
and has accrued $11,500 of foreign taxes with respect to FOGEI. The 
highest tax rate specified in section 11(b) for M's 1984 taxable year is 
46 percent. Pursuant to section 907(a), M's FOGEI taxes limitation level 
for 1984 is $9,200 (46% x $20,000). The foreign taxes in excess of this 
limitation level ($2,300) may be carried

[[Page 903]]

back or forward. See section 907(f) and Sec.  1.907(f)-1 and section 
907(e) and Sec.  1.907(e)-1.
    Example 2. The facts are the same as in Example 1 except that M is a 
partnership owned equally by U.S. citizens A and B who each file as 
unmarried individuals and do not itemize deductions. Pursuant to section 
905(a), A and B have elected to credit foreign taxes in the year 
accrued. The total amount of foreign taxes accrued by A and B with 
respect to their distributive shares of M's FOGEI is $11,500 ($5,750 
accrued by A and $5,750 accrued by B). A and B have no other FOGEI. A's 
only taxable income for 1984 is his 50% distributive share ($10,000) of 
M's FOGEI and A has a preliminary U.S. tax liability of $1,079. B has 
$112,130 of taxable income for 1984 (including his 50% distributive 
share ($10,000) of M's FOGEI) and has a preliminary U.S. tax liability 
of $44,000. Pursuant to section 907(a), A's FOGEI taxes limitation level 
for 1984 is $1,079 (($1,079/$10,000) x $10,000) and B's FOGEI taxes 
limitation level for 1984 is $3,924 (($44,000/$112,130) x $10,000).

    (e) Effect on other provisions--(1) Deduction denied. If a credit is 
claimed under section 901, no deduction under section 164(a)(3) is 
allowed for the amount of the FOGEI taxes that exceed a taxpayer's 
limitation level for the taxable year. See section 275(a)(4)(A). Thus, 
FOGEI taxes disallowed under section 907(a) are not added to the cost or 
inventory amount of oil or gas.
    (2) Reduction inapplicable. The reduction under section 907(a) does 
not apply to a taxpayer that deducts foreign taxes and does not claim 
the benefits of section 901 for a taxable year.
    (3) Section 78 dividend. The reduction under section 907(a) has no 
effect on the amount of foreign taxes that are treated as dividends 
under section 78.
    (f) Section 904 limitation. FOGEI taxes as reduced under section 
907(a) are creditable only to the extent permitted by the general 
limitation of section 904(d)(1)(I).

[T.D. 8338, 56 FR 11066, Mar. 15, 1991]



Sec.  1.907(b)-1  Reduction of creditable FORI taxes (for taxable years 
beginning after December 31, 1982).

    If the foreign law imposing a FORI tax (as defined in Sec.  
1.907(c)-3) is either structured in a manner, or operates in a manner, 
so that the amount of tax imposed on FORI is generally materially 
greater than the tax imposed by the foreign law on income that is 
neither FORI nor FOGEI (``described manner''), section 907(b) provides a 
special rule which limits the amount of FORI taxes paid or accrued by a 
person to a foreign country which will be considered income, war 
profits, or excess profits taxes. Section 907(b) will apply to a person 
regardless of whether that person is a dual capacity taxpayer as defined 
in Sec.  1.901-2(a)(2)(ii)(A). (In general, a dual capacity taxpayer is 
a person who pays an amount to a foreign country part of which is 
attributable to an income tax and the remainder of which is a payment 
for a specific economic benefit derived from that country.) Foreign law 
imposing a tax on FORI will be considered either to be structured in or 
to operate in the described manner only if, under the facts and 
circumstances, there has been a shifting of tax by the foreign country 
from a tax on FOGEI to a tax on FORI.

[T.D. 8338, 56 FR 11066, Mar. 15, 1991]



Sec.  1.907(c)-1  Definitions relating to FOGEI and FORI (for taxable years 
beginning after December 31, 1982).

    (a) Scope. This section explains the meaning to be given certain 
terms and items in section 907(c) (1), (2), and (4). See also Sec. Sec.  
1.907(a)-0(b) and 1.907(c)-2 for further definitions.
    (b) FOGEI--(1) General rule. Under section 907(c)(1), FOGEI means 
taxable income (or loss) derived from sources outside the United States 
and its possessions from the extraction (by the taxpayer or any other 
person) of minerals from oil or gas wells located outside the United 
States and its possessions or from the sale or exchange of assets used 
by the taxpayer in the trade or business of extracting those minerals. 
Extraction of minerals from oil or gas wells will result in gross income 
from extraction in every case in which that person has an economic 
interest in the minerals in place. For other circumstances in which 
gross income from extraction may arise, see paragraph (b)(3) of this 
section. For determination of the amount of gross income from 
extraction, see paragraph (b)(2) of this section. For definition of the 
phrase ``assets used by the taxpayer in the trade or business'' and for 
rules relating to that type of FOGEI, see paragraph (e)(1) of this 
section. The

[[Page 904]]

term ``minerals'' is defined in paragraph (f)(1) of this section. For 
determination of taxable income, see paragraph (f)(2) of this section. 
FOGEI includes, in addition, items listed in section 907(c)(3) (relating 
to dividends, interest, partnership distributions, etc.) and explained 
in Sec.  1.907(c)-2. For the reduction of what would otherwise be FOGEI 
by losses incurred in a prior year, see section 907(c)(4) and paragraph 
(c) of this section.
    (2) Amount. The gross income from extraction is determined by 
reference to the fair market value of the minerals in the immediate 
vicinity of the well. Fair market value is determined under paragraph 
(b)(6) of this section.
    (3) Other circumstances. Gross income from extraction or the sale or 
exchange of assets described in section 907(c)(1)(B) includes income 
from any arrangement, or a combination of arrangements or transactions, 
to the extent the income is in substance attributable to the extraction 
of minerals or such a sale or exchange. For instance, a person may have 
gross income from such a sale or exchange if the person purchased 
minerals from a foreign government at a discount and the discount 
reflects an arm's-length amount in consideration for the government's 
nationalization of assets that person owned and used in the extraction 
of minerals.
    (4) Income directly related to extraction. Gross income from 
extraction includes directly related income under paragraph (g) of this 
section.
    (5) Income not included. FOGEI as otherwise determined under this 
paragraph (b), nevertheless, does not include income to the extent 
attributable to marketing, distributing, processing or transporting 
minerals or primary products. Income from the purchase and sale of 
minerals is not ordinarily FOGEI. If the foreign taxes paid or accrued 
in connection with income from a purchase and sale are not creditable by 
reason of section 901(f), that income is not FOGEI. A taxpayer to whom 
section 901(f) applies is not a producer.
    (6) Fair market value. For purposes of this paragraph (b), the fair 
market value of oil or gas in the immediate vicinity of the well depends 
on all of the facts and circumstances as they exist relative to a party 
in any particular case. The facts and circumstances that may be taken 
into account include, but are not limited to, the following--
    (i) The facts and circumstances pertaining to an independent market 
value (if any) in the immediate vicinity of the well,
    (ii) The facts and circumstances pertaining to the relationships 
between the taxpayer and the foreign government. If an independent fair 
market value in the immediate vicinity of the well cannot be determined 
but fair market value at the port, or a similar point, in the foreign 
country can be determined (port price), an analysis of the arrangement 
between the taxpayer and the foreign government that retains a share of 
production could be evidence of the appropriate, arm's-length difference 
between the port price and the field price, and
    (iii) The other facts and circumstances pertaining to any difference 
in the producing country between the field and port prices.
    (7) Economic interest. For purposes of this paragraph (b), the term 
``economic interest'' means an economic interest as defined in Sec.  
1.611-1(b)(1), whether or not a deduction for depletion is allowable 
under section 611.
    (c) Carryover of foreign oil extraction losses--(1) In general. 
Pursuant to section 907(c)(4), the determination of FOGEI for a 
particular taxable year takes into account a foreign oil extraction loss 
incurred in prior taxable years beginning after December 31, 1982. There 
is no time limitation on this carryover of foreign oil extraction 
losses. Section 907(c)(4) does not provide for any carryback of these 
losses. Section 907(c)(4) operates solely for purposes of determining 
FOGEI and thus operates independently of section 904(f).
    (2) Reduction. That portion of the income of the taxpayer for the 
taxable year which but for this paragraph (c) would be treated as FOGEI 
is reduced (but not below zero) by the excess of--
    (i) The aggregate amount of foreign oil extraction losses for 
preceding taxable years beginning after December 31, 1982, over

[[Page 905]]

    (ii) The aggregate amount of reductions under this paragraph (c) for 
preceding taxable years beginning after December 31, 1982.
    (3) Foreign oil extraction loss defined--(i) In general. For 
purposes of this paragraph (c), the term ``foreign oil extraction loss'' 
means the amount by which the gross income for the taxable year that is 
taken into account in determining FOGEI for that year is exceeded by the 
sum of the deductions properly allocated and apportioned to that gross 
income as determined under paragraph (f)(2) of this section). A person 
can have a foreign oil extraction loss for a taxable year even if the 
person has not chosen the benefits of section 901 for that year.
    (ii) Items not taken into account. For purposes of paragraph 
(c)(3)(i) of this section, the following items are not taken into 
account--
    (A) The net operating loss deduction allowable for the taxable year 
under section 172(a),
    (B) Any foreign expropriation loss (as defined in section 172(h)) 
for the taxable year, and
    (C) Any loss for the taxable year which arises from fire, storm, 
shipwreck, or other casualty, or from theft.


A loss mentioned in paragraph (c)(3)(ii) (B) or (C) of this section is 
taken into account, however, to the extent compensation (for instance by 
insurance) for the loss is included in gross income.
    (4) Affiliated groups. The foreign oil extraction loss of an 
affiliated group of corporations (within the meaning of section 1504(a)) 
that files a consolidated return is determined on a group basis. If the 
group does not have a foreign oil extraction loss, the foreign oil 
extraction loss of a member of that group will not reduce on a separate 
basis that member's FOGEI for a later taxable year. For special rules 
affecting the foreign oil extraction loss in the case of certain related 
domestic corporations that are not members of the same affiliated group, 
see section 904(i).
    (5) FOGEI taxes. If FOGEI is reduced pursuant to this paragraph (c) 
(and thereby recharacterized as non-FOGEI income), any foreign taxes 
imposed on the FOGEI that is recharacterized as other income retain 
their character as FOGEI taxes. See section 907(c)(5).
    (6) Examples. The provisions of this paragraph (c) may be 
illustrated by the following examples.

    Example 1. (i) Facts. X, a U.S. corporation using the accrual method 
of accounting and the calendar year as its taxable year, is engaged in 
extraction activities in three foreign countries. X has only the 
following combined foreign tax items for the three countries (prior to 
the application of this paragraph (c)) for 1983, 1984, and 1985:

------------------------------------------------------------------------
                                                  1983     1984    1985
------------------------------------------------------------------------
FOGEI.........................................    $(700)    $100    $450
FOGEI taxes...................................       10       60     200
Net operating loss deduction..................     (200)       0       0
Foreign oil extraction loss allowable after        (500)       0       0
 adjustment for paragraph (c)(3)(ii) amounts..
General limitation taxes other than FOGEI            30       90     230
 taxes........................................
------------------------------------------------------------------------

    (ii) 1983. Because X's FOGEI for 1983 is a loss of $(700), X's 
section 907(a) limitation for 1983 is $0 (.46 x $0). Thus, none of the 
FOGEI taxes paid or accrued in 1983 ($10) can be credited in 1983. They 
can, however, be carried back to 1981 or 1982 pursuant to the provisions 
of section 907(e)(2) and Sec.  1.907(e)-1 and carried forward pursuant 
to the provisions of section 907(f) and Sec.  1.907(f)-1.
    (iii) 1984. X's FOGEI for 1984, prior to the application of this 
paragraph (c), is $100. X has a foreign oil extraction loss for 1983 of 
$(500). This loss must be applied against X's preliminary FOGEI of $100 
for 1984. Thus, X's FOGEI for 1984 is $0 and X has $(400) ($500-$100) of 
foreign oil extraction loss from 1983 to be carried to 1985. Since X's 
FOGEI for 1984 is $0, its section 907(a) limitation is $0 (.46 x $0). 
Therefore, none of the FOGEI taxes paid or accrued in 1984 ($60) can be 
credited in 1984. They can, however, be carried back pursuant to the 
provisions of section 907(e)(2) and Sec.  1.907(e)-1 and carried forward 
pursuant to the provisions of section 907(f) and Sec.  1.907(f)-1.
    (iv) 1985. X's FOGEI for 1985, prior to the application of this 
paragraph (c), is $450. X's remaining foreign oil extraction loss 
carryover from 1983 is $(400) and this must be applied against X's 
preliminary FOGEI of $450 for 1985. Thus, X's FOGEI for 1984 is $50 
($450-$400). X's section 907 (a) limitation is $23 (.46 x $50). 
Therefore, $23 of the FOGEI taxes paid or accrued in 1985, together with 
the other $230 of general limitation taxes, can be credited in 1985, 
subject to the general limitation of section 904(d)(1)(E) (as in effect 
prior to 1987). The excess of FOGEI taxes, $177 ($200-$23), can be 
carried back pursuant to the provisions of section 907(e)(2) and Sec.  
1.907(e)-1 and carried forward pursuant to

[[Page 906]]

the provisions of section 907(f) and Sec.  1.907(f)-1.
    Example 2. (i) Facts. The facts are the same as in Example 1 except 
that X's paragraph (c)(3)(ii) items for 1983 allocable to FOGEI are 
$(800) instead of $(200). FOGEI remains a loss of $(700). Thus, X does 
not have a foreign oil extraction loss for 1983 because it has $100 of 
FOGEI when its paragraph (c)(3)(ii) items are not taken into account 
($(700) + $800).
    (ii) 1983. The results are the same as in Example 1.
    (iii) 1984. Although X had FOGEI loss of $(700) in 1983, there is 
not a loss that can be carried forward after adjustment for paragraph 
(c)(3)(ii) items. Thus, X's FOGEI for 1984 is not reduced by the 1983 
loss. X's section 907(a) limitation for 1984 is $46 (.46 x $100). 
Therefore, $46 of the FOGEI taxes paid or accrued in 1984, together with 
the other $90 of general limitation taxes, can be credited in 1984, 
subject to the general limitation of section 904(d)(1)(E) (as in effect 
prior to 1987). The excess of $14 ($60-$46) can be carried back to 1982 
pursuant to the provisions of section 907(e)(2) and Sec.  1.907(e)-1 and 
carried forward pursuant to the provisions of section 907(f) and Sec.  
1.907(f)-1.
    (iv) 1985. Since there is no foreign oil extraction loss for either 
1983 or 1984 to be applied in 1985, X's FOGEI for 1985 is $450. Thus, 
its section 907(a) limitation for 1985 is $207 (.46 x $450) and all of 
its FOGEI taxes paid or accrued in 1985 ($200), together with the other 
$230 of general limitation taxes, can be credited in 1985, subject to 
the general limitation of section 904(d)(1)(E) (as in effect prior to 
1987). FOGEI taxes in the amount of $10 from 1983 and $14 from 1984 may 
be carried forward to 1985 if they have not been used in carryback 
years. However, because the excess section 907(a) limitation for 1985 is 
only $7, that is the maximum potential FOGEI taxes from 1983 or 1984 
that may be used in 1985.
    Example 3. (i) Facts. Y, a U.S. corporation using the accrual method 
of accounting and the calendar year as its taxable year, is engaged in 
extraction activities in three foreign countries. Y's only foreign 
taxable income is income subject to the general limitation of section 
904(d)(1)(E) (as in effect prior to 1987). Y has no paragraph (c)(3)(ii) 
items. Y has the following foreign tax items for 1983 and 1984:

------------------------------------------------------------------------
                                                        1983      1984
------------------------------------------------------------------------
FOGEI...............................................    $(400)      $300
Other foreign taxable income........................      250        200
U.S. taxable income.................................    1,000      1,100
Worldwide taxable income............................      850      1,600
FOGEI taxes.........................................       10        180
Other general limitation taxes......................       50         40
Foreign oil extraction loss.........................     (400)         0
------------------------------------------------------------------------

    (ii) 1983--(A) Section 907(a) limitation. Because Y's FOGEI for 1983 
is a loss of $(400), Y's section 907(a) limitation for 1983 is $0. Thus, 
none of the FOGEI taxes paid or accrued in 1983 ($10) can be credited in 
1983. They can, however, be carried back to 1981 or 1982 pursuant to the 
provisions of section 907(e)(2) and Sec.  1.907(e)-1 and carried forward 
pursuant to the provisions of section 907(f) and Sec.  1.907(f)-1.
    (B) Section 904(d) fraction. Y has a foreign loss of $(150) ($(400 + 
$250) for 1983. Thus, its fraction for purposes of determining its 
general limitation of section 904(d)(1)(E) is $0/$850.
    (iii) 1984--(A) Section 907(a) limitation. Y's foreign oil 
extraction loss for 1983 is $(400). Applying this loss to its 
preliminary FOGEI for 1984 ($300) eliminates all of Y's FOGEI for 1984. 
Because Y's FOGEI for 1984 is $0, its section 907(a) limitation is also 
$0. Thus, none of the FOGEI taxes paid or accrued in 1984 ($180) can be 
credited in 1984. They can, however, be carried back to 1982 pursuant to 
the provisions of section 907(e)(2) and Sec.  1.907(e)-1 and carried 
forward pursuant to the provisions of section 907(f) and Sec.  1.907(f)-
1. Y has a remaining foreign oil extraction loss of $(100) from 1983 to 
be carried to 1985.
    (B) Section 904(d) fraction. Y's preliminary foreign taxable income 
for purposes of determining its general limitation of section 
904(d)(1)(E) is $500 ($300 + $200). However, Y has an overall foreign 
loss from 1983 of $(150) ($(400) + $250) and thus, pursuant to section 
904(f), Y must recharacterize $150 (lesser of $150 or 50% of $500) of 
its 1984 foreign taxable income as U.S. taxable income. Thus, Y's 
fraction for purposes of determining its general limitation of section 
904(d)(1)(E) for 1984 is $350/$1,600.
    Example 4. (i) Facts. Assume the same facts as in Example 3 except 
that Y has the following foreign tax items:

------------------------------------------------------------------------
                                                 1983     1984     1985
------------------------------------------------------------------------
FOGEI........................................  .......    $(100)    $225
Other foreign source taxable income subject      $(50)
 to the general limitation of section
 904(d)(1)(E)................................
U.S. source taxable income...................      50
Worldwide taxable income.....................  .......     (100)     225
FOGEI taxes..................................  .......       10      125
Foreign oil extraction loss..................  .......     (100)  ......
------------------------------------------------------------------------

    (ii) 1983. For 1983, Y has a section 904(d)(1)(E) overall foreign 
loss account of $50; see section 904(f) and Sec.  1.904(f)-1(b).
    (iii) 1984. Because Y's FOGEI for 1984 is a loss of $(100), Y's 
section 907(a) limitation for 1984 is $0. Thus, none of the FOGEI taxes 
paid or accrued in 1984 ($10) can be credited in 1984. They can, 
however, be carried back under the provisions of section 907(e)(2) and 
Sec.  1.907(e)-1 and carried forward under the provisions of section 
907(f) and Sec.  1.907(f)-1.

[[Page 907]]

    (iv) 1985. Y's FOGEI loss of $(100) for 1984 is carried forward to 
1985 and offsets FOGEI income in that amount in 1985. The entire section 
904(d)(1)(E) overall foreign loss account of $50 is recaptured in 1985; 
therefore, Y has $75 of foreign source income and $50 of U.S. source 
income. However, Y has $125 of FOGEI since, for purposes of section 
907(a), the $50 resourced by section 904(f) will be treated as income 
from sources outside the United States; see Sec.  1.907(a)-1(c)(4)(iii). 
Accordingly, Y's section 907(a) limitation is $57.50 (.46 x $125). Y's 
section 904(d)(1)(E) limitation is, however, only $34.50 (.46 x $75). 
Thus, Y may claim a foreign tax credit of $34.50 in 1985. Y may carry 
back or carry forward $23 ($57.50-$34.50) and that amount is not subject 
to the section 907(a) limitation in the carry to year. In addition, 
$67.50 ($125-$57.50) may be carried back pursuant to the provisions of 
section 907(e)(2) and Sec.  1.907(e)-1 and carried forward pursuant to 
the provisions of section 907(f) and Sec.  1.907(f)-1. This amount is 
subject to the section 907(a) limitation in the carry to year.

    (d) FORI--(1) In general. Section 907(c)(2) defines FORI to include 
taxable income from the processing of oil and gas into their primary 
products, from the transportation or distribution and sale of oil and 
gas and their primary products, from the disposition of assets used in 
these activities and from the performance of any other related service. 
FORI may also include, under section 907(c)(3), certain dividends, 
interest, or amounts described in section 951(a). This paragraph (d) 
defines certain terms and items applicable to FORI.
    (2) Transportation. Gross income from transportation of minerals or 
primary products (``gross transportation income'') is gross income 
arising from carrying minerals or primary products between two places 
(including time or voyage charter hires) by any means of transportation, 
such as a vessel, pipeline, truck, railroad, or aircraft. Except for 
directly related income under paragraphs (d)(7) and (g) of this section, 
gross transportation income does not include gross income received by a 
lessor from a bareboat charter hire of a means of transportation, 
certain other rental income, or income from the performance of certain 
services.
    (3) Distribution or sale. The term ``distribution or sale'' means 
the sale or exchange of minerals or primary products to processors, 
users who purchase, store, or use in bulk quantities, other persons for 
further distribution, retailers, or consumers. Gross income from 
distribution or sale includes interest income attributable to the 
distribution of minerals or primary products on credit.
    (4) Processing. The term ``processing'' means the destructive 
distillation, or a process similar in effect to destructive 
distillation, of crude oil and the processing of natural gas into their 
primary products including processes used to remove pollutants from 
crude oil or natural gas.
    (5) Primary product from oil. The term ``primary product'' (in the 
case of oil) means all products derived from the processing of crude 
oil, including volatile products, light oils (such as motor fuel and 
kerosene), distillates (such as naphtha), lubricating oils, greases and 
waxes, and residues (such as fuel oil).
    (6) Primary product from gas. The term ``primary product'' (in the 
case of gas) means all gas and associated hydrocarbon components from 
gas wells or oil wells, whether recovered at the lease or upon further 
processing, including natural gas, condensates, liquefiable petroleum 
gases (such as ethane, propane, and butane), and liquid products (such 
as natural gasoline).
    (7) Directly related income. FORI also includes directly related 
income under paragraph (g) of this section.
    (e) Assets used in a trade or business--(1) In general. The term 
``assets used by the taxpayer in the trade or business'' in section 
907(c) (1)(B) and (2)(D) means property primarily used in one or more of 
the trades or businesses that are section 907(c) activities. For 
purposes of this paragraph (e), assets used in a trade or business are 
assets described in section 1231(b) (applied without regard to any 
holding period or the character of the asset as being subject to the 
allowance for depreciation under section 167).
    (2) Section 907(c) activities. Section 907(c) activities are those 
described in section 907(c)(1)(A) (for FOGEI) or (c)(2) (A) through (C) 
(for FORI). If an asset is used primarily in one or more section 907(c) 
activities, then the entire gain (or loss) will be considered 
attributable to those activities. For example, if a person uses a 
service station primarily to distribute primary products

[[Page 908]]

from oil, then all of the gain (or loss) on the sale of the station is 
FORI even though the person uses the station to distribute products that 
are not primary products (such as tires or batteries). If an asset is 
not primarily used in one or more section 907(c) activities, then the 
entire gain or loss will not be FOGEI or FORI.
    (3) Stock. Stock of any corporation (whether foreign or domestic) 
will not be treated as an asset used by a person in section 907(c) 
activities.
    (4) Losses on sale of stock. If, under Sec.  1.861-8(e)(7), a loss 
on the sale, exchange, or disposition of stock is considered a deduction 
which is definitely related and allocable to FOGEI or FORI, then 
notwithstanding Sec.  1.861-8 (e)(7) and paragraph (f)(2) of this 
section, this loss shall be allocated and apportioned to the same class 
of income that would have been produced if there were capital gain from 
the sale, exchange or disposition.
    (5) Character of gain or loss. Except in the case of stock, gain or 
loss from the sale, exchange or disposition of assets used in the trade 
or business may be FORI or FOGEI to the extent taken into account in 
computing taxable income for the taxable year, whether or not the gain 
or loss is ordinary income or ordinary loss.
    (6) Allocation of amount realized. The amount realized from the 
sale, exchange or disposition of several assets in one transaction is 
allocated among them in proportion to their respective fair market 
values. This allocation is made under the principles set forth in Sec.  
1.1245-1(a)(5) (relating to allocation between section 1245 property and 
non-section 1245 property).
    (7) Interest. Gross income from the sale, exchange or disposition of 
an asset used in a section 907(c) activity includes interest income from 
such a sale, exchange or disposition.
    (f) Terms and items common to FORI and FOGEI--(1) Minerals. The term 
``minerals'' means hydrocarbon minerals extracted from oil and gas 
wells, including crude oil or natural gas (as defined in section 
613A(e)). The term includes incidental impurities from these wells, such 
as sulphur, nitrogen, or helium. The term does not include hydrocarbon 
minerals derived from shale oil or tar sands.
    (2) Taxable income. Deductions to be taken into account in computing 
taxable income or net operating loss attributable to FOGEI or FORI are 
determined under the principles of Sec.  1.861-8. For an exception with 
regard to losses, see paragraph (e)(4) of this section.
    (3) Interest on working capital. FORI and FOGEI may include interest 
on bank deposits or on any other temporary investment which is not in 
excess of funds reasonably necessary to meet the working capital 
requirements and the specifically anticipated business needs of the 
person that is engaged in the conduct of the activities described in 
section 907(c) (1) or (2).
    (4) Exchange gain or loss. Exchange gain (and loss) may be FORI and 
FOGEI. For taxable years beginning after 1986, exchange gain or loss 
from a section 988 transaction may be FORI or FOGEI only if directly 
related to the business needs (under the principles of section 
954(c)(1)(D)) attributable to the conduct of the section 907(c) 
activity.
    (5) Allocation. Interest income and exchange gain (or loss) 
described, respectively, in paragraph (f) (3) and (4) of this section 
are allocated among FORI, FOGEI, and any other class of income relevant 
for purposes of the foreign tax credit limitations under any reasonable 
method which is consistently applied from year-to-year.
    (6) Facts and circumstances. Income not described elsewhere in this 
section may be FOGEI or FORI if, under the facts and circumstances in 
the particular case, the income is in substance directly attributable to 
the activities described in section 907(c) (1) or (2). For example, 
assume that a producer in the North Sea suffers a casualty caused by an 
explosion, fire, and resulting destruction of a drilling platform. 
Insurance proceeds received for the platform's destruction in excess of 
the producer's basis is extraction income if the excess constitutes 
income from sources outside the United States. In addition, income from 
an insurance policy for business interruption may be extraction income 
to the extent the payments under the policy are geared directly to the 
loss of income from production and are treated as income from

[[Page 909]]

sources outside the United States. Also, if an oil company's oil 
concession or assets used in extraction activities described in section 
907(c)(1)(A) and located outside the United States are nationalized or 
expropriated by a foreign government, or instrumentality thereof, income 
derived from that nationalization or expropriation (including interest 
on the income paid pursuant to the nationalization or expropriation) is 
FOGEI. Likewise, if a company's assets used in the activities described 
in section 907(c)(2) (A) through (C) and located outside the United 
States are nationalized or expropriated by a foreign government, or 
instrumentality thereof, income (including interest on the income paid 
pursuant to the nationalization or expropriation) derived from the 
nationalization or expropriation will be FORI. Nationalization or 
expropriation is deemed to be a sale or exchange for purposes of section 
907(c)(1)(B) and a disposition for purposes of section 907(c)(2)(D). In 
further example, assume that an oil company has an exclusive right to 
buy all the oil in country X from Y, an instrumentality of the foreign 
sovereign which owns all of the oil in X. The oil company does not have 
an economic interest in any oil in country X. Y has a temporary cash-
flow problem and demands that the oil company make advance deposits for 
the purchase of oil not yet delivered. In return, Y grants the oil 
company a discount on the price of the oil when delivered. Income 
represented by the discount on the later disposition of the oil is FORI 
described in section 907(c)(2)(C). The result would be the same if Y 
credited the oil company with interest on the advance deposits, which 
had to be used to purchase oil (the interest income would be FORI).
    (g) Directly related income--(1) In general. Section 907(c)(2)(E) 
and this paragraph (g) include in FORI, and this paragraph (g) includes 
in FOGEI, income from the performance of directly related services (as 
defined in paragraph (g)(2) of this section). This paragraph (g) also 
includes in FORI and FOGEI income from the lease or license of related 
property (as defined in paragraph (g)(3) of this section). Section 
907(c)(2)(E) with regard to FORI and this paragraph (g) with regard to 
both FORI and FOGEI do not apply to a person if--
    (i) Neither that person nor a related person (as defined in 
paragraph (g)(4) of this section) has FOGEI described in paragraph (b) 
of this section (other than paragraph (b)(4) of this section relating to 
directly related income) or FORI described in paragraph (d) of this 
section (other than paragraph (d)(7) of this section relating to 
directly related income), or
    (ii) Less than 50 percent of that person's gross income from sources 
outside the United States which is related exclusively to the 
performance of services and from the lease or license of property 
described in paragraph (g) (2) and (3) of this section, respectively, is 
attributable to services performed for (or on behalf of), leases to, or 
licenses with, related persons, but
    (iii) Paragraph (g)(1)(ii) of this section will not apply to a 
person if 50 percent or more of that person's total gross income from 
sources outside the United States is FOGEI and FORI (as both are 
described in paragraph (g)(1)(i) of this section).


A person described in paragraph (g)(1) (i) or (ii) of this section will, 
however, have directly related services income which is FOGEI if the 
income is so classified by reason of the income based on output test set 
forth in paragraph (g)(2)(i)(B) of this section.
    (2) Directly related services--(i) FOGEI. (A) Income from directly 
related services will be FOGEI, as that term is defined in paragraph (b) 
(1) and (3) of this section, if those services are directly related to 
the active conduct of extraction (including exploration) of minerals 
from oil and gas wells. Paragraph (b)(1) of this section provides that, 
in order to have extraction income, a person must have an economic 
interest in the minerals in place. However, paragraph (b)(3) of this 
section recognizes that income arising from ``other circumstances'' is 
extraction income if that income is in substance attributable to the 
extraction of minerals.
    (B) An example of ``other circumstances'' under paragraph (b)(3) of 
this section is the ``income based on output test.'' This income based 
on output test provides that, if the

[[Page 910]]

amount of compensation paid or credited to a person for services is 
dependent on the amount of minerals discovered or extracted, the income 
of the person from the performance of the services will be directly 
related services income which is FOGEI. This test will apply whether or 
not the person performing the services has, or had, an economic interest 
in the minerals discovered or extracted.
    (ii) FORI. With regard to the determination of directly related 
services income which is FORI, directly related services are those 
services directly related to the active conduct of the operations 
described in section 907(c)(2) (A) through (C). Those services include, 
for example, services performed in relation to the distribution of 
minerals or primary products or in connection with the operation of a 
refinery, or the types of services described in Sec.  1.954-6(d) (other 
than Sec.  1.954-6(d)(4) which relate to foreign base company shipping 
income.
    (iii) Recipient of the services. Directly related services described 
in paragraph (g)(2) (i) and (ii) of this section may be performed for 
any person without regard to whether that person is a related person.
    (iv) Excluded services--(A) FOGEI. Directly related services which 
produce FOGEI do not include insurance, accounting or managerial 
services.
    (B) FORI. Directly related services which produce FORI do not, 
generally, include insurance, accounting or managerial services. These 
services will, however, produce FORI if they are performed by the person 
performing the operations described in section 907(c)(2) (A) through 
(C). For these purposes, insurance income which is FORI means taxable 
income as defined in section 832(a).
    (3) Leases and licenses. A lease or license of related property is 
the lease or license of assets used (or held for use) by the lessor, 
licensor, or another person (including the lessee or a sublessee) in the 
active conduct of the activities described in section 907 (c)(1)(A) or 
(c)(2) (A) through (C). The leases or licenses described in this 
paragraph (g)(3) include, for example, a lease of a means of 
transportation under a bareboat charter hire, of drilling equipment used 
in extraction operations, or the license of a patent, know-how, or 
similar intangible property used in extracting, transporting, 
distributing or processing minerals or primary products. This paragraph 
(g)(3) applies without regard to whether the parties are related 
persons.
    (4) Related person. A person will be treated as a related person for 
purposes of this paragraph (g) if that person would be so treated within 
the meaning of section 954(d)(3) (as applied by substituting the word 
``corporation'' for the word ``controlled foreign corporation'') or that 
person is a partnership or partner described in section 707(b)(1).
    (5) Gross income. A foreign corporation shall be treated as a 
domestic corporation for the purpose of applying the gross-income rules 
in paragraph (g)(1) (ii) and (iii) of this section.
    (h) Coordination with other provisions--(1) Certain adjustments. The 
character of income as FOGEI or FORI is determined before making any 
adjustment under section 482 or section 907(d). For example, assume that 
X and Y are related parties, Y's only income is from the sale of oil 
that Y purchased from X, and FOGEI from X is diverted to Y through an 
arrangement described in paragraph (b)(3) of this section. Accordingly, 
Y has FOGEI. If under section 482 the Commissioner reallocates the FOGEI 
from Y to X, then Y's remaining income represents only a profit from 
distributing the oil, and thus is FORI. If the foreign taxes paid by Y 
on this income are otherwise creditable under section 901, the foreign 
taxes that are not refunded to Y retain their characterization as FOGEI 
taxes.
    (2) Section 901(f). Section 901(f) (relating to certain payments 
with respect to oil and gas not considered as taxes) applies before 
section 907. Taxes disallowed by section 901(f) are added to the cost or 
inventory amount of oil or gas.

[T.D. 8338, 56 FR 11067, Mar. 15, 1991]



Sec.  1.907(c)-2  Section 907(c)(3) items (for taxable years 
beginning after December 31, 1982).

    (a) Scope. This section provides rules relating to certain items 
listed in section 907(c)(3). The rules of this section

[[Page 911]]

are expressed in terms of FORI but apply for determining FOGEI by 
substituting ``FOGEI'' for ``FORI'' whenever appropriate. FOGEI does not 
include interest described in section 907(c)(3)(A). Dividends paid prior 
to January 1, 1987, and described in section 907(c)(3)(B), as in effect 
prior to amendment by the Technical and Miscellaneous Revenue Act of 
1988, are included in FORI and not FOGEI.
    (b) Dividend--(1) Section 1248 dividend. A section 1248 dividend is 
a dividend described in section 907(c)(3)(A). Except as otherwise 
provided in this paragraph (b)(1), gain (or loss) from the disposition 
of stock in any corporation is not FOGEI or FORI. See Sec.  1.907(c)-
1(e) (3) and (4).
    (2) Section 78 dividend. A section 78 dividend is FORI to the extent 
it arises from a dividend described in section 907(c)(3)(A), or an 
amount described in section 907(c)(3)(C).
    (c) Taxes deemed paid--(1) Voting stock test. Items described in 
section 907(c)(3) (A) or (C) are FORI only if a deemed-paid-tax test is 
met under the criteria of section 902 or 960. The purpose of this test 
is to require minimum direct or indirect ownership by a domestic 
corporation in the voting stock of a foreign corporation as a 
prerequisite for the item to qualify as FORI in the hands of the 
domestic corporation. The test is whether a domestic corporation would 
be deemed to pay any taxes of a foreign corporation when a dividend or 
an amount described in section 907(c)(3) (A) or (C), respectively, is 
included in the domestic corporation's gross income. In the case of 
interest described in section 907(c)(3)(A), the test is whether any 
taxes would be deemed paid if there were a hypothetical dividend.
    (2) Dividends and interest. For purposes of section 907(c)(3)(A), a 
domestic corporation is deemed under section 902 to pay taxes in respect 
of dividends and interest received from a foreign corporation whether or 
not the foreign corporation:
    (i) Actually pays or is deemed to pay taxes, or
    (ii) In the case of interest, actually pays dividends.


This paragraph (c)(2) also applies to dividends received by a foreign 
corporation from a second-tier or third-tier foreign corporation (as 
defined in Sec.  1.902-1(a) (3)(i) and (4), respectively). In the case 
of interest received by a foreign corporation from another foreign 
corporation, this paragraph (c)(2) applies if the taxes of both foreign 
corporations would be deemed paid under section 902 (a) or (b) for 
purposes of applying section 902(a) to the same taxpayer which is a 
domestic corporation. In the case of interest received by any 
corporation (whether foreign or domestic), all members of an affiliated 
group filing a consolidated return will be treated as the same taxpayer 
under section 907(c)(3)(A) if the foreign taxes of the payor and (if the 
recipient is a foreign corporation) the foreign taxes of the recipient 
would be deemed paid under section 902 by at least one member. The term 
``member'' is defined in Sec.  1.1502-1(b). Thus, for example, assume 
that P owns all of the stock of D1 and D2 and P. D1, and D2 are members 
of an affiliated group filing a consolidated return. Assume further that 
D1 owns all of the stock of F1 and D2 owns all of the stock of F2, where 
F1 and F2 are foreign corporations. Interest paid by F1 to P, D2, or F2 
may be FORI.
    (3) Amounts included under section 951(a). For purposes of section 
907(c)(3)(C), a domestic corporation is deemed under section 960 to pay 
taxes in respect of a foreign corporation, whether or not the foreign 
corporation actually pays taxes on the amounts included in gross income 
under section 951(a).
    (d) Amount attributable to certain items--(1) Certain dividends--(i) 
General rule. The portion of a dividend described in section 
907(c)(3)(A) that is FORI equals--

Amount of dividend x a/b

a = FORI accumulated profits in excess of FORI taxes paid or accrued, 
          and
b = Total accumulated profits in excess of total foreign taxes paid or 
          accrued.


This paragraph (d)(1)(i) applies even though the FORI accumulated 
profits arose in a taxable year of a foreign corporation beginning 
before January 1, 1983. Determination of the FORI amount of dividends 
under this paragraph (d)(1)(i) must be made separately for FORI 
accumulated profits and total

[[Page 912]]

accumulated profits that arose in taxable years beginning before January 
1, 1987, and for FORI accumulated profits and total accumulated profits 
that arose in taxable years beginning after December 31, 1986. Dividends 
are deemed to be paid first out of FORI and total accumulated profits 
that arose in table years beginning after December 31, 1986. With regard 
to FORI accumulated profits and total accumulated profits that arose in 
taxable years beginning after December 31, 1986, the portion of a 
dividend that is FORI equals--

Amount of dividend x a/b

a = Post-1986 undistributed FORI earnings determined under the 
          principles of section 902(c)(1), and
b = Post-1986 undistributed earnings determined under the principles of 
          section 902(c)(1).

    (ii) Cross-references. See Sec.  1.902-1(g) for the determination of 
a foreign corporation's earnings and profits and of those out of which a 
dividend is paid. See Sec.  1.1248-2 or 1.1248-3 for the determination 
of the earnings and profits attributable to the sale or exchange of 
stock in certain foreign corporations.
    (2) Interest received from certain foreign corporations. Interest 
described in section 907(c)(3)(A) is FORI to the extent the 
corresponding interest expense of the paying corporation is properly 
allocable and apportionable to the gross income of the paying 
corporation that would be FORI were that corporation a domestic 
corporation. This allocation and apportionment is made in a manner 
consistent with the rules of section 954(b)(5) and Sec.  1.861-8(e)(2).
    (3) Dividends from domestic corporation. The amount of a dividend 
from a corporation described in section 907(c)(3)(B), as in effect prior 
to amendment by the Technical and Miscellaneous Revenue Act of 1988, 
paid in a taxable year of that corporation beginning before December 31, 
1986, that is FORI is determined under the principles of paragraph 
(d)(1)(i) of this section with respect to its current earnings and 
profits under section 316(a)(2) or its accumulated earnings and profits 
under section 316(a)(1), as the case may be.
    (4) Amounts with respect to which taxes are deemed paid under 
section 906(a)--(i) Portion attributable to FORI. The portion of an 
amount described in section 907(c)(3)(C) that is FORI equals:
[GRAPHIC] [TIFF OMITTED] TC07OC91.045

A = Amount described in section 907(c)(3)(C)
B = FORI earnings and profits
C = Total earnings and profits


For taxable years ending after January 23, 1989, the facts and 
circumstances will be used to determined what part of the amount of the 
section 907(c)(3)(C) amount is directly attributable to FOGEI, FORI and 
other income.
    (ii) Earnings and profits. Total earnings and profits are those of 
the foreign corporation for a taxable year under section 964 and the 
regulations under that section.
    (5) Section 78 dividend. The portion of a section 78 dividend that 
will be considered FORI will equal the amount of taxes deemed paid under 
either section 902(a) or section 960(a)(1) with respect to the dividend 
to the extent the taxes deemed paid are FORI taxes under Sec.  1.907(c)-
3 (b) or (c). See Sec.  1.907(c)-3(a)(1).
    (6) Special rule. (i) No item in the formula described in paragraph 
(d)(1)(i) of this section includes amounts excluded from the gross 
income of a United States shareholder under section 959(a)(1).
    (ii) With respect to a foreign corporation, earnings and profits in 
the formula described in paragraph (d)(4)(i) of this section do not 
include amounts excluded under section 959(b) from its gross income.
    (7) Deficits--(i) Allocation of deficits within a separate category. 
In a taxable year in which a foreign corporation described in section 
907(c)(3)(A) pays a dividend or has income that is subject to inclusion 
under section 951, if the foreign corporation has positive post--1986 
undistributed earnings in a separate category but within that separate 
category there is a deficit in post-1986 undistributed earnings 
attributable to earnings other than FOGEI and FORI, that deficit shall 
be allocated ratably between the FOGEI and FORI post-1986

[[Page 913]]

undistributed earnings within that separate category. Any deficit in 
post-1986 undistributed earnings attributable to either FOGEI or FORI 
shall be allocated first to FOGEI or FORI post-1986 undistributed 
earnings (as the case may be) to the extent thereof. Post-1986 
undistributed FORI earnings are the post-1986 undistributed earnings (as 
defined in section 902 and the regulations under that section) 
attributable to FORI as defined in section 907(c) (2) and (3). Post-1986 
undistributed FOGEI earnings are the post-1986 undistributed earnings 
(as defined in section 902 and the regulations under that section) 
attributable to FOGEI as defined in section 907(c) (1) and (3).

    Example. Foreign corporation X for years 1987 and 1988 had the 
following undistributed earnings (none of which is income that is 
subject to inclusion under section 951) and foreign taxes:

------------------------------------------------------------------------
                                                        Earnings   Taxes
------------------------------------------------------------------------
FOGEI.................................................     $800     $400
FORI..................................................     (750)  ......
Other.................................................      700      250
                                                       -----------------
  Total...............................................     $750     $650
                                                       -----------------
------------------------------------------------------------------------



On December 31, 1988, X paid a dividend of all of its post-1986 
undistributed earnings to its sole shareholder Y. Under paragraph (d)(5) 
and (7)(i) of this section and Sec.  1.907 (c)-2 (d)(5), $450 of Y's 
dividend is attributable to FOGEI ($50 from undistributed earnings plus 
a $400 section 78 dividend) and $950 is attributable to other earnings 
($700 from undistributed earnings plus a $250 section 78 dividend).

    (ii) Deficits allocated among separate categories. If a deficit in a 
separate category (``first separate category'') is allocated to another 
separate category (``second separate category'') under sections 902 and 
960 pursuant to notice 88-71, 1988-2 CB 374 and the regulations under 
those sections, the following rules shall apply. Any deficit in post-
1986 undistributed earnings attributable to either FOGEI (or FORI) from 
the first separate category shall be allocated to post-1986 
undistributed earnings in the second separate category to the extent 
thereof in the following order:
    (A) FOGEI (or FORI),
    (B) FORI (or FOGEI), and
    (C) Other income.


Any deficit in post-1986 undistributed earnings attributable to other 
income from the first separate category shall be allocated first to 
other post-1986 undistributed earnings and then ratably to FOGEI and 
FORI post--1986 undistributed earnings in the second separate category.
    (iii) Pre-1987 deficits. The amount of a dividend paid by a foreign 
corporation described in section 907(c)(3)(A) out of positive pre-1987 
earnings that is attributable to FOGEI and FORI shall be determined in a 
manner similar to that used in paragraph (d)(7) (i) and (ii) of this 
section except that the determinations shall be made on an annual basis.
    (8) Illustrations. The application of this paragraph (d) is 
illustrated by the following examples.

    Example 1. X, a domestic corporation, owns all of the stock of Y, a 
foreign corporation organized in country S. Y owns all of the stock of 
Z, a foreign corporation also organized in country S. Each corporation 
uses the calendar year as its taxable year. In 1983, Z has $150 of FOGEI 
earnings and profits and $250 of earnings and profits other than FOGEI 
or FORI. Assume that Z paid no taxes to S and X must include $100 in its 
gross income under section 951(a) with respect to Z. Under paragraph 
(d)(4)(i) of this section, $37.50 of the amount described in section 
951(a) is FOGEI ($100 x $150/$400). the remaining $62.50 of the section 
951(a) amount represents other income.
    Example 2. Assume the same facts as in Example 1 except that the 
taxable year in question is 1988. In addition, under the facts and 
circumstances, it is determined that of the $100 section 951(a) amount 
included in X's gross income, $30 is directly attributable to Z's FOGEI 
activity, $60 is directly attributable to Z's FORI activity and $10 is 
directly attributable to Z's other activity. Accordingly, under 
paragraph (d)(4)(i), $30 will be FOGEI and $60 will be FORI to X.
    Example 3. (i) Assume the same facts as in Example 1. Assume further 
that, in 1983, Z distributes its entire earnings and profits ($400) to Y 
which consists of a dividend of $300 and a section 959(a)(1) 
distribution of $100. Y has no other earnings and profits during 1983. 
Assume that the dividend and distribution are not foreign personal 
holding company income under section 954(c). Y pays no taxes to S. In 
1983, Y distributes its entire earnings and profits to X.
    (ii) Under paragraphs (c)(2) and (d)(1)(i) of this section, Y has 
FOGEI of $112.50, i.e., the amount of the dividend received by Y ($300) 
multiplied by the fraction described in paragraph (d)(1)(i). The 
numerator of the fraction is Z's FOGEI accumulated profits in excess

[[Page 914]]

of the FOGEI taxes paid ($112.50) and the denominator is Z's total 
accumulated profits in excess of total foreign taxes paid ($400) minus 
the amount excluded from Y's gross income under section 959(a)(1) 
($100). The rule of paragraph (d)(6)(ii) of this section does not apply 
since X does not include any amount in its gross income under section 
951(a) with respect to Y. If Y paid taxes to S, this paragraph (d) would 
apply to characterize those taxes as FOGEI taxes or other taxes. See 
Sec.  1.907(c)-3(a)(8) and Example 2 (iii) under Sec.  1.907(c)-3(e).
    (iii) The distribution from Y to X is a dividend to the extent of 
$300, i.e., the amount of the distribution ($400) minus the amount 
excluded from X's gross income under section 959(a)(1) ($100). Under 
paragraphs (d) (1)(i) and (6)(i) of this section, $112.50 of the 
dividend is FOGEI, i.e., the amount of the dividend ($300) multiplied by 
a fraction. The numerator of the fraction is $112.50, i.e., the FOGEI 
accumulated profits of Y in excess of FOGEI taxes paid ($150) minus the 
FOGEI accumulated profits of Y in excess of FOGEI taxes paid excluded 
from X's gross income under section 959(a)(1) ($37.50). The denominator 
of the fraction is $300, i.e., the total accumulated profits of Y in 
excess of taxes paid ($400) minus the amount excluded from X's gross 
income under section 959(a)(1) ($100).
    Example 4. Assume the same facts as in Example 1 with the following 
modifications: In 1983, Z's only earnings and profits are FORI earnings 
and profits which are included in X's gross income under section 951(a). 
Z distributes its entire earnings and profits to Y. In 1983, Y has total 
earnings and profits of $100 without regard to the dividend from Z, $60 
of which are FORI earnings and profits. Y also has $40 which is included 
in X's gross income under section 951(a). Under paragraph (d)(6)(ii) of 
this section, the dividend from Z is disregarded for purposes of 
applying paragraph (d)(4)(i) of this section to the $40 included in X's 
gross income under section 951(a) with respect to Y. Accordingly, $24 of 
the amount described in section 951(a) is FORI ($40 x $60/$100). Had 
these circumstances existed in 1988, and if the $40 included in X's 
gross income under section 951(a) was directly attributable to FORI 
activity, all of that income would be FORI to X.

    (e) Dividends, interest, and other amounts from sources within a 
possession. FORI includes the items listed in (A) and (C) to the extent 
attributable to FORI of a corporation that is created or organized in or 
under the laws of a possession of the United States.
    (f) Income from partnerships, trusts, etc. FORI and FOGEI include a 
person's distributive share (determined under the principles of section 
704) of the income of any partnership and amounts included in income 
under subchapter J of chapter 1 of the Code (relating to the taxation of 
trusts, estates, and beneficiaries) to the extent the income and amounts 
are attributable to FORI and FOGEI. For taxable years beginning after 
1986, the principles of Sec.  1.904-5 (h) and (i) shall be applied to 
determine whether (and to what extent) a person's distributive share is 
FORI and FOGEI. Thus, for example, a less-than-10 percent corporate 
partner's share of income of the partnership would generally be treated 
as passive income to the partner, and not as FORI or FOGEI, unless an 
exception under Sec.  1.904-5 (h) and (i) applies.

[T.D. 8338, 56 FR 11071, Mar. 15, 1991]



Sec.  1.907(c)-3  FOGEI and FORI taxes (for taxable years 
beginning after December 31, 1982).

    (a) Tax characterization, allocation and apportionment--(1) Scope. 
Paragraphs (a) (2) through (6) of this section provides rules for the 
characterization, allocation, and apportionment of the income taxes 
(other than withholding taxes) paid or accrued to a foreign country 
among FOGEI, FORI, and other income relevant for purposes of sections 
907 and 904. Some of the rules in this section are expressed in terms of 
FOGEI taxes but they apply to FORI taxes by substituting ``FORI taxes'' 
for ``FOGEI taxes'' whenever appropriate. For the treatment of 
withholding taxes, see paragraph (a)(8) of this section. FOGEI taxes are 
determined without any reduction under section 907(a). In addition, 
determination of FOGEI taxes will not be affected by recharacterization 
of FOGEI by section 907(c)(4). See Sec.  1.907(c)-1(c)(5). Foreign taxes 
will not be characterized as creditable FORI taxes if section 907(b) and 
Sec.  1.907(b)-1 apply.
    (2) Three classes of income. There are three classes of income: 
FOGEI, FORI, and other income.
    (3) More than one class in a foreign tax base. If more than one 
class of income is taxed under one tax base under the law of a foreign 
country, the amount of pre-credit foreign tax for each base must be 
determined. This amount is the foreign taxes paid or accrued to that 
country for the base as increased

[[Page 915]]

by the tax credits (if any) which reduced those taxes and were allowed 
in the country for that tax. More than one class of income is taxed 
under the same base, if, under a foreign country's law, deductions from 
one class of income may reduce the income of any other class and the 
classes are subject to foreign tax at the same rates.
    (4) Allocation of tax within a base. If more than one class of 
income is taxed under the same base under a foreign country's law, the 
pre-credit foreign tax for the base is apportioned to each class of 
income in proportion to the income of each class. Tax credits are than 
allocated (under paragraph (a)(6) of this section) to the apportioned 
pre-credit tax. Income of a class over the deductions allowed under 
foreign law for, and which are attributable to, that class.
    (5) Modified gross income. Modified gross income is not necessarily 
the same as gross income as defined for purposes of chapter 1 of the 
Internal Revenue Code. Modified gross income is determined with 
reference to the foreign tax base for gross income (or its equivalent). 
However, the characterization of the base as a particular class of 
income is governed by general principles of U.S. tax law. Thus, for 
example--
    (i) Gross income from extraction is the fair market value of oil or 
gas in the immediate vicinity of the well (as determined under Sec.  
1.907(c)-1(b)(6) (without any deductions)).
    (ii) Whether cost of goods sold (or any other deduction) is a 
deduction from modified gross income and the amount of such a deduction 
is determined under foreign law.
    (iii) Modified gross income includes items that are part of the 
foreign tax base even though they are not gross income under U.S. law so 
long as the foreign taxes paid on the base constitute creditable taxes 
under section 901 (including taxes described in section 903). For 
example, if a foreign country imposes a tax (creditable under section 
901) on a tax base that includes in small part a percentage of the value 
of a company's oil reserves in place, modified gross income from 
extraction includes such a percentage of value solely for purposes of 
making the tax allocation in paragraph (a)(4) of this section.
    (iv) Modified gross income from extraction is increased for purposes 
of this paragraph (a)(5) by the entire excess of the posted price over 
fair market value if the foreign country uses a posted price system or 
other pricing arrangement described in section 907(d) in imposing its 
income tax.
    (v) Modified gross income from FORI is that income attributable to 
the activities in sections 907(c)(2) (A) through (C) and (E).
    (vi) Modified gross income for any class may not include gross 
income that is not subject to taxation by the foreign country.
    (6) Allocation of tax credits. The foreign taxes paid or accrued on 
a particular class of income equals the precredit tax on the class 
reduced (but not below zero) by the credits allowed under foreign law 
against the foreign tax on the particular class. Any tax credit 
attributable to a class that is not allocated to that class is allocated 
to the other class in the base or, if there are three classes in the 
base, is apportioned ratably among the taxes paid or accrued on the 
other two classes (as reduced in accordance with the preceding 
sentence).
    (7) Withholding taxes. Paragraph (a) (2) through (6) of this section 
does not apply to withholding taxes imposed by a foreign country. FOGEI 
taxes may include withholding taxes imposed with respect to a 
distribution from a corporation. The portion of the total withholding 
taxes on a distribution that constitutes FOGEI taxes is determined by 
the portion of the distribution that is FOGEI. In addition, FOGEI taxes 
may include taxes imposed on a distribution described in section 
959(a)(1) or on amounts described in section 959(b). The portion of the 
total withholding taxes imposed on a distribution described in section 
959(a)(1) or on amounts described in section 959(b) is determined by 
reference to the portion of the amount included in gross income under 
section 951(a) that was FOGEI.
    (b) Dividenss--In general. (i) FOGEI taxes deemed paid with respect 
to a dividend equal the total taxes deemed

[[Page 916]]

paid with respect to the dividend multiplied by the fraction:

FOGEI taxes paid or accrued by the payor/Total foreign taxes paid or 
accrued by the payor.

    (ii) With regard to dividends received in taxable years beginning 
after December 31, 1986, FOGEI taxes deemed paid with respect to a 
dividend equal the total taxes deemed paid with respect to the portion 
of the dividend within a separate category multiplied by the fraction:
[GRAPHIC] [TIFF OMITTED] TC07OC91.046

    (iii) This paragraph (b) applies to a dividend described in section 
907(c)(3)(A) (including a section 1248 dividend) with reference to the 
particular taxable year or years of those accumulated profits out of 
which a dividend is paid. Determination of FOGEI taxes under this 
paragraph (b) must be made separately.
    (A) For FOGEI taxes paid on FOGEI accumulated profits and total 
taxes paid on accumulated profits that arose in taxable years beginning 
before January 1, 1987, to which paragraph (b)(1)(i) of this section 
applies, and
    (B) For FOGEI taxes paid on FOGEI accumulated profits and total 
taxes paid on accumulated profits that arose in taxable years beginning 
after December 31, 1986, to which paragraph (b)(1)(ii) of this section 
applies.


For purposes of these determinations, dividends are deemed to be paid 
first out of FOGEI and total accumulated profits that arose in taxable 
years beginning after December 31, 1986. See Sec.  1.907(c)-2(d)(1)(i). 
See section 960(a)(3) and Sec.  1.960-2 relating to distributions that 
are treated as dividends for purposes of section 902.
    (2) Section 78 dividend. There are no FOGEI taxes with respect to 
section 78 dividends.
    (c) Includable amounts under section 951(a). (1) FOGEI taxes deemed 
paid with respect to an amount includable in gross income under section 
951(a) equal the total taxes deemed paid with respect to that amount 
multiplied by the fraction:
[GRAPHIC] [TIFF OMITTED] TC07OC91.047

    (2) With regard to an amount includable in gross income under 
section 951(a) in taxable years beginning after December 31, 1986, FOGEI 
taxes deemed paid with respect to that amount equal the total taxes 
deemed paid with respect to that amount within a separate category 
multiplied by the fraction:
[GRAPHIC] [TIFF OMITTED] TC07OC91.048


[[Page 917]]



Taxes in the fraction in this paragraph (c)(2) include only those 
foreign taxes that may be deemed paid under section 960(a) by reason of 
such inclusion. See Sec. Sec.  1.960-1(c)(3) and 1.960-2(c).
    (d) Partnerships. A partner's distributive share of the 
partnership's FOGEI taxes is determined under the principles of section 
704.
    (e) Illustrations. The application of this section may be 
illustrated by the following examples.

    Example 1. X, a domestic corporation, owns all of the stock of Y, a 
foreign corporation organized in country S. Y owns all of the stock of 
Z, a foreign corporation organized in country T. Each corporation used 
the calendar year as its taxable year. In 1983, X includes in its gross 
income an amount described in section 951(a) with respect to Z. Assume 
that the taxes deemed paid under section 902(a) by X by reason of such 
an inclusion is $70. Assume further that Z paid total taxes of $120, $80 
of which is FOGEI tax. Under paragraph (c) of this section, the FOGEI 
tax deemed paid is $46.67 (i.e., $70 x $80/$120). This $46.67 is also 
FOGEI under Sec.  1.907(c)-2(d)(5) because it must be included in X's 
gross income under section 78.
    Example 2. (i) Assume the same facts as in Example 1. Assume further 
that in 1983, Z distributes its entire earnings and profits to Y. Y has 
no earnings and profits during 1983 other than this dividend. Y paid a 
tax of $50 to S. Assume that Y is deemed under section 902(b)(1) to pay 
$50 of the tax paid by Z which was not deemed paid by X under section 
960(a)(1) in 1983. In 1983, Y distributes its entire earnings and 
profits to X. Assume that X is deemed under section 902(a) to pay $100 
of the taxes actually paid, and deemed paid, by Y.
    (ii) Paragraph (b)(1) of this section applies to characterize the 
$50 tax of Z that Y is deemed to pay under section 902(b)(1). Y is 
deemed to pay $33.33 of FOGEI tax, i.e., the amount of the tax deemed 
paid by Y ($50) multiplied by a fraction. The numerator of the fraction 
is the amount of Z's FOGEI tax ($80) and the denominator is the total 
taxes paid by Z ($120).
    (iii) Under paragraph (a)(8) of this section, a portion of the $50 
tax actually paid by Y on the earnings and profits received from Z is 
FOGEI tax. The amount of tax actually paid by Y that is FOGEI tax 
depends on the amount of the distribution from Z that is FOGEI (see 
Sec.  1.907(c)-2(d)(1) (i) and Example 2 (ii) under Sec.  1.907(c)-
2(d)(8)). This result does not depend upon whether a portion of the 
distribution from Z is described in section 959(b) and it follows even 
though a portion of Y's earnings and profits will be excluded from X's 
gross income under section 959(a)(1) when distributed by Y. Assume that 
$12.50 of the $50 tax actually paid by Y is FOGEI tax.
    (iv) Under paragraph (b)(1) of this section, X is deemed to pay 
$45.83 of FOGEI tax by reason of the distribution from Y. This amount is 
determined by multiplying the total taxes deemed paid by X by reason of 
such distribution ($100) by a fraction. The numerator of the fraction is 
the FOGEI tax paid, and deemed paid, by Y ($45.83, i.e., $33.33 under 
paragraph (ii) of this example plus $12.50 under paragraph (iii) of this 
example). The denominator of the fraction is the total taxes paid, and 
deemed paid, by Y ($100). This $45.83 is FOGEI under Sec.  1.907(c)-
2(d)(5) because it is included in X's gross income as a section 78 
dividend.
    Example 3. (i) X, a domestic corporation, has a concession with 
foreign country Y that gives it the exclusive right to extract and 
export the crude oil and natural gas owned by Y. The concession 
agreement and location of the oil and gas wells mandate that X construct 
a system of pipelines to transport the minerals that are extracted to a 
port where they are loaded onto tankers for export. X owns the 
transportation facilities. Y has an income tax system under which income 
from mineral operations is subject to a 50 percent tax rate. The 
taxation by Y of the mineral operations is a separate tax base under 
paragraph (a)(3) of this section. Under this system, Y imposes the tax 
at the port prior to export and it establishes a posted price of $12 per 
barrel. Y also collects royalties of $1.44 per barrel (i.e., 12 percent 
of this posted price) which is deductible in computing the petroleum 
tax. Y also allows X deductible lifting costs of $.20 per barrel and 
deductible transporting costs of $.80 per barrel. Y does not allow any 
credits against the mineral tax. Assume that X does not have any income 
in Y other than the mineral income. (In 1983, X extracts, transports, 
and exports 10,000,000 barrels of crude oil, but for convenience, all 
computations are in terms of one barrel). X pays foreign taxes of $4.78 
per barrel, computed as follows:

Sales.................................................  .......   $12.00
Royalties.............................................    $1.44  .......
Lifting...............................................      .20  .......
Transporting..........................................      .80  .......
                                                       ---------
                                                           2.44   (2.44)
                                                                --------
Income base...........................................  .......     9.56
Tax rate (percent)....................................  .......      .50
Tax...................................................  .......     4.78
 


Assume that these taxes are creditable taxes under section 901, that the 
fair market value of the oil at the port is $10 per barrel, and that 
under Sec.  1.907(c)-1(b)(6) fair market value in the immediate vicinity 
of the oil wells is $9 per barrel. Thus, at the port, the excess of 
posted price ($12) over fair market value ($10) is $2.

[[Page 918]]

    (ii) The $4.78 foreign tax paid to Y is allocated to FOGEI and FORI 
in accordance with the rules in paragraph (a) (2) through (5) of this 
section.
    (iii) Under paragraph (a)(3) of this section, FOGEI and FORI are 
subject to foreign taxation under one tax base. This foreign tax is 
allocated between FOGEI tax and FORI tax in accordance with paragraph 
(a) (4) and (5) of this section.
    (iv) The modified gross income for FOGEI is $11, i.e., fair market 
value in the immediate vicinity of the well ($9) plus the excess at the 
port of posted price over fair market value ($2). The modified gross 
income for FORI is $1, i.e., value added to the oil beyond the well-head 
which is part of Y's tax base ($10-$9).
    (v) The royalty deductions are all directly attributable to FOGEI.
    (vi) Under paragraph (a)(4) of this section, the income of each 
class is determined as follows:

------------------------------------------------------------------------
                                                        FOGEI     FORI
------------------------------------------------------------------------
Modified gross income...............................    $11.00     $1.00
Deductions:
    Royalties.......................................      1.44         0
    Lifting.........................................       .20         0
    Transporting....................................         0       .80
    Total...........................................      1.64       .80
Net Income..........................................      9.36       .20
------------------------------------------------------------------------

    (vii) Under paragraph (a)(4) of this section, the total tax paid to 
Y is allocated to FOGEI and FORI in proportion to the income in each 
class. The calculation is as follows:

FOGEI tax = $4.78 x $9.36/$9.56 = $4.68
FORI tax = $4.78 x $0.20/$9.56 = $0.10

Thus, for the 10,000,000 barrels, the FOGEI tax is $46,800,000 and the 
FORI tax is $1,000,000.

    (viii) The allocation under paragraph (a)(4) of this section, rather 
than the direct application of stated foreign tax rates to foreign-law 
taxable income in each class of income (which would produce the same 
results in the facts of this example), is necessary when a foreign 
country taxes more than one class of income under a progressive rate 
structure. See Example 4 in this paragraph (e).
    Example 4. Assume the same facts as in Example 3 except that Y's tax 
is imposed at 40 percent for the first $20,000,000 of income and at 60 
percent for all other income. The foreign taxes are allocated under 
paragraph (a)(4) of this section between FOGEI and FORI in the same 
manner as in paragraphs (vi) and (vii) of Example 3, as follows:

(1) Taxable income........................................   $95,600,000
(2) Tax:
    (a) 40% of $20,000,000................................     8,000,000
    (b) 60% of $75,600,000................................    45,360,000
    (c) Total tax.........................................    53,360,000
(3) FOGEI tax (line 2(c) x $9.36/$9.56)...................    52,243,680
(4) FORI tax (line 2(c) x $0.20/$9.56)....................     1,116,320
 

    Example 5. Assume the same facts as in Example 3. Assume further 
that X refines the crude oil into primary products prior to export and Y 
imposes its tax on the basis of crude oil equivalences of $12 per 
barrel, rather than the value of the primary products, to establish port 
prices. Assume that this arrangement is a pricing arrangement described 
in section 907(d). Thus, Y does not tax the refinery income. The results 
are the same as in Example 3 even if $12 per barrel is equal to, more 
than, or less than, the value of the primary products at the port. See 
paragraph (a)(5)(vi) of this section.

[T.D. 8338, 56 FR 11073, Mar. 15, 1991]



Sec.  1.907(d)-1  Disregard of posted prices for purposes of chapter 1 
of the Code (for taxable years beginning after December 31, 1982).

    (a) In general--(1) Scope. Section 907(d) applies if a person has 
FOGEI from the--
    (i) Acquisition (other than from a foreign government) or
    (ii) Disposition of minerals at a posted price that differs from the 
fair market value at the time of the transaction. Also, if a seller 
(other than a foreign government) derives FOGEI upon a disposition 
described in the preceding sentence, section 907(d) applies to the 
acquisition by the purchaser whether or not the purchaser has FOGEI. 
Thus, section 907(d) may apply in determining a person's FORI.
    (2) Initial computation requirement. If section 907(d) applies to 
any person, income on the transaction as initially reflected on the 
person's return shall be computed as if the transaction were effected at 
fair market value. This requirement applies the first time a person has 
taxable income derived from either the transaction or an item (such as a 
dividend described in section 907(c)(3)(A)) determined with reference to 
that income.
    (3) Burden of proof. The taxpayer must be able to demonstrate the 
transaction as it actually occurred and the basis for reporting the 
transaction under the principles of paragraph (a)(2) of this section.
    (4) Related parties. Section 907(d) (as a rule of characterization) 
applies whether or not the parties to the transaction are related. Thus, 
the excess of the posted price over the fair market value

[[Page 919]]

may never be taken into account in determining a person's FOGEI under 
section 907(a) but may be taken into account in determining a person's 
FORI.
    (b) Adjustments. If a taxpayer does not comply with the initial 
requirement of paragraph (a)(2) of this section, adjustments under 
section 907(d) may be made only by the Commissioner in the same manner 
that section 482 is administered. Correlative and similar adjustments 
consistent with the substantive and procedural principles of section 482 
and Sec.  1.482-1(d) apply. However, section 907(d) is not a limitation 
on section 482. If a taxpayer disposing of minerals at a posted price 
does comply with the initial computation requirement of this section, 
adjustments and correlative and similar adjustments consistent with the 
substantive and procedural aspects of section 482 and Sec.  1.482-1(d) 
shall apply, whether made on the return by the taxpayer or on a later 
audit. This paragraph (b) does not apply to an actual sale or exchange 
of minerals made between persons with respect to whom adjustments under 
section 482 would never apply (but see paragraph (a)(4) of this 
section).
    (c) Definitions. For purposes of this section--
    (1) Foreign government. The term foreign government means only the 
integral parts or controlled entities of a foreign sovereign and 
political subdivisions of a foreign country.
    (2) Minerals. The term minerals has the same meaning as in Sec.  
1.907(c)-1(f)(1).
    (3) Posted price. The term posted price means the price set by, or 
at the direction of, a foreign government to calculate income for 
purposes of its tax or at which minerals must be sold.
    (4) Other pricing arrangement. The term other pricing arrangement in 
section 907(d) means a pricing arrangement having the effect of a posted 
price.
    (5) Fair market value. The term fair market value, whether or not at 
the port prior to export, is determined in the same way that the 
wellhead price is determined under Sec.  1.907(c)-1(b)(6).

[T.D. 8338, 56 FR 11075, Mar. 15, 1991]



Sec.  1.907(e)-1  [Reserved]



Sec.  1.907(f)-1  Carryback and carryover of credits disallowed 
by section 907(a) (for amounts carried between taxable years that each 
begin after December 31, 1982).

    (a) In general. If a taxpayer chooses the benefits of section 901, 
any unused FOGEI tax paid or accrued in a taxable year beginning after 
December 31, 1982, may be carried to the taxable years specified in 
section 907(f) under the carryback and carryover principles of this 
section Sec.  1.904-2(b). See section 907(e) and Sec.  1.907(e)-1 for 
transitional rules that apply to unused FOGEI taxes carried back or 
forward between a taxable year beginning before January 1, 1983, and a 
taxable year beginning after December 31, 1982.
    (b) Unused FOGEI tax--(1) In general. The ``unused FOGEI tax'' for 
purposes of this section is the excess of the FOGEI taxes for a taxable 
year (year of origin) over that year's limitation level (as defined in 
Sec.  1.907(a)-1(b)).
    (2) Year of origin. The term ``year of origin'' in the regulations 
under section 904 corresponds to the term ``unused credit year'' under 
section 907(f).
    (c) Tax deemed paid or accrued. The unused FOGEI tax from a year of 
origin that may be deemed paid or accrued under section 907(f) in any 
preceding or succeeding taxable year (``excess limitation year'') may 
not exceed the lesser of--
    (1) The excess extraction limitation for the excess limitation year, 
or
    (2) The excess general section 904 limitation for the excess 
limitation year.
    (d) Excess extraction limitation. Under section 907(f)(2)(A), the 
``excess extraction limitation'' for an excess limitation year is the 
amount by which that year's section 907(a) extraction limitation exceeds 
the sum of--
    (1) The FOGEI taxes paid or accrued, and
    (2) The FOGEI taxes deemed paid or accrued in that year by reason of 
a section 907(f) carryback or carryover from preceding years of origin.
    (e) Excess general section 904 limitation. Under section 
907(f)(2)(B), the ``excess general section 904 limitation'' for an 
excess limitation year is the amount

[[Page 920]]

by which that year's section 904 general limitation exceeds the sum of--
    (1) The general limitation taxes paid or accrued (or deemed to have 
been paid under section 902 or 960) to all foreign countries and 
possessions of the United States during the taxable year,
    (2) The general limitation taxes deemed paid or accrued in such 
taxable year under section 904(c) and which are attributable to taxable 
years preceding the unused credit year, plus
    (3) The FOGEI taxes deemed paid or accrued in that year by reason of 
a section 907(f) carryover (or carryback) from preceding years of 
origin.
    (f) Section 907(f) priority. If a taxable year is a year of origin 
under both section 907(f) and section 904(c), section 907(f) applies 
first. See section 907(f)(3)(A).
    (g) Cross-reference. In computing the carryback and carryover of 
disallowed credits under section 907(f), the principles of Sec.  1.904-2 
(d), (e), and (f) apply.
    (h) Example. The following example illustrates the application of 
section 907(f).

    Example. X, a U.S. corporation organized on January 1, 1983, uses 
the accrual method of accounting and the calendar year as its taxable 
year. X's only income is income which is not subject to a separate tax 
limitation under section 904(d). X's preliminary U.S. tax liability 
indicates an effective rate of 46% for taxable years 1983-1985. X has 
the following foreign tax items for 1983-1985:

------------------------------------------------------------------------
                                            1983       1984       1985
------------------------------------------------------------------------
1. FOGEI...............................    $15,000    $20,000    $10,000
2. FOGEI taxes.........................      7,500      9,200      4,200
3. Other foreign taxable income........      8,000      5,000     10,000
4. Other foreign taxes.................      3,200      2,000      3,000
5. (a) Section 907(a) limitation (.46 x      6,900      9,200      4,600
 Line 1)...............................
  (b) General section 904 limitation        10,580     11,500      9,200
   (.46 x (line 1 plus line 3))........
6. (a) Unused FOGEI taxes (excess of           600          0          0
 line 2 over line 5(a))................
  (b) Unused general limitation taxes            0          0          0
   (excess of line 4 plus lesser of
   line 2 or line 5(a) over line 5(b)).
7. (a) FOGEI taxes from years preceding          0          0          0
 1983 deemed accrued under section
 907(f)................................
  (b) Section 904 general limitation             0          0          0
   taxes from years preceding 1983
   deemed accrued under section 904(c).
8. (a) Excess section 907(a) limitation          0          0        400
 (excess of line 5(a) over sum of line
 2 and line 7(a))......................
  (b) Excess section 904 general               480        300      2,000
   limitation (excess of line 5(b) over
   sum of line 4, lesser of line 2 and
   line 5(a) and line 7(b))............
9. Limit on FOGEI taxes that will be             0          0        400
 deemed accrued under section 907(f)
 (lesser of line 8(a) and line 8(b)....
------------------------------------------------------------------------


X has unused 1983 FOGEI taxes of $600. Since the excess section 907(a) 
limitation for 1984 is zero, the unused FOGEI taxes are carried to 1985. 
Of the $600 carryover, $400 is deemed accrued in 1985 and the balance of 
$200 is carried to following years (but not to a year after 1988). After 
the carryover from 1983 to 1985, the excess section 904 general 
limitation for 1985 (line 8(b)) is reduced by $400 to $1,600 to reflect 
the amount of 1983 FOGEI taxes deemed accrued in 1985 under section 
907(f).

[T.D. 8338, 56 FR 11079, Mar. 15, 1991]

[[Page 921]]



                              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 923]]



                    Table of CFR Titles and Chapters




                      (Revised as of April 1, 2019)

                      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--599)
        VI  National Capital Planning Commission (Parts 600--699)

                    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  Department of Housing and Urban Development (Parts 
                2400--2499)
       XXV  National Science Foundation (Parts 2500--2599)
      XXVI  National Archives and Records Administration (Parts 
                2600--2699)

[[Page 924]]

     XXVII  Small Business Administration (Parts 2700--2799)
    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)

[[Page 925]]

    XXVIII  Department of Justice (Parts 3800--3899)
      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)

[[Page 926]]

     LXXIV  Federal Mine Safety and Health Review Commission 
                (Parts 8400--8499)
     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)
    XCVIII  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 (Parts 10000--10049)
        CI  National Mediation Board (Part 10101)

                      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)

[[Page 927]]

        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)
        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)

[[Page 928]]

                    Title 8--Aliens and Nationality

         I  Department of Homeland Security (Immigration and 
                Naturalization) (Parts 1--499)
         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  (Parts 500--599) [Reserved]
        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)

[[Page 929]]

       XIV  Farm Credit System Insurance Corporation (Parts 1400--
                1499)
        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  National Technical Information Service, Department of 
                Commerce (Parts 1100--1199)

[[Page 930]]

      XIII  East-West Foreign Trade Board (Parts 1300--1399)
       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) [Reserved]

                    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) [Reserved]

                     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)

[[Page 931]]

        IV  Employees' Compensation Appeals Board, Department of 
                Labor (Parts 500--599)
         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)

[[Page 932]]

        II  National Highway Traffic Safety Administration and 
                Federal Highway Administration, Department of 
                Transportation (Parts 1200--1299)
       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)
       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 933]]

                           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--899)
         V  Bureau of Indian Affairs, Department of the Interior, 
                and Indian Health Service, Department of Health 
                and Human Services (Part 900--999)
        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 934]]

        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 935]]

      VIII  Office of Investment Security, 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, Department 
                of Defense (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 936]]

        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  (Parts 1100--1199) [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  National Institute of Standards and Technology, 
                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 937]]

                       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 938]]

       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)
   II--III  [Reserved]
        IV  Centers for Medicare & Medicaid Services, Department 
                of Health and Human Services (Parts 400--699)
         V  Office of Inspector General-Health Care, Department of 
                Health and Human Services (Parts 1000--1099)

                   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)

[[Page 939]]

         V  Foreign Claims Settlement Commission of the United 
                States, Department of Justice (Parts 500--599)
        VI  National Science Foundation (Parts 600--699)
       VII  Commission on Civil Rights (Parts 700--799)
      VIII  Office of Personnel Management (Parts 800--899)
        IX  Denali Commission (Parts 900--999)
         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  Administration for Children and Families, 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 of Fine Arts (Parts 2100--2199)
     XXIII  Arctic Research Commission (Parts 2300--2399)
      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)
         V  The First Responder Network Authority (Parts 500--599)

[[Page 940]]

           Title 48--Federal Acquisition Regulations System

         1  Federal Acquisition Regulation (Parts 1--99)
         2  Defense Acquisition Regulations System, Department of 
                Defense (Parts 200--299)
         3  Department of 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)
        99  Cost Accounting Standards Board, Office of Federal 
                Procurement Policy, Office of Management and 
                Budget (Parts 9900--9999)

[[Page 941]]

                       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 (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 943]]





           Alphabetical List of Agencies Appearing in the CFR




                      (Revised as of April 1, 2019)

                                                  CFR Title, Subtitle or 
                     Agency                               Chapter

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 of                        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 of                          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
Animal and Plant Health Inspection Service        7, III; 9, I

[[Page 944]]

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 of                               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    34, IV
     of
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, XIII
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 of                           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; 37, IV
  National Marine Fisheries Service               50, II, IV
  National Oceanic and Atmospheric                15, IX; 50, II, III, IV, 
       Administration                             VI
  National Technical Information Service          15, XI
  National Telecommunications and Information     15, XXIII; 47, III, IV
       Administration
  National Weather Service                        15, IX
  Patent and Trademark Office, United States      37, I
  Secretary of Commerce, Office of                15, Subtitle A
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
Defense, Department of                            2, XI; 5, XXVI; 32, 
                                                  Subtitle A; 40, VII
  Advanced Research Projects Agency               32, I
  Air Force Department                            32, VII

[[Page 945]]

  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
Denali Commission                                 45, IX
Disability, National Council on                   5, C; 34, XII
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
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 Policy, National Commission for        1, IV
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
  National Drug Control Policy, Office of         2, XXXVI; 21, III
  National Security Council                       32, XXI; 47, 2

[[Page 946]]

  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 of                          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
Forest Service                                    36, II
General Services Administration                   5, LVII; 41, 105

[[Page 947]]

  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, XIII
  Community Services, Office of                   45, X
  Family Assistance, Office of                    45, II
  Federal Acquisition Regulation                  48, 3
  Food and Drug Administration                    21, I
  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
Immigration and Customs Enforcement Bureau        19, IV
Immigration Review, Executive Office for          8, V
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
[[Page 948]]

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 of                           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 of                            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 of                              2, XXIX; 5, XLII
  Employee Benefits Security Administration       29, XXV
  Employees' Compensation Appeals Board           20, IV
  Employment and Training Administration          20, V
  Employment Standards Administration             20, VI
  Federal Acquisition Regulation                  48, 29
  Federal Contract Compliance Programs, Office    41, 60
     of
[[Page 949]]

  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
Libraries and Information Science, National       45, XVII
     Commission on
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, VI
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; 37, IV
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                          5, CI; 29, X
National Oceanic and Atmospheric Administration   15, IX; 50, II, III, IV, 
                                                  VI
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

[[Page 950]]

National Security Council and Office of Science   47, II
     and Technology Policy
National Technical Information Service            15, XI
National Telecommunications and Information       15, XXIII; 47, III, IV, V
     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 of                               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
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
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

[[Page 951]]

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 of                              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
Tennessee Valley Authority                        5, LXIX; 18, XIII
Trade Representative, United States, Office of    15, XX
Transportation, Department of                     2, XII; 5, L
  Commercial Space Transportation                 14, III
  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
  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 of the                       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
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
U.S. Copyright Office                             37, II
Utah Reclamation Mitigation and Conservation      43, III
     Commission
Veterans Affairs, Department of                   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 953]]







                      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
1.25-1T....................................................    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
1.42-5.....................................................    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
1.47-1.....................................................    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
1.50B-4....................................................    1545-0895
1.50B-5....................................................    1545-0895
1.51-1.....................................................    1545-0219

[[Page 954]]

 
                                                               1545-0241
                                                               1545-0244
                                                               1545-0797
1.52-2.....................................................    1545-0219
1.52-3.....................................................    1545-0219
1.56(g)-1..................................................    1545-1233
1.57-5.....................................................    1545-0227
1.58-1.....................................................    1545-0175
1.59-1.....................................................    1545-1903
1.61-2.....................................................    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
1.103A-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
1.132-2....................................................    1545-0771
1.132-5....................................................    1545-0771
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
                                                               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(i)-1.................................................    1545-1331
1.168-5....................................................    1545-0172
1.169-4....................................................    1545-0172

[[Page 955]]

 
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
1.170A-15..................................................    1545-1953
1.170A-16..................................................    1545-1953
1.170A-17..................................................    1545-1953
1.170A-18..................................................    1545-1953
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
1.179-2....................................................    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
1.338(h)(10)-1.............................................    1545-1658
1.338(i)-1.................................................    1545-1990
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

[[Page 956]]

 
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
1.401-14...................................................    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)-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(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
                                                               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
1.453A-1...................................................    1545-0152
                                                               1545-1134
1.453A-3...................................................    1545-0963
1.454-1....................................................    1545-0074
1.455-2....................................................    1545-0152

[[Page 957]]

 
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
1.481-4....................................................    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
1.506-1T...................................................    1545-2268
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
1.561-1....................................................    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
1.585-3....................................................    1545-0123
1.585-8....................................................    1545-1290
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

[[Page 958]]

 
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
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1.812-2....................................................    1545-0128
1.815-6....................................................    1545-0128
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1.819-2....................................................    1545-0128
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1.831-3....................................................    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
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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
1.861-8....................................................    1545-0126
1.861-8(e)(6) and (g)......................................    1545-1224
1.861-9T...................................................    1545-0121
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1.927(a)-1T................................................    1545-0935
1.927(d)-2T................................................    1545-0935
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1.936-10(c)................................................    1545-1138
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1.1033(g)-1................................................    1545-0184
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1.1092(b)-3T...............................................    1545-0644
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1.1244(e)-1................................................    1545-0123
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1.1248(f)-2................................................    1545-2183
1.1248(f)-3T...............................................    1545-2183
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1.1252-2...................................................    1545-0184
1.1254-1(c)(3).............................................    1545-1352
1.1254-4...................................................    1545-1493
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
1.1275-2...................................................    1545-1450
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1.1294-1T..................................................    1545-1002
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1.1311(a)-1................................................    1545-0074
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1.1366-1...................................................    1545-1613
1.1367-1(f)................................................    1545-1139
1.1368-1(f)(2).............................................    1545-1139
1.1368-1(f)(3).............................................    1545-1139
1.1368-1(f)(4).............................................    1545-1139
1.1368-1(g)(2).............................................    1545-1139
1.1374-1A..................................................    1545-0130
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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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1.1502-21T.................................................    1545-2171
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1.1502-77A.................................................    1545-0123
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1.1502-77B.................................................    1545-1699
1.1502-78..................................................    1545-0582
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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
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1.1503(d)-6................................................    1545-1946
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1.1561-3...................................................    1545-0123
1.1563-1...................................................    1545-0123
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1.6013-6...................................................    1545-0074
1.6013-7...................................................    1545-0074
1.6015-5...................................................    1545-1719
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
                                                               1545-0087
                                                               1545-0090
1.6031(a)-1................................................    1545-1583
1.6031(b)-1T...............................................    1545-0099
1.6031(c)-1T...............................................    1545-0099
1.6032-1...................................................    1545-0099
1.6033-2...................................................    1545-0047
                                                               1545-0049
                                                               1545-0052
                                                               1545-0092
                                                               1545-0687
                                                               1545-1150
                                                               1545-2117
1.6033-3...................................................    1545-0052
1.6034-1...................................................    1545-0092
                                                               1545-0094
1.6035-2...................................................    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
                                                               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

[[Page 963]]

 
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-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
1.6425-1...................................................    1545-0170
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
1.6655(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
1.6696-1...................................................    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.305-1...................................................    1545-0110
5c.442-1...................................................    1545-0152
5f.103-1...................................................    1545-0720

[[Page 964]]

 
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
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
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

[[Page 965]]

 
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(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
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
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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
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31.6011(a)-5...............................................    1545-0028
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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
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31.6053-2..................................................    1545-0008
31.6053-3..................................................    1545-0065
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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
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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
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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
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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
44.4401-1..................................................    1545-0235
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
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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
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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
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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
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48.4071-1..................................................    1545-0023
48.4073-1..................................................    1545-0023
48.4073-3..................................................    1545-0023
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48.4081-2..................................................    1545-1270
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48.4081-3..................................................    1545-1270
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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
48.4101-1..................................................    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
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48.4216(c)-1...............................................    1545-0023
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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
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48.4223-1..................................................    1545-0023
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48.6302(c)-1...............................................    1545-0023
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48.6416(a)-1...............................................    1545-0023
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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
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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
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48.6416(f)-1...............................................    1545-0023
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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
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48.6420-2..................................................    1545-0162
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48.6420-3..................................................    1545-0162
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48.6420-4..................................................    1545-0162
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48.6420-5..................................................    1545-0162
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48.6420-6..................................................    1545-0162
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48.6421-0..................................................    1545-0162
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48.6421-1..................................................    1545-0162
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48.6421-2..................................................    1545-0162
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48.6421-3..................................................    1545-0162
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48.6421-4..................................................    1545-0162
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48.6421-5..................................................    1545-0162
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48.6421-6..................................................    1545-0162
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48.6421-7..................................................    1545-0162
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48.6424-0..................................................    1545-0723
48.6424-1..................................................    1545-0723
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
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48.6427-2..................................................    1545-0162
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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
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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
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53.6060-1(a)(1)............................................    1545-1231
53.6065-1..................................................    1545-0052
53.6071-1..................................................    1545-0049
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53.6107-1..................................................    1545-1231
53.6161-1..................................................    1545-0575
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
54.6011-1..................................................    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
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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
301.6034-1.................................................    1545-0092
301.6036-1.................................................    1545-0013
                                                               1545-0773
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
                                                               1545-0367
                                                               1545-0387
                                                               1545-0957
                                                               1545-1461
                                                               1545-2242
301.6109-3.................................................    1545-1564
301.6110-3.................................................    1545-0074
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
301.6222(b)-1..............................................    1545-0790
301.6222(b)-2..............................................    1545-0790
301.6222(b)-3..............................................    1545-0790
301.6223(b)-1..............................................    1545-0790
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
301.6224(c)-1..............................................    1545-0790
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
301.6316-4.................................................    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
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301.6361-2.................................................    1545-0024
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301.6402-3.................................................    1545-0055
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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
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301.6501(d)-1..............................................    1545-0074
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301.6511(d)-1..............................................    1545-0024
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301.6511(d)-2..............................................    1545-0024
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301.6511(d)-3..............................................    1545-0024
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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
301.6903-1.................................................    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
301.7705-1T................................................    1545-2266
301.7705-2T................................................    1545-2266
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
                                                               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
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.govinfo.gov.

[[Page 971]]



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, 2014 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.govinfo.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.govinfo.gov.

                                  2014

26 CFR
                                                                   79 FR
                                                                    Page
Chapter I
1.861-9T (e)(2), (3) and (h)(4) revised; (k) amended; (l) removed 
                                                                   41426
1.861-11 (d)(3) through (6) revised................................41426
1.861-11T (d)(6)(ii) revised; (h) amended; (i) removed.............41426
1.871-14 B, (c)(2), (3)(i), (4) and (e)(1) revised; (c)(1)(i)(B) 
        amended; (i)(3) added......................................12746
    (c)(2) through (3)(i) correctly revised........................37182
1.871-14T Added....................................................12746
    (c)(2)(v) and (vi) correctly added.............................37182

                                  2015

26 CFR
                                                                   80 FR
                                                                    Page
Chapter I
1.851-3 Revised....................................................55245
1.851-5 Revised....................................................55245
1.871-14 (h) and (i) redesignated as (i) and (j); new (h) and 
        (j)(3) added...............................................56879
1.871-15 (d)(1) introductory text, (i) through (iv) and (o) 
        redesignated as (d)(1)(i), (A) through (D) and (r)(2); new 
        (r)(2) heading revised; new (d)(1)(i) and new (r)(2) 
        amended; (a), (b), (c), new (d)(1) introductory text, 
        (ii), (2), (e) through (q), (r)(1) and (3) added...........56879
    (i)(4) Example 1 and Example 2 correctly amended; (r)(1) and 
(3) correctly revised; (r)(4) correctly added......................75946
1.871-15T Added....................................................56885
    (h)(7) Example (iv) correctly amended; (h)(7) Example (viii) 
correctly added....................................................75946

                                  2016

26 CFR
                                                                   81 FR
                                                                    Page
Chapter I
1.856-3 (d) revised................................................59860
1.856-10 Added.....................................................59860
    (g) Example 10 correctly amended...............................68934
1.861-9T (g)(2)(ii)(A)(1) revised; (g)(2)(vi) added................88819
1.884-5 (e)(3)(ii)(A) amended......................................91030

[[Page 972]]

1.897-2 (f)(2)(i), (ii), (h)(2)(v) and (4)(ii) amended; 
        (f)(2)(iii) added...........................................8400
1.897-3 (c) introductory text, (d)(1) and (f)(1) amended............8400
1.901(m)-1T Added..................................................88107
1.901(m)-2T Added..................................................88108
1.901(m)-4T Added..................................................88108
1.901(m)-5T Added..................................................88109
1.901(m)-6T Added..................................................88109

                                  2017

26 CFR
                                                                   82 FR
                                                                    Page
Chapter I
1.871-14 (b), (c)(2) introductory text, (i) through (iv), (3)(i), 
        (4), (e)(1) and (j) revised; (e)(4)(iv) removed.............2055
1.871-14T Removed...................................................2056
1.871-15 (a)(1), (14)(i), (c)(2)(ii), (iv), (g)(2), (3), (h), 
        (i)(3)(ii). (iii), (l)(2), (4), (p)(1), (q), (r)(3) and 
        (4) revised; (a)(14)(ii)(B) amended; (g)(4), (n)(3)(i) and 
        (ii) redesignated as (g)(5), (n)(3)(ii) and (iii); new 
        (g)(4), (i)(1) introductory text, (j)(4), new (n)(3)(i), 
        (p)(4)(iii), (5) and (r)(5) added...........................8155
    (a)(3), (5), (14)(ii)(B), (15), (c)(1) introductory text, (i), 
(ii), (iii), (2)(i), (d)(2)(i), (ii), (e)(1), (2), (i)(1), (2)(i), 
(ii), (iii), (j)(1)(i), (ii) introductory text, (iii) introductory 
text, (l)(1), (7), (m)(2)(ii), (n)(4)(iii), (p)(4)(ii) and (r)(4) 
heading amended.....................................................8160
    (r)(2) removed; (r)(3), (4) and (5) redesignated as (r)(2), 
(3) and (4)........................................................49508
    (a)(14)(ii)(B), (l)(1), (q)(1), (4), (5) and (r)(1) amended....49508
1.871-15T Revised...................................................8161
    (r)(5) redesignated as (r)(4)..................................49509
    (p)(5) and (q) through (r)(4) amended..........................49509

                                  2018

                       (No regulations published)

                                  2019

   (Regulations published from January 1, 2019, through April 1, 2019)

26 CFR
                                                                   84 FR
                                                                    Page
Chapter I
1.851-2 (b)(1) and (b)(2)(i) revised; (b)(2)(iii) and (d) added.....9961
1.861-9T (b)(3)(ii) amended; (b)(3)(ii) redesignated as 
        (b)(3)(ii)(A); new (b)(3)(ii)(A) Example redesignated as 
        (b)(3)(ii)(B)...............................................9236
1.871-1 (a) amended.................................................9236
1.902-3 (g)(2) removed..............................................9236


                                  [all]